Entity Concept in Financial Accounting: Meaning & Golden Rules Explained

ENTITY CONCEPT IN FINANCIAL ACCOUNTING

The entity concept is one of the central tenets of accounting. An understanding of the same is therefore of paramount importance to students. However, the entity concept came as a solution to a problem faced by earlier accountants. To understand the benefits of the solution provided, we must look at the problem first.

• CONFUSION IN MEASUREMENT

In reality a business is just another aspect of a person’s life. When many people get together and start a business, it is their collective effort. However, this can cause confusion for the accountants. Imagine accounting for personal and business expenses together. The accountants would never be able to come to an accurate picture of profits.

• SEPARATION OF CONCERNS

To solve this problem, accountants created the entity concept. This was the separation of personal and professional concerns of the entrepreneur. For the purpose of accounting, the business is considered to be an entity which is independent and separate from its entrepreneur.

• LEGAL STATUS IRRELEVANT

The separation of concerns in accounting is irrespective of the legal status of the organization. In real life, some forms of organizations like private limited and public limited companies are considered to be separate entities whereas other forms like partnerships and sole proprietorships are considered to be part of the owner’s entity. Accounting does not make this distinction.

• IMPLICATIONS

The entity concept may seem to be a frivolous and obvious assumption of accounting. However, the implications that thus assumption creates is both start and counterintuitive. Here is a look at the implications.

• Capital Appears as Liability: In everyday usage we consider the word liability with a negative connotation. On the other hand, we consider capital with a positive connotation. If you ask a layman whether capital should be considered a liability, they would surely say “No”. However, that is exactly what needs to be done. In accounting, capital always appears under the liabilities, when the balance sheet is prepared. This is because of the entity concept. The entity concept considers the company separate from its owners. Thus, capital is money that owners have lent to the company. This is why it appears on the liabilities side of the company’s financial statements. If you prepare the owners personal financial statements, the same capital will appear as his asset.
• Profit Appears as Liability: Profit is nothing but an increase in capital. Therefore, keeping in line with the entity concept, profit is also accounted for as a liability. 

DIFFERENT TYPES OF ENTITIES IN A BUSINESS

Businesses may all look the same when you look at the building in which they operate, the employees they hire and the product they sell. However, they can be very different when it comes to their legal structure. The legal structure determines the type of entity they are which in turn determines the rules that will be applied to them. Here is a list of the types of entities and their relevance to accounting.

• SOLE PROPRIETORSHIP

Sole Proprietorship is when there is one owner of the business. The owner does not need to register his firm with the government. The proprietor has unlimited liability. The proprietor can withdraw funds from the organization at will. This is called drawings. The proprietor need not seek anybody’s permission before making such withdrawals.

• PARTNERSHIP

Partnership is when there are multiple owners of a business. The partners may have a equal share of profit or loss or as decided amongst them. Partners in profits only are also legally allowed. The partners too have joint unlimited liability. Their withdrawals from the firm are however controlled. They can withdraw money only to the extent decided in the partnership agreement. If they require more than the above amount, they may be required to attain explicit consent of the other partners.

• HUF

Hindu Undivided Family (HUF) is a type of entity which exists in India only. It has a head of the business called the “karta” who has decision making powers and unlimited liability. In a HUF, the rules for the functioning of the organization are laid down by the “Karta”. These rules include rules on drawings.

• JOINT VENTURE

Joint Venture is when two organizations come together for a specific purpose. It is like a partnership, except for the fact that it is meant to achieve a common purpose after which the parties to the joint venture proceed their own way.

• CORPORATIONS

The most common type of organizations today is corporations. This is because corporations have limited liability. This feature helps their owners separate the ownership and management of the business. There are two types of corporations:

1. Private Limited Corporation: A private limited corporation may not be required to disclose its information to outside parties.
2. Public Limited Corporation: A public limited company solicits money and other resources from the general public and hence results pertaining to its performance must be made public.

Apart from the following there are co-operative organizations, not for profit organizations etc. They too are different types of entities. The type of entity has a profound effect on the accounting system of the organization.

DIFFERENT TYPES OF ACCOUNTS IN A BUSINESS

The entity concept separates the concerns of the owners from the business. An extension of the same concept is the concept of accounts which splits up the business’s affairs further. The account concept becomes clearer once the double entry system of accounting is explained. That is done at a later stage in the tutorial.

