In accounting, an economic entity has its own individuality and is considered a separate entity from its owners. It means that personal transactions of owners should not be mixed with those of the economic entity. Separate books of account of the economic entity should be maintained and only the business transactions that pertain to the entity’s business should be recorded in the entity’s books.
In corporations, personal activities of the owners are relatively distinct from the entity’s business, however, in the case of sole proprietorships, it is often observed that personal transactions of the owners can easily be mixed with those of the business. Accountants should pay special attention to maintain this distinction and record only those transactions in the books of the business which are purely related to the business. For instance, owner of a business pays the utility bill of his house out of the business bank account. This should not be recorded as expense as it is not a business expense. It should be treated as funds withdrawn by the owner and should be recorded in drawings account. Similarly, if there are any common expenses between owner and the business, such expenses should be allocated on some reasonable basis and charged accordingly. For instance, a sole proprietorship has its office in his home, with one floor used for personal needs and the other for official use. In such a case, rent of this house should be apportioned and 50% of the rent should be charged as expense in the books of business.
Economic entity concept has several advantages including the following:
- It results in accurate financial reporting, presenting financial information that is purely related to the business.
- It avoids mixing of personal transactions of owners with business transactions, thus enabling effective analysis of financial position and performance possible.
- Taxation laws usually follow this economic entity concept as well, as corporate tax rates may differ from non-corporate tax.