Economic entity principle – What is the economic entity principle?
The economic entity principle is an accounting principle that states that a business entity’s finances should be keep separate from those of the owner, partners, shareholders, or related businesses.
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An economic, business, or financial entity is any kind of organisation that was established for the purpose of trading or making profit.
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 sometimes also referred to as the business entity concept or the economic entity assumption. It is considered one of the core, fundamental principles of accounting.
Small businesses, sole traders and the economic entity principle
Small businesses and sole traders often experience more difficultly 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. However, as a freelancer, sole trader, or small business owner, you must be sure to follow the economic entity principle and keep your finances separate from those of your business.
For example, most small businesses require some initial investment from the owner, unless they secure enough capital from crowdfunding or a business angel. Any money put into the business by an owner should be recorded as capital investment.
If you make a purchase for your business on a personal credit card at a later date, this amount should also be recorded as capital investment, as this gives a more accurate picture of your company’s financial position and separates your personal and company finances.
Economic entity principle vs. limited liability
Limited liability creates a legal distinction between a business, its owner, and its shareholders. Like the economic entity principle, limited liability separates a business’s finances from the finances of the owners or shareholders; however, there are several key defences between the two concepts.
Firstly, the economic entity principle applies to all businesses, regardless of structure. Limited liability does not apply to certain business structures, such as a sole trader.
Secondly, whereas the economic entity principle is a guideline for accounting standards, limited liability is a form of legal protection. The economic entity principle therefore only separates an owner from their business in terms of financial accounts, whereas limited liability prevents an owner or shareholder being held responsible for a company’s debts or losses.