Explanation of the Business Entity Principle

The business entity concept is the idea that the transactions of a business entity and its balances do not include the owner’s personal expenses. This is to keep the accounting organized and to avoid calculation mistakes due to the owner’s personal spending which is not necessary to the functioning of the business, and other accounting complications. It also shows whether or not a business can sustain itself without cash flow from the owner.

Business Entity Principle Video Tutorial With Examples

Separate accounting records are therefore kept for the owners and the business entity. The entity may be structured as a corporation, limited liability company, partnership, or proprietorship, but the concept is the same for all of them. This principle applies even in the case of a sole proprietorship, or a company owned by just one person.

Examples of the Business Entity Concept
Sarah owns an apartment complex and has a debit card attached to the bank account in which she receives her monthly rent. She uses the debit card on a regular basis to purchase food, clothes, cosmetics, and other personal items which are not business expenses. Clothing and food are personal expenses, and as a result the rental unit’s bank account lists several debits that are not related to its business operations. This results in complicated accounting and confusion as to how profitable the apartment complex really is.

Mark is a plumber with a contracting business and he is the sole employee of the company. He uses his savings from his landscaping work to purchase new equipment for the business on a regular basis. He does not document this on his business’s accounting as an owner contribution to the company. If he continues to use his own savings or other sources of income outside of the business to keep it operational, he may not be aware that his plumbing business is not self-sustaining and he is violating the business entity principal.

Reasons for the Business Entity Principal
There are many other reasons why this principal exists. The records of a business cannot be easily audited when there are personal expenses mixed in with business expenses. Investors who are looking to purchase a business will also have confusion as to how profitable the company really is.

If there is a liability issue with the business, it must be proven that the assets of the company are separate from personal assets, if the owner’s assets are to be protected from liability. The liability issues can become very complicated and troublesome for a business owner, and if their personal savings are tied up into a business with the proper documentation.

The business can also become a major source of economic burden on the owner without the owner realizing how much or she is putting into it. It is critical for business owners to carefully document their business’s income and expenditures and document and treat any use of business income for personal purposes as a cash withdrawal to the owner. Likewise, any owner contribution should be considered as an owner deposit.