ECONOMIC ENTITY: CHARACTERISTICS, TYPES AND EXAMPLES - ECONOMY - 2025

An economic entity is one of the assumptions made in generally accepted accounting principles. It establishes that the activities of the entity must be kept separate from the activities of its owner and from all other economic entities.

This means that separate accounting records and bank accounts should be kept for each entity, and the assets and liabilities of their owners or business partners should not be mixed with them. In addition, each business transaction must be associated with an entity.

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Almost any type of organization in society can be an economic entity. Examples are: hospitals, businesses, and government agencies.

The economic entity principle is of particular concern when businesses are just starting out, as this is when owners are most likely to mix their funds with those of the business.

A common result is that a trained accountant must be hired after the business begins to grow, so that previous transactions can be sorted out and those that should be more related to owners can be eliminated.

characteristics

According to the principle of economic entity, all financial transactions must be assigned to a specific business entity, and entities cannot combine their accounting records, bank accounts, assets or liabilities. It is considered one of the fundamental accounting principles.

An economic, commercial or financial entity is any type of organization that was established for the purpose of making a profit.

The principle of economic entity applies to all economic entities, regardless of their structure.

The only exception are subsidiaries and their parent company, which can combine their financial statements through a process called group consolidation.

Small companies

Most small businesses require an initial investment from the owner, unless they raise sufficient capital from other forms of financing. Any money an owner puts into the business must be recorded as a capital investment.

If a purchase is subsequently made for the business with a personal credit card, this amount should also be recorded as a capital investment, as it provides a more accurate picture of the financial situation of the business, separating it from personal finances.

A sole proprietor must keep separate accounting records for business activities. They must be different from the owner's personal transactions.

Principle of economic entity vs. limited liability

Like the principle of economic entity, limited liability separates the finances of a company from the finances of the owners. However, there are several differences between the two concepts.

In the first place, the principle of economic entity applies to all companies, regardless of their structure. Limited liability does not apply to certain business structures, such as a sole proprietorship.

Second, while the economic entity principle is a guide to accounting standards, limited liability is a form of legal protection.

Therefore, the principle of economic entity only separates an owner from his business in terms of financial accounts, while limited liability prevents an owner or shareholder from being liable for the debts or losses of a company.

Types

Unique property

It is a business operated by a single person, who is the owner. It can be any type of business, such as a nail salon or a small convenience store.

For tax and liability purposes, in this type of entity the business owner is personally responsible for everything, including expenses, profits, losses and government regulations, etc.

Society

It is a business owned by two or more people, who work together. Usually, two or more friends, family members, or acquaintances have an idea, their own money, and decide to start the business.

Usually, they also define how they would share responsibilities and how they would address those problems that they can already foresee.

Business partners should put as many topics in writing as possible, such as:

- Original financial contribution of each person.

- Role of each person.

- Benefits or earnings of each person.

- What to do when a member does not fulfill their responsibilities.

- What to do if a member retires or dies.

Corporation

It is a small, medium or large company that is registered, with many legal ramifications. The entities that own the shares, called shareholders, do not have personal responsibilities to the company, or they have limited liability to the company.

If the company is successful, the shareholders make money. If the company is failing, shareholders may lose money, but their personal assets, such as houses or cars, would not be confiscated.

Government agency

It is a permanent organization in the government machinery, responsible for managing specific functions, such as an intelligence agency. The functions of an agency are normally executive in nature.

They can be established by legislation or by executive powers. The autonomy and responsibility of government agencies vary widely.

Examples

Example 1

Alexander owns his own bike shop. The shop not only sells various models of bicycles, but also performs a variety of services to ensure that bicycles purchased by customers are kept in excellent condition.

Alexander not only enjoys running his bike shop, he also loves riding his bike around town. When his home is visited, everyone enjoys admiring the incredible collection of bicycles he owns.

One day, a customer who receives service for his bicycle at the shop hears about a classic bicycle that Alexander personally owns.

He approaches Alexander with an offer to buy him the bike. Alexander negotiates and sells the classic bicycle to the customer for $ 5,000.

The classic bike, Alexander's personal property, was never part of the bike shop's inventory, and therefore the sale of $ 5,000 should never improperly inflate the bike shop's sales records. Personal and business finances should always be separate.

Example 2

Karl runs a web design business from his home. He has several regulars and a lot of work. The business is structured as a sole proprietorship.

The following transactions appear in the accounting records that Karl maintains for his web design business:

- Purchase of a computer, used exclusively for commercial activities.

- Purchase of web design software.

- Costs associated with your business website.

- Internet costs.

All of these transactions are directly associated with the web design business. The sole proprietorship accounting records correctly contain the details of these transactions. However, Karl will not be able to attribute the following expenses to the business:

- Travel expenses for vacations in New York.

- Purchase of a new car for your personal use.

References

1. Wikipedia, the free encyclopedia (2018). Economic entity. Taken from: en.wikipedia.org.
2. Steven Bragg (2018). Economic entity principle. Accounting Tools. Taken from: accountingtools.com.
3. Debitoor (2018). Economic entity principle - What is the economic entity principle? Taken from: debitoor.com.
4. Crush the CPA Exam (2018). Economic Entity Assumption. Taken from: crushthecpaexam.com.
5. My Accounting Course. What is the Economic Entity Assumption? Taken from: myaccountingcourse.com.
6. Functionx (2018). Economic Entities. Taken from: functionx.com.