What is the economic entity principle?
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Definition: The economic entity assumption is an accounting principle that states businesses should be treated as separate economic entities from other companies as well as their owners. Across the globe, millions of entrepreneurs run great businesses that deal in all manner of activities. These entrepreneurs need to pay taxes and, occasionally, an external party may want to do a valuation of the
business. For the valuation to happen, financial records of the business must be available for perusal. Additionally, the financial records must tell an untainted story about the finances of the business. Here is where the economic entity assumption comes in. This is a general principle that accountants follow whereby they treat the affairs of the business separately from the affairs of the business owner. If the business is a sole proprietorship, it is highly likely that the owner
himself/herself keeps all records, including finance-related. However, the economic entity assumption holds that the business owner must not mix his records with those of the business. This assumption is crucial here because it is easy for a sole proprietor to mix up the records. The principle applies to large companies too. Say, for example, an agribusiness company is involved in operating an orchard as well as a dairy farm. Obviously, these two operations would run as two distinct
divisions. Each division earns different sums in revenue and the expenses are unique. Under the economic entity assumption, the financial records of each of the divisions should be kept separately. For example, an expense incurred by the orchard should not appear under the dairy farm. Many stakeholders have interests in different businesses. For a sole
proprietorship, the government may want to know the nature of the finances for tax purposes. In this case, the economic entity assumption ensures that the transactions that appear in the financial records of the business are actually those that reflect the operations of the business. The principle facilitates the clarity of the records and makes it easier to audit the records. Take this example. Quentin owns a bicycle shop that is located a few meters away fromhis parents’ house. He keeps all the records of sales and expenses neatly. The most recent records reads: Sure, all the entries made by Quentin are valid as far as the business is concerned. This is
because they are related to the business. As long as the activity is directly related to the business, there is no doubt about it being included in the records. It would not be okay if Quentin added items like: Well, these are not related to the business in any way. Instead, these are personal expenses probably done with
money from the business’ coffers. If Quentin files taxes and captures these items as operational expenses for the bicycle shop, he would be breaking the tax law. Notably, the principle of economic entity prevents business owners from filing the wrong amount to the IRS. That is why it is advisable to keep separate bank accounts; one for the business owner’s personal finances and another one solely for the business. Corporations are huge and the owners are separated from the business since incorporation. However, the economic entity assumption still applies especially when the company runs various divisions. Under the assumption, each division or department must keep separate financial records. This makes it easier for auditors to appraise the company in the event of a major development like a takeover or a merger. If an investor wants to put money in the
business, he/she would want to be sure that the asset would recoup the capital. The only way to get the assurance is to peruse through financial records. However, this can be hectic if the records are in a chaotic jumble. Contents
In accounting, an economic entity is one of the assumptions made in generally accepted accounting principles. 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 the activities of the entity are to be kept separate from the activities of its owner and all other economic entities.[1] See also[edit]
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What is example of economic entity principle?For example, a company might operate two independent businesses. It is expected that the company would present the financial statements of these two entities separately so that the true value of the company can be ascertained.
What does entity mean in economics?An entity is an organization created by one or more individuals to carry out the functions of a business, and that maintains a separate legal existence for tax purposes.
What is the economic entity assumption in accounting?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.
What are the three 3 economic entity?Households, companies and the government are the three basic entities of an economy because they carry out the primary economic activities of manufacturing and consumption in an economic system.
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