Small business accounting can be a complex practice, but there are several general accounting principles that help business owners structure their accounting procedures and maintain clear and accurate books. It is important that businesses adhere to the practice of business entity assumption so that they are not only protected legally, but so their company's financial picture is also clearly portrayed.
Business Entity Assumption Defined
Business entity assumption, sometimes referred to as separate entity assumption or the economic entity concept, is an accounting principal that states that the financial records of any business must be kept separate from those of its owners or any other business. All income derived from the company's operation must be recorded as earnings and all expenses must be those belonging solely to the business. Any personal expenses of the owner should not be passed on to the company. This strict adherence to separation allows the business to be evaluated for profitability and tax purposes based on accurate financial data rather than a muddled mix of personal and business finances. It is also applied to all businesses even if legally a business and its owner as viewed as the same entity.
Legal vs. Accounting Separation
Businesses exist in a variety of forms and each structure has its own legal and taxing regulations applied to it. Many small businesses are considered pass-through entities, where the business is not taxed on its income, but all income is "passed through" to the owners and they are taxed on the amount of income the business has earned. Examples of pass-through entities include sole proprietorships, S corporations and limited liability companies (LLC). However in a sole proprietorship, the business and the individual owner are viewed legally as one and the same. All the liabilities of the business, financial and legal, become the liabilities of the owner. Still, even though viewed legally as the same, sole proprietors must maintain and report their personal and business finances separately.
Accurate Recording Keeping Required
One of the disadvantages of the business entity concept in accounting is that company owners must be very careful to keep detailed and accurate financial records, particularly of their expenditures. All personal and business expenses must be kept separate. This means that procedures should be set in place to ensure that accounting records reflect accurate expense amounts based on the purpose or percentage of use. For example, if a business owner purchases gas for a car personally owned by him using a personal credit card, but uses that gas and car for business travel, then the owner should be reimbursed for those expenses using the standard mileage rate allowed by the Internal Revenue Service (IRS). However, if the business owner takes the company owned car and uses his business credit card to purchase gas while on a week-long vacation, those expenditures should not be recorded as business expenses in the company financial records but should be taken as a personal withdrawal.
Managing Corporate Divisions or Multiple Businesses
Another business entity example that requires separate accounting is when distinct divisions exist within a company or an individual owns more than one business. If your business grows, you may have the opportunity to expand beyond the scope of your current operations. You may choose to set up a separate division within the company to handle this new business opportunity. In order to track the financial health and operations of this segment of the company, it is a good idea to record all the income and expenses separately from the other part of the company. This can be done by utilizing "classes" within accounting software such as QuickBooks. For tax and legal purposes, the division still falls under the auspices of the main company, but the separate accounting will enable you to evaluate the its financial health independently.
Similarly, if a business owner runs more than one company, separate entity assumption should be maintained for each business. Although the owner is the same, the companies may be very different in scope and size, and all transactions should be recorded separately.
Generally Accepted Accounting Principles or GAAP is a defined set of rules and procedures that needs to be followed in order to create financial statements, which are consistent with the industry standards. It is the accounting standard that is followed in the US.
Following are some of the GAAP multiple choice questions and answers that will help the students in brushing up their understanding of the concept of GAAP.
Q.1 GAAP stands for:
(a) Generally Accepted Accounting Provisions
(b) Generally Accepted Accounting Policies
(c) Generally Accepted Accounting Principles
(d) None of these
Answer: c
Q.2 Which accounting principle states that companies and owners should be treated as separate entities.
(a) Monetary Unit Assumption
(b) Business Entity Concept
(c) Periodicity Assumption
(d) Going Concern Concept
Answer: b
Q.3 Cost or expenses must be recorded at the same time as the revenue to which they correspond is specified by which principle?
(a) Matching Principle
(b) Going Concern Principle
(c) Consistency Principle
(d) Prudence Principle
Answer: a
Q.4 Which concept states that “for every debit, there is a credit”?
(a) Money Measurement Concept
(b) Accounting Period Concept
(c) Separate Entity Concept
(d) Dual Aspect Concept
Answer: a
Q.5 For measuring income, the most acceptable method is?
(a) To apply normal rate of return on capital invested
(b) To apply the average return in industry on capital
(c) To match the cost with revenue
(d) To find out the difference in net worth as on two dates
Answer: c
Q.6 The correct form of Accounting equation is
(a) Assets – Receivable = Equity
(b) Assets + Receivable = Equity
(c) Assets – Liabilities = Equity
(d) Assets + Liabilities = Equity
Answer: c
Q.7 As per revenue recognition principle, sales revenues should be recognized at the time when?
(a) Order is taken for merchandise
(b) Ownership of goods gets transferred from the seller to the buyer
(c) Cash is received
(d) All of the above
Answer: b
Q.8 Due to which concept, accounting does not record non-financial transactions?
(a) Going concern concept
(b) Money measurement concept
(c) Accrual concept
(d) Cost concept
Answer: b
Q.9 The owner of the business is treated as a creditor of the business according to which of the following concept?
(a) Entity concept
(b) Materiality concept
(c) Consistency concept
(d) Periodicity concept
Answer: a
Q.10 As per the accrual concept of accounting, any financial or business transaction should be recorded:
(a) when profit is computed
(b) when balance sheet is prepared
(c) when cash is received or paid
(d) when transaction occurs
Answer: d
For reading more such MCQs on various topics pertaining to Commerce, visit here