Definition (Economic Entity Assumption) –
The economic entity assumption is an accounting principle that states that all transactional data associated with a specific entity is assumed to be clearly attributed to the entity, and does not include other transactional data associated with the entity’s owners or business partners. Almost any type of organization or unit in society can be an economic entity. Examples of economic entities are hospitals, companies, municipalities, and federal agencies.
The economic entity assumption states that each entity or unit must be separate from all others for accounting purposes.
There are two parts to this assumption, specifically:
- Each business entity’s accounting must be separate from personal accounting
- A business must keep the accounting for each department separate from other departments
The business entity principle allows users of an entity’s financial statements to feel confident that the transactional data is not tainted by the inappropriate mixing of business and personal finances.
The users of the financial statements can reasonably assume that the detailed transactional data that support the financial statements belong to the specific entity, and no other transactions that may be associated with the owner(s) or other affiliates of the business are included.
Economic Entity Principle –
A business entity can take a variety of forms, such as a sole proprietorship, partnership, corporation, or government agency. The business entity that experiences the most trouble with the economic entity principle is the sole proprietorship since the owner routinely mixes business transactions with his own personal transactions.
According to the economic entity principle, all financial transactions must be assigned to a specific business entity, and entities cannot mix their accounting records, bank accounts, assets, or liabilities.
The economic entity principle applies to all financial entities, regardless of structure. The only exception is subsidiaries and their parent companies, which can combine their financial statements through a process called group consolidation.
The economic entity principle is a particular concern when businesses are just being started, for that is when the owners are most likely to commingle their funds with those of the business. A typical outcome is that a trained accountant must be brought in after a business begins to grow, in order to sort through earlier transactions and remove those that should be more appropriately linked to the owners.
Small businesses and sole traders often experience more difficulty with the economic entity principle than other types of companies, as it is common for sole traders to mix personal and business transactions.
This is particularly likely at the start of a new company when owners often use their own bank accounts or credit cards to make purchases for their business.
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