Business Entity Assumption Definition & Explanation
You may not think this, especially in comparison with typically bigger entities that incorporate into corporations but, small businesses can also have a rather complicated process for accounting.
Though there are a number of generally accepted accounting principles that aid in structuring accounting procedures to help business owners maintain accurate and clear books, from a legal point of view, it is vital for businesses to adhere to and observe the practice of having a business entity assumption to protect them.
In addition, having a business entity assumption will also clearly portray the financial standing of a company.
Definition of a Business Entity Assumption
A business entity assumption is a term used to refer to an accounting principle that declares the separation of every financial record of the business from any of the financial records of its owners or that of other businesses.
A business entity assumption may sometimes be known as a separate entity assumption or as the economic entity concept.
A business entity assumption works by recording every income that was a result of the company’s business operations as earnings and every expense recorded must only be the costs that the business itself has incurred.
With that said, any personal expenses of any of the business owners involved should not be recorded or passed onto the books of the business.
Strictly adhering to having a business entity assumption to accurately separate and make business transactions distinct from the transactions of its owners permits the precise and correct evaluation of the business to take place for profitability and tax purposes by basing the evaluation on accurately gathered financial data instead of an indistinct mix of business and personal finances.
Business entity assumptions are applicable to all businesses even if a business and its owner are legally viewed as one and the same entity.
Accounting Separation vs. Legal Separation
There are different forms a business can exist in and each of those structures will have its own regulations in taxing and legalities that will be applicable to it.
Several businesses are classified as a pass through entity which allows the business to skip taxation on its income and instead, have its income passed through to its owners who are the ones that are taxed according to the amount of business income they have received in the distribution of profits.
Even if a sole proprietorship is considered as a pass through entity that has accounting separation from its business, from a legal point of view, a sole proprietor and their sole proprietorship is still lawfully considered as one and the same entity.
Every liability of the sole proprietorship business, whether that is legal or financial, also effectively becomes the personal liability of the owner.
Despite the lack of legal separation, a sole proprietor must still maintain and subsequently report their business and personal financial transactions separately.
The requirement of Accurate Record Keeping
It can be seen as a disadvantage to adhere to the business entity assumption in accounting since the owners of the company will need to be diligent and careful with logging accurately detailed financial records – while possessing a particular attentiveness and mindfulness over the recording of the expenditures the business incurs.
Every single business expense must always be kept separate from any of the personal expenses of the business owners.
In order to effectively implement business entity assumption, there have to be policies, systems, courses of actions or procedures established to ensure that the company’s records of accounting reflect nothing but accurate numbers of expenses based off of the percentage and purpose of use.
An example to illustrate this is when a business owner would purchase gas on a personal credit card for a car that the business owner bought for personal use yet, the gas purchased for the personal vehicle was utilized on a business trip.
The owner is then entitled to a reimbursement for the previously mentioned expenses incurred via the standard mileage rate that is permitted by the Internal Revenue Service (IRS).
On the other hand, in the event that the business owner would use a car officially owned by the company and use the credit card for the business to purchase gas while on a vacation that lasts for a week, the expenditures incurred should not be recorded under the expenses of the business and therefore should also not be reflected in the company’s financial records; instead, it should be considered as a personal withdrawal.
The management of multiple businesses or corporate divisions
There is another example of a business entity that would require accounting separation.
When different divisions start existing within a company or when an individual has ownership of more than one business, separate accounting will occur.
When a business grows and develops, the opportunity to expand beyond the current scope of the business’ operations may be present.
In these kinds of cases, the choice to establish a distinct division dedicated to handling the new business opportunity can be something the business owner opts for.
In tracking the operations and the financial health of the new segment of the company, it is recommended to have every income and expense recorded separately from the other already existing segments of the company.
Separate accounting for different records of a company’s different divisions can be done by using “classes” which is a feature that is available within accounting software like that of QuickBooks.
For legal and tax purposes, the separate division will still be classified under the auspices of the parent or the main company; however, accounting separation will allow the owners, accountants or other financial advisers to analyze and evaluate the corporate division’s financial health independently.
In a similar sense, a business owner that runs two or more companies should maintain distinct business entity assumptions for each of their businesses.
Even if the owners of each of those companies are one and the same, the businesses of each could vary drastically whether it comes to its scope or size therefore, every financial transaction is advisable to be recorded separately.
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IRS.gov "Standard Mileage Rates" Page 1 . July 6, 2021
IRS.gov "Deducting Business Expenses" Page 1 . July 6, 2021
FAF - Financial Accounting Foundation "About GAAP (Generally Accepted Accounting Principles)" Page 1 . July 6, 2021