The business entity concept states that the transactions associated with a business must be separately recorded from those of its owners or other businesses. Doing so requires the use of separate accounting records for the organization that completely exclude the assets and liabilities of any other entity or the owner. Without this concept, the records of multiple entities would be intermingled, making it quite difficult to discern the financial or taxable results of a single business. Here are several examples of the business entity concept:
- A business issues a $1,000 distribution to its sole shareholder. This is a reduction in equity in the records of the business, and $1,000 of taxable income to the shareholder.
- The owner of a company personally acquires an office building, and rents space in it to his company at $5,000 per month. This rent expenditure is a valid expense to the company, and is taxable income to the owner.
- The owner of a business loans $100,000 to his company. This is recorded by the company as a liability, and by the owner as a loan receivable.
There are a number of reasons for the business entity concept, including:
- Each business entity is taxed separately
- It is needed to calculate the financial performance and financial position of an entity
- It is needed when an organization is liquidated, to determine the amounts of payouts to the various owners
- It is needed from a liability perspective, to ascertain the assets available in the event of a legal judgment against a business entity
- It is not possible to audit the records of a business if the records have been combined with those of other entities and/or individuals