What is Economic Entity Assumption? - Cod. #


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The economic entity principle is also known as the business entity assumption, business entity principle, entity assumption, entity principle, and economic entity assumption. One limitation of this assumption is that only quantifiable information are recorded in the accounting books and reflected in the financial statements. In other words, events and transactions that could not be assigned with a monetary value is not recorded in the financial statements. Some examples of these transactions are the improvement in the quality of the products and the efficiency produced after investing in trainings to improve employee skills and knowledge. The company should only report the delivery vehicle in its financial statements. The vehicle used by Ms. C for her personal trips should be accounted as a withdrawal of resources by the owner, thus decreasing her equity in the business.

But how can businesses be compared and evaluated against each other with any level of reliability? That comes from having a common set of accounting principles, assumptions https://accounting-services.net/legal-person/ and concepts that are the same worldwide. Financial statements are normally prepared under the assumption that the company will remain in business indefinitely.

When preparing their financial information, Felix only includes transactions related to FFF and not any personal transactions like the holiday he took to Japan. An Accounting Period is the time frame covered by a company’s financial statements. All financial transactions that occurred within this period undergo an accounting process which results to information reported in the financial statements.

Commissions paid to salespersons for obtaining revenues also is an example of an expense recognized based on this approach. Some revenue-producing activities call for revenue recognition over time, rather than at one particular point in time. For example, revenue recognition could take place during the earnings process for long-term construction contracts. That chapter also describes in more detail the concept of an earnings process and how it relates to performance measurement. Each business entity comes with its own advantages and drawbacks, such as limited liability and increased bureaucracy. When choosing a business entity, the tax regulations, liability, and management terms need to be taken into consideration to find out what works best for your particular business model.

Government should become involved in markets when those markets fail to produce efficient or fair outcomes.d. They try to boil down an economic situation to its most basic elements. Mr. D opened a software start-up business and used the garage of his house as his office.

What is Economic Entity Assumption?

Although Ms. B is the common owner of the two companies, she shouldn’t record the business transactions of both companies into a single set of books or accounting records. The transactions of each company in this case should be accounted separately. The only time that both companies can report their business transactions together into a single set of financial statements is when both companies merge into a single company. The economic entity assumption does not always apply to a legal entity. For instance, a parent corporation and its subsidiaries can issue consolidated financial statements without contradicting the economic entity principle.

  • Information would be difficult to use if, for example, assets were listed as “three machines, two trucks, and a building.” A common denominator is needed to measure all elements.
  • Each unit maintains its own accounting records specific to the business operations.
  • In other words, events and transactions that could not be assigned with a monetary value is not recorded in the financial statements.
  • However, this leads us to another limitation of this assumption which is its applicability only in regions that enjoy low inflation rates.

Something within a business that cannot be accurately and reliably measured (such as the value of Instagram influencers who promote a business’s products) cannot be included in the financial statements. However, if an influencer is given products in exchange for a social media post – the retail value of those products can be used as the value of that transaction when preparing the accounting records. According to the economic entity assumption, a person evaluating a company’s records assumes all the transactions pertaining to the business are being reviewed. A sole proprietor should keep their business transactions separate from their own personal transactions. The assumption is also applicable to businesses with different types of activities. Irrespective of the type of ownership, the economic entity assumption requires that the activities of the business entity must kept separate from those of the owners.

The Purpose of the Time Period Assumption

A corporation is an entity that operates under state law is limited to the scope of activity delineated in its charter or articles of incorporation. Articles of incorporation must be filed with the state to form a corporation. The stakeholders have limited liability and employees of a corporation can enjoy tax-free benefits such as health insurance.


These underlying assumptions enhance the understanding of the financial statements by providing guidelines on how business transactions are recorded. Unfortunately, for most expenses there is no obvious cause-and-effect relationship between a revenue and expense event. In other words, the revenue event does not directly cause expenses to be incurred.

Economic Entity Assumption

Business activity in January generally is quite slow following the very busy Christmas period. We can see from the FedEx financial statements that the company’s fiscal year ends on May 31. The Campbell Soup Company’s fiscal year ends in July; Clorox’s in June; and Monsanto’s in August.


If a company is going out of business, the financials have to disclose that fact. Ordinarily, the assumption is that a business is on-going and therefore assets do not need to be sold at fire‐sale values and debt does not need to be paid off immediately. This principle supports classifying assets and liabilities as short‐term (current) and long‐term.

A single company can also segregate business operations by department if the definition of “entity” is deemed to be within a company. The economic entity assumption also assumes that if an owner owns two or more companies, each company should maintain separate accounting records and financial statements. This also applies to a parent or holding company and its subsidiary. In the case of a sole proprietorship, the law considers the business and the proprietor as a single entity wherein the liabilities of the business may extend to the personal properties of its owner. The proprietor also reports the income of the business in his or her personal income tax return rather than on a separate tax return. However, at the viewpoint of accounting, the owner and the proprietorship business are still considered as two separate entities, with their transactions being accounted for separately.

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The effect of changing prices on financial information generally is discussed elsewhere in your accounting curriculum, often in an advanced accounting course. The economic entity assumption is important for all business entities but it is particularly so for small start-ups where mistakes are often made before proper accounting procedures are established. Although some transactions cannot be expressed in money, they could still have an impact on the performance of the business.

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