Economic entity assumption
Economic entity assumption - otherwise called an accounting entity. A term used in finance, in accounting. It is the most important principle of four basic assumptions of financial accounting [1].
These assumptions restrict the amount of information and provide the groundwork for accountants in the process of creating and elaborating financial statements [2]. Through acquired information, each entity can be recognized and analyzed in terms of financial situation [3].
According to this assumption, a business and its owner are assumed to be separate entities. Also, any other business unit should be distinct. Such business transactions must always be carried out separately from those conducted by proprietors [4].
Despite the fact that from the legal point of view business entity and its proprietor are treated as a unity, in pursuance of economic entity assumption they are treated separately [5].
Each organization or unit from the public sector (e.g. government unit, municipality) or private sector (e.g. enterprise) can be classified as an economic entity. This principle is also used for companies that run more than one type of activity [6].
Assumptions of financial accounting
Amongst assumptions of financial accounting, 4 types can be distinguished[7]:
- economic entity assumption
- monetary unit assumption
- going concern assumption
- periodicity assumption
Examples of Economic entity assumption
- The economic entity assumption states that the transactions and operations of an entity are separate from those of its owners, creditors, and other entities. This means that the transactions of an entity are recorded and reported independently of the transactions of its owners, creditors, and other entities. An example of this would be a business which is legally separate from its owners. The business' transactions are recorded and reported separately from the transactions of its owners.
- Another example of the economic entity assumption is when a company has multiple divisions that are legally separated. The transactions of each division are recorded and reported separately from the other divisions and from the company as a whole. This helps ensure that the financial information of each division is accurate and up to date.
- A third example of the economic entity assumption is when a company has multiple subsidiaries. Each subsidiary is legally separate from the company, and its transactions are recorded and reported separately from the company's. This helps to maintain accurate financial records for each subsidiary and for the company as a whole.
Advantages of Economic entity assumption
The economic entity assumption is a fundamental principle in accounting that allows for the recording of financial transactions of a single economic entity separately from other economic entities. This assumption has several advantages, including:
- Improved accuracy in financial reporting and improved decision making, as the transactions of a single economic entity are tracked and reported separately from other entities.
- Improved auditability, as transactions can be more easily reviewed and verified.
- Improved control over the entity’s finances, as transactions are tracked and reported separately.
- Improved transparency, as financial reports are more easily understood.
- Improved management of the entity’s financial resources, as transactions can be tracked and reported separately.
Limitations of Economic entity assumption
The economic entity assumption states that a company’s financials can be reported separately from its owners and other entities. However, there are a number of limitations to this assumption. These include:
- Lack of distinction between owner and business transactions: This assumption does not clearly differentiate between the transactions of the owner and the business, since both are recorded in the same financial statements.
- Unrecorded transactions: This assumption does not account for any transactions that may have taken place outside of the business’s books, such as loans taken out by the owner or other entities.
- Misleading financial statements: Since the assumption does not account for any transactions that have taken place outside of the books, the financial statements may not accurately reflect the true financial position of the business.
- Limited information: The economic entity assumption may not provide enough information to make informed decisions, as it does not account for any external transactions that may have taken place.
- Inability to track changes: This assumption does not allow for tracking changes in the financial position of the business over time, as it does not provide any information about transactions that may have taken place outside of the books.
The Economic entity assumption is one of the fundamental concepts in accounting, which states that an organization should be treated as an independent entity from its shareholders and owners. In addition to this assumption, there are several other approaches that can be taken when accounting for a business. These include:
- Accrual basis of accounting which requires that revenue and expenses be recorded when they are earned and incurred, rather than when they are paid or received.
- Going concern assumption which states that the business will continue to operate in the foreseeable future, and that it is not likely to be liquidated or cease trading.
- Materiality assumption which states that transactions and events should be recorded if they have a significant effect on the financial statements.
- Consistency assumption which requires that the same accounting methods and procedures be used from period to period.
- Matching principle which states that expenses should be recorded in the same period as the revenue they generate.
In conclusion, the economic entity assumption is one of the main concepts in accounting, however there are other approaches that should also be taken into consideration when accounting for a business. These include the accrual basis of accounting, the going concern assumption, the materiality assumption, the consistency assumption, and the matching principle.
Footnotes
| Economic entity assumption — recommended articles |
| Closing entries — Abbreviated accounts — Opening entries — Accounting Convention — Closing the accounts — Periodicity concept — Statutory books — Opening balance — Time period concept |
References
- Goyal V.K. (2007), Accountancy for Class XI, Tata McGraw-Hill Publishing Company Limited, New Delhi
- Goyal Ruchi, Goyal V.K. (2012), Financial Accounting for BBA, PHI Learning Private Limited, New Delhi
- Kieso Donald E., Warfield Terry D., Weygandt Jerry J. (2011), Intermediate Accounting: IFRS Edition, John Wiley & Sons, Inc.
- Kimmel Paul D., Kieso Donald E., Weygandt Jerry J. (2010), Financial Accounting, John Wiley & Sons, Inc.
- Pratt Jamie (2011), Financial Accounting in an Economic Context, John Wiley & Sons, Inc.
- Tulsian P.C.,Tulsian S.D. (2005), ICSE Tulsian's Commercial Studies and Applications for Class X, Ratna Sagar P. Ltd
Author: Oksana Szłapowska
