Brocker.Org: Business entity concept


Business Entity Concept is one of the first and common concepts in financial accounting and it would be usually ask for financial accounting assignments.  The business is treated as a distinct entity from the individuals who own it and accordingly accountants record transactions. For example, if the owner of a shop withdraws Rs. 10,000 for personal use, from the business entity point of view, the entity has less cash though it belongs to the owners. Therefore, this amount is shown as a reduction in owner’s capital, which in view of business entity concept appears as a liability in the balance sheet of the business. Without such a distinction the affairs of the shop will be mixed with the personal affairs of the owner.

For a company the distinction is easier as legally the company is a distinct entity from the persons who own it. Therefore, an entity is a business organization or activity in relation to which accounting reports are compiled. It may include universities, voluntary organizations, and government and non-business units. What we have stated above is just a superficial discussion of the concept, though the central point has been brought out clearly. But we have to go at least a little deeper because out of this basic concept, a large number of very important sub-concepts emerge, dealing with ownership equities, without which we cannot understand properly many of the modern accounting practices. Constrained by the limited scope of Study Notes to deal exhaustively with a particular concept, the discussion that follows in this regard will touch upon the basic outlines of the sub concepts related to the Business Entity Concept.  But before we take up the specific sub-concepts, let us turn to the factors, which compelled the emergence of the basic concept of Business Entity.

There are two ways in which we may look at it. Namely, pure accounting angle and legal viewpoint. Let us consider the pure accounting viewpoint first.

Pure Accounting Viewpoint starts from the fundamental accounting equation, that is:

Debit = Credit (i)

And, Assets=Liabilities (ii)

And, Assets = Internal Liabilities + External Liabilities (iii)

And finally, Assets = Capital + Liabilities; or A = C + L (iv)

The above equation/s epitomises the logic of the double-entry system of bookkeeping. There was internally no difficulty in recording all financial transactions, except the entry for introduction of capital by the owner. The matter was further compounded by the fact that an owner may own a number of business enterprises besides his personal financial affairs.

When the Industrial Revolution became a grand reality nearly 250 years ago, formation of company type of business Organisation became an inevitable event, to raise huge capitals, which are possible only with a large number of co-owners, need to finance production on hitherto unknown scales of production. Prior to the centre-stage appearance of the companies, partnership was the predominant form of doing large-scale business form. But partnership was risky affair for the partners with unlimited liability.