Accountancy · Ch 2 — Theory Base of Accounting
Business Entity Concept
Business Entity Concept
The Business Entity Concept is the foundation on which the entire structure of accounting is built. It is the first and most important assumption you must make before recording any transaction.
This concept states that for accounting purposes, the business is a completely separate and distinct entity from its owner. The owner is one person, and the business is another. They are not the same, even if the business is a sole proprietorship where the owner and the business are legally one and the same.
Why does accounting make this assumption? Because accounting records must show the financial position of the business alone. If the owner’s personal assets and liabilities were mixed with the business’s, you could never tell how the business itself was performing. The business is treated as an artificial person that owns assets, owes liabilities, earns revenue, and incurs expenses.
The Accounting Treatment of Capital
The most direct application of this concept is how we treat the money the owner brings into the business. When a person starts a business and invests ₹1,00,000 as capital, the business does not see this as its own money. From the business’s point of view, it has received ₹1,00,000 from an outsider — the owner. The business now owes this amount back to the owner. Therefore, Capital is recorded as a liability of the business to the owner.
The journal entry is:
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| Cash A/c | Dr. | 1,00,000 | ||
| To Capital A/c | 1,00,000 | |||
| (Being capital brought in by the owner) |
Here, the business is receiving cash (an asset) from one entity (the owner), and it is creating a liability (Capital) to that same entity. The business and the owner are treated as two separate parties exchanging money.
The Accounting Treatment of Drawings
When the owner withdraws money from the business for personal use (say, ₹10,000 for household expenses), this is called Drawings. Under the Business Entity Concept, this is a repayment of the business’s liability to the owner. The business is giving money back to the owner, which reduces the amount it owes him. Consequently, the owner’s capital (the liability) decreases.
The journal entry is:
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| Drawings A/c | Dr. | 10,000 | ||
| To Cash A/c | 10,000 | |||
| (Being cash withdrawn by the owner for personal use) |
At the end of the accounting period, the Drawings account is closed by transferring its balance to the Capital account, thereby reducing the capital.
The Drawings account is a contra-equity account (or contra-capital account). It reduces the owner’s capital. It is not an expense of the business.
What This Concept Means for Recording Transactions
Because the business is a separate entity, the accounting records are always kept from the point of view of the business, not the owner. This leads to two critical rules:
- Personal assets and liabilities of the owner are ignored. If the owner owns a personal house or has a personal car loan, these are never recorded in the books of the business. Only the assets and liabilities of the business itself are recorded.
- Personal transactions of the owner are not recorded. If the owner buys a television for his home using his personal bank account, this transaction has nothing to do with the business. It is not recorded. A transaction is recorded in the business books only if it involves an inflow or outflow of business funds. …