Let me start this article by telling us what happened when I was a senior manager of a company several years ago.
The CEO of the company was a very vibrant and hardworking lady, she has invested so much time, money and energy on the business but she doesn't understand the entity concept as concern her business. I offered her some explanations and possible solutions in respect to this important concept but she ignored them. The business collapsed two years after I resigned. I saw the collapse coming, infact it was an inevitable one due to the way the business is being managed.
This brings us to be big question "WHY DID THE FIRM COLLAPSED?"
Statistics has shown that not abiding by this concept has liquidated so many small businesses and SMEs.
Now let us take a look at the entity concept and narrow it down to the main reason why the business failed.
Let us imagine that it took me so many years of hard work, dedication and alot of money to establish a business. I sacrificed alot to make sure that the business is where it is today.
The question is "WHO OWNS THE BUSINESS?"
The entity concept says that the affairs of the business should not be mixed with the affairs of the owner or group of owners of the business. The business is a separate entity, it is separated from its owner(s). This concept is very important for every business. You can check all the businesses that have lasted for a long time, they remain loyal to this concept.
For accounting purposes, this concept states that the business entity and owners are two different independent persons.
For instance: When the business owner invests money into the business (Capital), it is recorded in the books as a liability of the business to the own. It means that the business owes the business owner the amount which was introduced to the business. This is why capital is regarded as a liability.
Similarly, when the owner of the business takes away goods or cash for his personal use, it will not be treated as the expenses of the business. The accounting records in the books are made from the business unit not the owner.
We are going to illustrate this using some case study. Below are some of them:
CASE STUDY 1:
A business purchases fuel for the generator that powers the office. The owner of the business usually visit the company during off- business hours, then he puts on the generator to entertain his family and friends.
CASE STUDY 2:
A business owner places his wife and kids who are not employees of the company on salary. They receive entitlement and emoluments from the company monthly.
CASE STUDY 3:
Every Friday, a business owner hosts his friends in a hotel, the company pays for the hotel hall and entertainment expenses.
CASE STUDY 4:
The company's CEO usually take the cheque book of the business and issue money to himself from the company's account for private use.
Can you identify the business entity solution to the above cases?