What is the economic entity assumption?

The economic entity assumption is one of four assumptions underlying financial statements. It says that you can identify economic activity with a particular unit of accountability.

Put another way, the economic entity assumptions says that certain transactions are “inside” a business, while other transactions are “outside” of the business. Suppose that you run a candy store. Buying candy in order to resell it is “inside” of your business. Your intent is to earn a profit. On the other hand, buying candy in order to eat it is “outside” your business – your intent is to eat candy.

In taxes, a businessperson must be very careful to segregate personal expenses (“outside” the business) from business expenses (“inside” the business). Taxing authorities do not like when businesses deduct personal expenses. Ask Dennis Kozlowski.

Many businesses are actually combined “groups” of businesses. A corporation might own several dozen other corporations, each representing a different line of business. Each corporation may be its own economic entity, reporting its own financial statements. The combined group of corporations may also be an economic entity, reporting its own financial statements.

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