Business Entity Concept | Need, Significance and Limitations

What is Business Entity Concept?

Under Business Entity Concept, a business is treated as separate from its owners. Business and owners are two independent entities because business too is considered as an artificial person. If an owner invests money in the business, it will be treated as a liability for the business. However, if the owner takes out some money from the business for personal use, it will be considered drawings. Therefore, the assets and liabilities of a business are the business’s assets and liabilities, not the owner’s. A business’s financial obligations are different from that of the owner.

Geeky Takeaways:

• Businesses and owners are treated as separate entities while recording transactions.
• Assets, liabilities, incomes, expenses, etc. belong to the business and not the owner.
• Books of accounts are prepared from the viewpoint of the business and not the owner.
• The business entity concept applies to partnerships, companies, sole proprietorships, small enterprises, and large enterprises. 

Need for Business Entity Concept

Business Entity Concept is needed for various purposes like as determining the individual financial position of the business, and the comparison between various businesses. This concept is also helpful when it comes to filing taxes, it will be easy and beneficial to file taxes when personal finances are not involved in business finances. Business Entity Concept is also helpful when it comes to dissolving the firm and repayment is to be done among different shareholders, debenture holders, and owners. Owner’s Equity also gets calculated easily when personal finances are not entangled with business finances.

Example of Business Entity Concept

• Assume the owner needs to withdraw ₹50,000 for the construction of his/her own house. Such withdrawal acts will be known as Drawings, and it is not the expense of the business but the owner’s. The transaction must be written as Drawings to show the personal use of fund by the owner.
• If the owner invests money in the business, the amount is considered a loan to the business and is the liability of the firm towards the owner. The business must repay the loan to its owner.

Significance of Business Entity Concept

1. Keeps it simple: Business entity concept prevents the entanglement of personal finances and business finances.

2. Accountability: In case, the owner withdraws any amount from the business for personal use i.e. drawings, he/she will remain accountable and answerable for the use of finances for personal use. He/she will be held responsible for any diversion of funds.

3. Tax benefit: Keeping personal and business finances away from each other gives tax benefits to the owner. At the time of filing tax, the business entity concept prevents disruption of cash flows and profitability.

4. Business Performance: Having separate business records helps the stakeholders in the evaluation of business position only. The company’s financial position is relevant from various perspectives and is relevant for various parties.

5. Comparison: The company’s financial position helps in the comparison of businesses by SWOT (strengths, weaknesses, opportunities, and threats) analysis. SWOT remains helpful for comparison only if it is of business and not a combination of business and personal finances.

Limitations of Business Entity Concept

1. Small businesses: In small businesses, especially sole proprietorships and partnerships, the line between personal and business transactions can be blurred out. The business entity concept may be difficult to apply when personal and business assets are mixed.

2. Limited Scope: The concept of a business entity might not fully account for intangible assets, such as brand value, human capital, and intellectual property, which can be crucial contributors to a company’s value but are not always quantifiable.

3. Consolidation: While consolidation is often necessary for financial reporting, it can lead to challenges when attempting to present a clear financial picture of an individual business entity within a larger group.

4. Owner’s Influence: In cases where a single owner has significant influence/control over the business, financial statements might not provide a complete picture of the entity’s financial health, as certain transactions could be influenced by the owner’s interest.