Definition: The economic entity assumption is an accounting principle that states that all transactional data associated with a specific entity is assumed to be clearly attributed to the entity, and does not include other transactional data associated with the entity’s owners or business partners. While this assumption applies to all varieties of businesses, it most notably applies to sole proprietorships, for which the transactional records are maintained by the entity’s owners.
What Does Economic Entity Assumption Mean?
What is the definition of economic entity assumption? Simply put, the business entity principle allows users of an entity’s financial statements to feel confident that the transactional data is not tainted by the inappropriate mixing of business and personal finances.
The users of the financial statements can reasonably assume that the detailed transactional data that supports the financial statements belong to the specific entity, and no other transactions that may be associated with the owner(s) or other affiliates of the business are included.
Let’s taka quick look at an example.
Let’s say your friend owns his own bicycle shop. The shop not only sells bicycles and maintains inventory of various bicycle models, but it also performs a variety of services to ensure all bicycles purchased by its customers stay in great shape. Your friend has a successful business selling and working on bicycles, and he’s extremely passionate about the success of his business.
Not only does your friend enjoy operating his bicycle shop, but he also loves to ride his own bicycles around town. When you visit him at his home, he has a beautiful collection of bicycles that he himself owns, and everyone takes great joy in admiring his amazing collection.
One day, an older gentleman getting his bicycle serviced at the shop, hears about a classic bicycle that your friend personally owns. He approaches your friend with an offer to purchase the bicycle from him. Your friend agrees, and he sells the man the classic bicycle for $5,000. The question is, where should your friend recognize the $5,000 transaction?
Since the transaction was personal, the $5,000 should never impact the financial records of the bicycle shop. The classic bicycle, owned personally by your friend, was never part of the bicycle shop’s inventory, and therefore the $5,000 sale should never inappropriately inflate the sales records of the bicycle shop’s profit & loss statement. Personal and business finances should always be separated.
Define Economic Entity Assumption: Business entity concept means that the company and its owners are separate entities and should be recorded as separate in the financial records.