Accuracy in financial accounting relies on 10 basic assumptions, also called accounting principles, created by the Financial Accounting Standards Board. The objective is to compile a set of generally accepted accounting principles that ensure the procedures businesses use to prepare annual financial statements remain consistent from year-to-year. Although most apply specifically to public companies, the entity assumption applies to privately held small businesses.

Entity Assumption Explained

An entity assumption, more commonly referred to as an economic entity assumption, is the first of 10 general accounting principles. The assumption states that in a business organized as a sole proprietorship, the owner’s personal transactions and the business’s financial transactions must be kept separate. It’s important to understand that while the entity assumption refers specifically to privately held sole proprietorships it also applies to other business entities, including partnerships, corporations and government agencies.

Small-Business Significance

The entity assumption holds the most significance to privately held sole proprietorships and partnerships. The reason for this is that while the business and the owner or owners of a sole proprietorship or partnership are legally considered to be a single entity, for accounting purposes the business and its owners are considered to be distinctly separate entities. While established businesses are considerably less likely to violate this principle by commingling business and personal funds and financial transactions, new business owners frequently start out commingling funds. The result is that as owners become educated and the business starts to grow, an experienced accountant must be brought in to separate previous commingled transactions and correct accounting entries.

GAAP Association

Together with the remaining nine accounting principles, an entity assumption works to ensure a business’s financial reports are procedurally consistent and allow for financial transparency. In addition to the economic entity assumption, GAAP guidelines also include a monetary unit and time-period assumption, a cost principle, a full disclosure, going concern, matching and revenue recognition principle as well materiality and conservatism guidelines. These guidelines accomplish objectives such as establishing the U.S. dollar as the official monetary unit, and ensuring businesses use accrual-basis accounting and fully disclose financial information. Transparency aspects ensure interested parties such as lenders and investors have all the information they need to make lending or investing decisions.

Small-Business Exceptions

With the exception of a requirement to adhere to the economic entity assumption, many privately held businesses aren’t required to comply with GAAP guidelines. This is because most privately held businesses aren’t required to file an annual report with the U.S. Securities and Exchange Commission. Exceptions to the general rule exist when a privately held business contracts with a third party to conduct an external audit, offers stock shares to private investors or decides to convert to public company status. In addition, some businesses choose to voluntarily comply, mainly to provide financial transparency and heighten the business’s reputation.