07 May What is Economic Entity Assumption?
The economic entity assumption is an accounting principle that separates the transactions carried out by a business entity and its owner. It could also apply to various divisions within the same company. Each unit must maintain separate accounting records that specifically pertain to its business operations.
What does economic entity assumption mean?
Many external agencies utilize the financial records maintained by a business unit. Government agencies and lenders may refer to a firm’s accounting records to evaluate its performance. For this reason, it is important that the recorded activities correctly reflect the particulars of the entity that is being reviewed.
According to the economic entity assumption, a person evaluating a firm’s accounting records assumes that all the accounting entries pertain to the business unit that is being reviewed.
A sole proprietorship should maintain separate accounting records for its business activities. These should be distinct from the sole proprietor’s personal transactions.
The economic entity assumption is also applicable to businesses that engage in several different types of activities. Say, a certain company has two business divisions. The first runs a hotel and the other, an auto dealership.
Separate accounting records must be maintained for each division. The expenses pertaining to the hotel division cannot be attributed to the auto dealership. Similarly, each transaction must be recorded in the books of account of the division that it is related to.
Example of economic entity assumption
Karl Fuentes runs a successful web designing business from his home in Denver. He has a number of regular clients and more work than he can handle. The business is structured as a sole proprietorship.
The following transactions appear in the accounting records that Karl maintains for his web designing business:
- Purchase of a computer that is exclusively used for business activities.
- Purchase of web design software.
- Costs associated with his business website.
- Internet costs.
All the transactions listed above are directly associated with the web design business. The accounting records of the sole proprietorship correctly contain details of these transactions.
However, the following expenses cannot be attributed to the business by Karl:
- Travel costs for a holiday to New York.
- The amount that Karl paid for buying a new car for his personal use.
The economic entity assumption states that a business must keep its transactions separate from other businesses and from the personal expenses of the owner.