• TRANSACTIONS WITHIN THE FIRM

The firm conducts transactions with outside parties and the accounting system is capable of keeping a track of the same. However, there are many transaction that are internal to the firm. For instance, when a company undertakes production, it converts raw material into finished products. This transaction is internal to the firm but has a material effect. If the firm were considered as one unit, it would be impossible to account for the transaction as the same party cannot be on both sides of the transaction.

• ENTITY SPLIT UP INTO ACCOUNTS

An appropriate analogy to draw would be that of the human body. The business is the complete entity i.e. the body. Accounts on the other hand are like lungs, kidneys, heart etc. They are like the vital organs that are constituent parts of the entity. They have their own independent existence. However, it is the relationship between these accounts that is of prime importance. That is why it is called the accounting system.

TYPES OF ACCOUNTS

All accounts within the organization can be split into three types. An account can be of one and only one of the following types and not more. Here are the various types of accounts.

1. Personal: Personal accounts make most intuitive sense. We keep a track of all the transactions that we have undertaken with a particular person in them. We all maintain personal accounts like the money we owe our friends, the grocer and so on.
2. Real: Real accounts are accounts which have been created to account for tangible things. Accounts such as land and building, machinery a/c etc are called real accounts. Although they are not living beings, we still transact with such entities. Records of such transactions are kept in real accounts.
3. Nominal: Nominal accounts are a special category of accounts. While the other accounts can hold balance and carry it forward, nominal account is automatically reset to zero as soon as the time period is over. Their balance is carried forward to other accounts and the books for that period are closed. Examples of such accounts are Profit a/c, depreciation a/c etc. 

DEBITS AND CREDITS IN ACCOUNTS

Debits and credits are the building blocks of the double entry accounting system. Many accounting students find the usage of these words confusing. Many try to understand them by trying to draw an analogy with something they already know like plus and minus. However, debits and credits are distinctly different from plus and minus. Sometimes a debit entry may make an account balance go up whereas other times it will make an account balance go down. Let’s try and understand how this debit and credit system works.

The debit credit system can be understood to be a two layered system. The steps involved in deciding whether an account needs to be debited or credited are as follows:

1. Ascertain the type of account
2. Ascertain the type of transaction

ASCERTAINING THE TYPE OF ACCOUNT

Accounts are of two types the debit and the credit types. Here is how they are distinguished

1. The 4 Classifications: There are four major classifications of accounts in accounting. They are assets, liabilities, income and expenses. Any item can be classified as exactly one of these classifications. However, the same item may be split into two- and be-part asset and part expense and so on.
2. Divide into Two Groups: We could consolidate these 4 categories into 2 categories. Expenses and assets denote outflow of resources from the firm. Income and Liabilities denote inflow of resources to the firm. Thus accounts can be classified as outflow and inflow
• The outflow accounts i.e. expenses and assets have a by default debit balance
• The inflow accounts i.e. income and sales have a by default credit balance

When you debit an account which has a default debit balance, you increase its value. When you credit an account which has a default debit balance, you decrease its value. The same is true for credit accounts as well.

ASCERTAIN THE TYPE OF TRANSACTION

Now you can decide whether to debit or credit an account. Let’s say you have to increase the cash balance. Cash is an asset and therefore has a default debit balance. When you debit it further, you increase its balance. Therefore, you will debit the cash account.

Similarly, you can ascertain whether an item needs to be debited or credited. As a check, you must ensure that the debits in every transaction are equal to the credits. This is like the fundamental principle of accounting.

THE GOLDEN RULES OF ACCOUNTING

1. Debit The Receiver, Credit the Giver

This principle is used in the case of personal accounts. When a person gives something to the organization, it becomes an inflow and therefore the person must be credit in the books of accounts. The converse of this is also true, which is why the receiver needs to be debited.

2. Debit What Comes In, Credit What Goes Out

This principle is applied in case of real accounts. Real accounts involve machinery, land and building etc. They have a debit balance by default. Thus, when you debit what comes in, you are adding to the existing account balance. This is exactly what needs to be done. Similarly, when you credit what goes out, you are reducing the account balance when a tangible asset goes out of the organization.

3. Debit All Expenses and Losses, Credit All Incomes and Gains

This rule is applied when the account in question is a nominal account. The capital of the company is a liability. Therefore, it has a default credit balance. When you credit all incomes and gains, you increase the capital and by debiting expenses and losses, you decrease the capital. This is exactly what needs to be done for the system to stay in balance.

The golden rules of accounting allow anyone to be a bookkeeper. They only need to understand the types of accounts and then diligently apply the rules.