Many concepts explain how companies should account for and present information to users of financial statements. In this lesson, you will learn about the economic entity assumption.
What Is the Economic Entity Assumption?
Jake started a business last year. He is preparing financial information for his first year-end. His accountant made some changes to his financial statements and told him that he needs to follow the economic entity assumption. Jake is not sure what this means or how it applies to his financial statements. Let’s see if we can help Jake with this problem.
One of the goals of financial reporting is to ensure that it conveys useful information to those individuals who rely upon it to make financial decisions . Readers want to receive enough information about the business to allow them to make informed decisions about it. The economic entity assumption helps readers achieve this objective. The economic entity assumption states that each entity or unit must be separate from all others for accounting purposes.
There are two parts to this assumption, specifically:
- Each business entity’s accounting must be separate from personal accounting
- A business must keep the accounting for each department separate from other departments
Let’s examine each of these parts in more detail.
Business Entity’s Accounting Separate from Personal Accounting
A user wants to evaluate how well a business is doing based on the financial information the company provides. For example, a reader wants to evaluate a company’s net income or the difference between the amount the company earned from selling its products and services, and the amount the company spent to earn it. A reader would also want to evaluate how many assets or economic resources the company owns as well as its liabilities or the amount of money it owes to others.
The economic entity assumption states that a business must only present information that relates to the events that occur in the business. Let’s assume that Jake prepared his financial information and included some of his personal assets such as his personal residence and his cottage on his financial statements. These assets have nothing to do with his business and he will not use them to earn any money for the company, so he should not include them on the financial statements. Including these assets would show readers that his business has more assets than it really does.
Keeping Accounting for Each Department Separate
The economic entity states that a company must keep the accounting for each department separate from other departments. This separation allows a user of the financial information to accurately evaluate the performance of each individual department.
Let’s return to Jake. His business has two departments, an adult fiction department and a children’s book department. Jake must keep the accounting for each department separate so that he and other users of the financial information can determine how much money each department earned, and whether each department met its goals for the period. Reporting on each department separately also allows Jake to identify areas where a department underperformed and make changes where necessary.
Let’s assume that department information showed that the adult fiction department of Jake’s store met its sales targets, but the children’s book department did not. Jake will want to investigate why the children’s department did not meet its goals so that he can implement changes, such as creating a brightly-colored seating area for parents and children to explore books before purchasing them or hosting events to showcase particular children’s authors.
The economic entity assumption states that a company must account for financial information for each entity or unit separately from all others. Specifically, a company must keep the accounting for its business separate from personal accounting, and it must keep the accounting for each department separate from other departments.
Separating business activity from personal activity helps a reader evaluate the amount of assets or economic resources a company owns and identifies the amount that it owes to others which is known as its liabilities. Reporting on the financial results of each department separately helps a reader determine how much of a company’s net income, or the difference between the amount the company earned from selling its goods and services and the amount the company spent to earn it, came from each department.