What is Economic Entity Assumption?
Definition: The economic entity assumption is an accounting principle that states businesses should be treated as separate economic entities from other companies as well as their owners.
Across the globe, millions of entrepreneurs run great businesses that deal in all manner of activities. These entrepreneurs need to pay taxes and, occasionally, an external party may want to do a valuation of the business. For the valuation to happen, financial records of the business must be available for perusal. Additionally, the financial records must tell an untainted story about the finances of the business. Here is where the economic entity assumption comes in.
This is a general principle that accountants follow whereby they treat the affairs of the business separately from the affairs of the business owner. If the business is a sole proprietorship, it is highly likely that the owner himself/herself keeps all records, including finance-related. However, the economic entity assumption holds that the business owner must not mix his records with those of the business. This assumption is crucial here because it is easy for a sole proprietor to mix up the records.
The principle applies to large companies too. Say, for example, an agribusiness company is involved in operating an orchard as well as a dairy farm. Obviously, these two operations would run as two distinct divisions. Each division earns different sums in revenue and the expenses are unique. Under the economic entity assumption, the financial records of each of the divisions should be kept separately. For example, an expense incurred by the orchard should not appear under the dairy farm.
Why is the Business Entity Principle Important?
Many stakeholders have interests in different businesses. For a sole proprietorship, the government may want to know the nature of the finances for tax purposes.
In this case, the economic entity assumption ensures that the transactions that appear in the financial records of the business are actually those that reflect the operations of the business. The principle facilitates the clarity of the records and makes it easier to audit the records.
Economic Entity Assumption for Sole Proprietorships
Take this example. Quentin owns a bicycle shop that is located a few meters away fromhis parents’ house. He keeps all the records of sales and expenses neatly. The most recent records reads:
- Bought a new stock of 10 bicycles
- Brought in spare parts from the city
- Expanded the shop to accommodate more stock
- Hired an assistant
Sure, all the entries made by Quentin are valid as far as the business is concerned. This is because they are related to the business. As long as the activity is directly related to the business, there is no doubt about it being included in the records.
It would not be okay if Quentin added items like:
- Took one week on vacation in Florida
- Replaced the broken screen to the iPhone
- Rented an apartment to move out of the parents’ home
Well, these are not related to the business in any way. Instead, these are personal expenses probably done with money from the business’ coffers. If Quentin files taxes and captures these items as operational expenses for the bicycle shop, he would be breaking the tax law. Notably, the principle of economic entity prevents business owners from filing the wrong amount to the IRS. That is why it is advisable to keep separate bank accounts; one for the business owner’s personal finances and another one solely for the business.
Economic Entity Assumption for Corporations
Corporations are huge and the owners are separated from the business since incorporation. However, the economic entity assumption still applies especially when the company runs various divisions. Under the assumption, each division or department must keep separate financial records. This makes it easier for auditors to appraise the company in the event of a major development like a takeover or a merger.
If an investor wants to put money in the business, he/she would want to be sure that the asset would recoup the capital. The only way to get the assurance is to peruse through financial records. However, this can be hectic if the records are in a chaotic jumble.