What is the entity concept?

If you are learning accounting for the first time, one of the earlier things you should learn are basic accounting concepts. These are underlying rules which apply to accounting no matter how simple or complex the business or (to the best of my knowledge) the location.

One of these concepts is called the entity concept. In accounting,  financial statements (e.g. income statement, statement of financial position (balance sheet)) need to be prepared for each business entity or group of entities under common control. When we think of large companies this is probably a simple enough concept to grasp.  Companies are by nature separate legal entities too, and costs and revenues for each legal entity are normally easy enough to identify. In large groups, the entities are combined to prepare financial statements for the group as a whole. When we get down to the typical one-man-show type sole trader, things can get a bit blurred. But, the sole trader is probably the best example to explain the entity concept.  For the sole trader, the entity concept would dictate that all business and personal expenses must be separated. Here’s an example. Let’s say a sole trader makes a business trip which means an overnight stay in a hotel. Let’s assume his/her partner comes along. Should any costs associated with the partner be treated as expenses in the sole trader’s accounts? Of course, the answer is no. (But hotel rooms often cost the same for 1 or 2 persons you’re thinking – so make sure your partner’s name does not appear on any bills for the room!). I remember another example from my time in practice. Following a tax audit, the tax inspectors correctly disallowed a repair to a washing machine as a business expense. This would only be an expense in a laundrette or similar business.

So the  key thing to remember about the entity concept is to isolate the business entity and only include costs and revenues associated with that entity. Any personal costs/revenues should not be included.  Costs/revenues of other entities should be excluded in general too (unless you are looking at a group).