The economic entity assumption is one of the fundamental underlying assumptions used in accounting when preparing financial statements.
The assumption is sometimes referred to as the business entity assumption and simply means that the business entity exists separate from its owners.
What is a Business Entity?
A business entity or accounting entity can take many forms including a sole proprietor, partnership, limited liability company, or group of companies.
Each type of business entity will have owners. In the case of a sole proprietor an individual owns the business, a partnership will have a number of individuals who are partners each owning a percentage of the business, a company will have stockholders who might be individuals or other businesses, which own shares representing their ownership.
Irrespective of the type of ownership, the economic entity assumption requires that the activities of the business entity must kept separate from those of the owners. The business must keep accounting records which only include accounting transactions relating to that business and exclude transactions relating to the owners.
Economic Entity Assumption Example
The economic entity concept means that the business should maintain separate bank accounts, and clearly identify its assets and liabilities from those of its owners.
For example, in the case of a sole proprietor, if the owner pays cash into the business, then the business must record the cash coming into its bank account as an asset and likewise record the amount owed to the owner as capital (equity).
This transaction is more fully discussed in our capital introduction example.
Note: The owner in turn might make their own accounting record showing the cash leaving their bank account and recording their investment in the business. Since this is not a transaction of the business, the economic entity assumption stipulates that this transaction must be kept separate from the business entities accounting records.
The economic entity assumption is important for all business entities but it is particularly so for small start-ups where mistakes are often made before proper accounting procedures are established.
For example, if the owner of a business purchases a motor vehicle for private use, then this is not as asset of the business and must not be recorded as such in its accounting records. However, if the owner purchases a vehicle for the business, then this is an asset of the business and needs to be recorded irrespective of how the vehicle was paid for.