Separate Entity Principle

Here we are going to cover the idea of the business being a separate entity.  This principle states that the owner of the business and the business itself are completely separate.  The personal finances and affairs of the owners of a business must be kept out of the financial records.  This allows people to ensure that the records of the business accurately reflect the performance of the business.

Any money which is paid into a business by the owner is called the initial capital.  This is accounted for as an amount that is owed back the owner as some point.  This is the owners investment in the business.  Also, if the owner takes any money from the business is treated as a repayment of the investment that is owed to the owner.  These amounts that are taken from the business are called ‘drawings’.

In terms of the bookkeeping of the business we only look at it from the business point of view.  This is because when studying bookkeeping we are only looking at the business, we do not consider the owners personal finances.

Following of from before, the dual effect principle is still here.  When investment is made into the business one effect is that the business has money, the other is that it owes money to the owner.

Many owners of small businesses fail to see this “line” drawn between the business and the owners. The direct consequence is the recording of personal expenditure in the books of the business entity.  This is how we can lead to the records of the business not being a true reflection of the performance of the business.

The movement of money in and out of the business by the owner, as well as the profits of the business, are tracked through the owners ‘capital account’.  The balance on the capital account at an given time will equate to the amount of either investment, or profit, which has not been withdrawn from the business by the owner.

Owners Capital account

  • At the start of the business John puts £5,000 of initial capital into the business
  • During the year the business makes £20,000 of profit
  • During the year John takes £14,000 of cash from the business

At the end of the period the amount in the owners capital account is as follows:

Investment made                              5,000

Profits earned                                     20,000

Cash taken                                            -14,000

Amount owed to owner                  9,000

The example above assumes that the owner had kept the records of the business ‘clean’. This means they had not paid any personal expenses out of the business accounts.

If when the year-end procedures were being carried out we found that the owner had paid £1,000 for new tv for their home from the business bank account, what effect would that have.  What would then happen is that there would be another figure entered in the calculation above.  We treat items paid for private expense exactly the same as cash taken from the business, and deduct if from the owners capital account.

This would mean we would adjust the calculation as follows:

Investment made                                5,000

Profits earned                                        20,000

Cash taken                                              -14,000

Private items paid in business        -1,000

Amount owed to owner                      8,000

By getting personal expenses incorporated into business expenditure a business can reduce its profitability falsely.  The reason why this is an aim of smaller businesses is that the tax that the business has to pay is calculated on the profit they make.  Therefore is a business owner can pass some of their own spending off as that of the business then they will pay less tax.