What is an Entity Concept?

The entity concept is a principle of accounting which allows a business to be treated separately from its owners for accounting purposes. As such, the financial activities of the individuals, either private owners or shareholders, who own the business are independent from the business itself. Under the entity concept, the business itself makes all of its own transactions, amassing profits and losses, and is taxed accordingly on those results. This concept applies to all types of companies, from those owned by multiple individuals, like partnerships or corporations, to those owned by single individuals, who are known as sole traders.

It is common to think of a large corporation as having an existence all its own. Some of the most well-known companies in the business world have taken on their own identities over time, through their marketing strategies and their interactions with the public. For accounting purposes, that perception of companies turns out to be relatively accurate, since they are usually treated as if they were a living thing separate from their owners. This is known as the entity concept, the overarching accounting principle which determines how businesses are taxed.

When considering the entity concept, it is important to understand that some common business terms are judged differently depending on the context in which they are viewed. For example, profit is something that every business wishes to achieve in abundance. Yet, in terms of the business as an entity, profit is actually something which is owed by the business to the owners.

Building upon that notion, the entity concept that governs business accounting stipulates that a business must be taxed according to its own actions. These actions must be held separately from the owners, which can be numerous in the case of corporations or partnerships. If the owners of the business start using business funds for their own purposes, they must report these actions. Failure to do so is in essence a form of tax fraud.

For individuals who are the lone owners of companies, the entity concept holds different ramifications. In such cases, it is crucial to separate the money put into the business from the owner's own personal funds from the capital earned by the business from sales and other income streams. By the same token, money taken out of the business must be recorded as drawings by the owner. These distinctions are important to the tax implications on businesses owned by so-called sole traders.