The separate entity concept states that we should always separately record the transactions of a business and its owners. Otherwise, there is a considerable risk that the transactions of the two will become intermingled. For example:
- An owner cannot remove funds from a business without recording it as either a loan, compensation, or an equity distribution. Otherwise, the owner may buy something (such as real estate) and leave it on the books of the business, when in fact the owner is treating it as a personal possession.
- An owner cannot extend funds to a business without recording it as either a loan or a stock purchase. Otherwise, undocumented cash appears in the business.
- An owner is the sole investor in a building, and arranges to have his business operate from that building in exchange for a monthly rent payment. The business should report this payment as an expense, and the owner should report it as taxable income.
The separate entity concept is useful for determining the true profitability and financial position of a business. It should also be applied to the operating divisions of a business, so that we can separately determine the same information for each division. The concept is more difficult to apply at the division level, for there is a temptation to allocate corporate expenses to each of the subsidiaries; this makes it more difficult to ascertain profitability and financial position at the operating unit level.
Once the policies and procedures for the accounting for a separate entity have been stated, they should be followed consistently; otherwise, there will continue to be a gray area in regard to transactions belonging to the owners or the separate entity.
The separate entity concept is also useful in case there is a legal judgment against a business, since the owner does not want to have personal assets intermingled with those of the business, and therefore subject to forfeiture.