Accounting principles: Business entity concept
One of the fundamental concepts of accounting is that the activity of a business is separate from the personal activities of the owner(s) and employees. This is the business entity concept or separate entity concept, which applies to all organizations – regardless of their legal statuses. This means that any personal transactions and activities of the owner that involves the business would be recorded accordingly.
The business entity concept is utilized in the accounting equation Assets = Capital + Liabilities. Capital is what the business owes to the owner – the owner’s financial input. Liabilities are what the business owes to other parties.
Any reduction in capital reduces the assets of the business and is known as drawings. Any injection of capital or assets by the owner would be regarded as capital. Notice that this allows double-entry accounting with transactions undertaken by the owner; as capital increases, assets increase and as capital decreases, assets decrease.
One way that the business entity concept relates to the preparation of financial statements is the treatment of profit. Profit is a good thing for the business, but it is viewed as a liability when determining the financial position of a business; profit is a business’ obligation to the owner(s).
Even with a sole trader, personal bankruptcy of the owner would not necessarily affect the business. However, if a sole trader’s business becomes insolvent, his personal assets may be liquidated to meet obligations. All of this is made possible through the separate entity concept.