Business Entity Concept in Accounting Explanation and Examples

Fri, 01/23/2015 - 22:51 -- Umar Farooq


The business entity concept means that business is separate entity apart from its owners. The accounting records are maintained for the business entity. It is important in order to evaluate the performance of the business. A business entity may have many accounting entities in it.

Definition of Business Entity Concept

An accounting entity is an individual or organization or a section of an organization that stands apart from other organizations and individuals as a separate economic unit. From an accounting perspective, there are strict boundaries around each entity, it will help to evaluate periodically and economic decisions made accordingly. An entity is assumed to own its assets and incur liabilities.

Following are the examples of entity concept in accounting

  • If a company issues $2,000.00 to its owners. It means reduction in equity and increase in the taxable income of owner.
  • For example, if owner loans a $1,000 to business. This will be recorded as liability and payable to the owner.
  • Suppose, the owner purchases a vehicle and rents to company for $1,500 a month, this is a valid transaction in company records and taxable income to the owner.

The Reliability (or Objectivity) Principle

The primary objective of financial reporting is to provide information useful for making investments and lending decisions. To be useful, this information must be rele­vant, reliable and comparable. Accountants strive to meet these goals in the informa­tion they produce. Accounting records and statements must be based on the most re­liable data available so that they are as accurate and useful as possible. This guideline is the reliability principle, also called the objectivity principle. Reliable data are veri­fiable and any independent observer may confirm them.

The Cost Principle

The cost principle states that acquired assets and services should be recorded at their exchange price (called historical cost) agreed by the parties. The purchaser may be­lieve the price paid is a bargain, but the item is to be recorded at the actual price in the transaction and not at the 'expected' cost. The actual price is measured by the cash paid or to be paid, if exchange is on credit. In accounting, transactions are recorded on objective evidence and not on subjective estimates. The objective evidence could only be for actual price.

The Going Concern Assumption

Another reason for measuring assets at historical cost is the going-concern concept. It means that an entity is supposed to remain in operation for the foreseeable future. The economic resources are acquired by the business for use and not for resale. The accountants assume that the business will remain in operation, long enough to use existing assets for their intended purpose. The market value of an asset the price for which the asset can be sold may change during the asset's life, therefore, an asset's current market value may not be relevant for decision-making. Moreover, historical cost is a more reliable accounting measure for assets than is market value.

It is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared one a different basis and, if so, the basis used is disclosed.

The Stable Currency Assumption

Accountants assume that the money's purchasing power is relatively stable and this concept is the basis for ignoring the effect of inflation in the accounting records. It allows accountants to add and subtract rupee amounts as though each rupee has the same purchasing power as any other rupee at any other time.

When inflation rates are high, serious doubts are raised about the reliability of finan­cial statements prepared under this assumption. In the UK, after a long debate, an experiment of preparing financial statements at current cost was made. However, it could not continue and accountants again reverted to historical cost.

Ethics the Most Fundamental Principle of Accounting

Though not mentioned by IAS, a universally accepted fundamental concept and one which is all the more important for Muslims is the concept of ethics. Every society has divided overall human behaviour into two segments good behaviour and bad behaviour. The term 'ethics' means the principles of conduct. Ethical behaviour is behaviour that is acceptable by the society and unethical behaviour is not approved the general norms of the society. An unethical action may be within the limits of law yet recognized as ethically wrong. Some actions are not clearly right or wrong hut are ethically questionable.