Economic entity principle
/What is the Economic Entity Principle?
The economic entity principle states that the recorded activities of a business entity should be kept separate from the recorded activities of its owner(s) and any other business entities. This means that you must maintain separate accounting records and bank accounts for each entity, and not intermix with them the assets and liabilities of its owners or business partners. Also, you must specifically associate every business transaction with an entity.
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, where an owner routinely mixes business transactions with his or her own personal transactions. This is especially common when entrepreneurs start up operations from their home, paying for their new business with funds from their personal checking account.
It is customary to consider a commonly-owned group of business entities to be a single entity for the purposes of creating consolidated financial statements for the group, so the principle could be considered to apply to the entire group as though it were a single unit.
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.
Terms Similar to the Economic Entity Principle
The economic entity principle is also known as the business entity assumption, business entity principle, entity assumption, entity principle, and economic entity assumption.
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Example of the Economic Entity Principle
Sarah owns a bakery called Sweet Treats LLC. She engages in the following transactions:
Sarah deposits $10,000 of her personal savings into the business's bank account as a capital investment. This is recorded as a contribution to the business, increasing the equity of Sweet Treats LLC. This is a correct handling of the transaction under the economic entity principle.
Sweet Treats LLC generates $50,000 in revenue from selling baked goods. This revenue is considered the bakery's income, not Sarah's personal income. This is a correct handling of the transaction under the economic entity principle.
Sarah uses the business bank account to pay for personal expenses, like her home electricity bill or personal vacations, without recording it as a withdrawal or loan. This blurs the distinction between the business's financial records and her personal finances, which violates the economic entity principle.
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