Entity Concept in Financial Accounting
The entity concept is one of the central tenets of accounting. An
understanding of the same is therefore of paramount importance to
students. However, the entity concept came as a solution to a
problem faced by earlier accountants. To understand the benefits of the
solution provided, we must look at the problem first.
Confusion in Measurement
In reality a business is just another aspect of a person’s life. When
many people get together and start a business, it is their collective
effort. However, this can cause confusion for the accountants. Imagine
accounting for personal and business expenses together. The accountants
would never be able to come to an accurate picture of profits.
Separation of Concerns
To solve this problem, accountants created the entity concept. This
was the separation of personal and professional concerns of the
entrepreneur. For the purpose of accounting, the business is considered
to be an entity which is independent and separate from its entrepreneur.
Legal Status Irrelevant
The separation of concerns in accounting is irrespective of the legal
status of the organization. In real life, some forms of organizations
like private limited and public limited companies are considered to be
separate entities whereas other forms like partnerships and sole
proprietorships are considered to be part of the owner’s entity.
Accounting does not make this distinction.
Implications
The entity concept may seem to be a frivolous and obvious assumption
of accounting. However, the implications that thus assumption creates is
both start and counterintuitive. Here is a look at the implications.
- Capital Appears as Liability: In everyday usage we
consider the word liability with a negative connotation. On the other
hand, we consider capital with a positive connotation. If you ask a
layman whether capital should be considered a liability, they would
surely say “No”. However, that is exactly what needs to be done. In
accounting, capital always appears under the liabilities, when the
balance sheet is prepared. This is because of the entity concept.
The entity concept considers the company separate from its owners.
Thus, capital is money that owners have lent to the company. This is why
it appears on the liabilities side of the company’s financial
statements. If you prepare the owners personal financial statements, the
same capital will appear as his asset.
- Profit Appears as Liability: Profit is nothing but an increase in capital. Therefore keeping in line with the entity concept, profit is also accounted for as a liability.