What exactly is an Accounting Entity?
An accounting entity refers to an economic unit separating the accounting of specific transactions from other subdivisions or accounting entities. Corporations, sole proprietorships, and subsidiaries within corporations are all can act as accounting entities. On the other hand, the accounting entity must keep a separate set of books or records outlining its assets and liabilities from the owner.
Accounting entities are part of the business entity concept, which helps to ensure that owners' and entities' financial transactions and accounting records are not mixed.
How does an Accounting Entity work?
Although keeping different accounting entities gives helpful information to management, more corporate resources are necessary to keep the financial reporting structure in place as the number of companies' entities increases over time.
Accountants must keep separate records for each accounting entity and compute their cash flows accordingly. Cash flow refers to the amount of money that flows in and out of business due to its day-to-day operations.
Once an accounting entity is created, it should remain the same since it jeopardizes the comparability of future financial data. With separate accounting entities, it becomes somewhat easier to calculate the applicable tax and to do proper financial reporting.
Internal Accounting Entities
Accounting entities are defined arbitrarily depending on management's information needs or grouped based on company operations commonalities. Following the formation of the accounting entity, all relevant transactions, assets, and liabilities are reported to it for reporting and accountability purposes.
Accounting entities can be created for specific product lines or geographic areas where a company sells its products. Furthermore, thorough accounting records can be preserved based on an entity's essential principles or by customer base if each client base can be distinguished from the next. Internal accounting entities typically include a bank's investment section and a firm's sales department.
Internal accounting entities are useful because they allow a company's management to independently examine activity from several business sectors. Separating financial data across entities simplifies forecasting and financial analysis. Separate accounting records help strategic examination of numerous product lines and determine whether to stop or develop a certain business operation.
External Accounting Entities
The financial records of a firm must be maintained separately from those of its owners and investors. As a result, for legal and tax reasons, a business is regarded an accounting entity. Accounting entities allow taxing authorities to calculate appropriate taxes as per tax regulations.
The accounting entities' financial reporting standards may vary from one to another. Separate financial reporting is necessary since it identifies who owns what assets if the accounting entity is obliged to liquidate in the event of bankruptcy. With separate accounting entities, various accounting firms can easily audit the financial accounts of an organization. Corporations, partnerships, and trusts are examples of larger accounting entities.
Special Purpose Vehicles (SPVs)
An SPV is a legal entity that functions as a subsidiary business and has an asset and liability structure that protects its commitments even if the parent company fails.
An SPV can also be a subsidiary of a financial firm that is formed to act as a counterparty for swaps and other credit-sensitive derivative instruments. A derivative is a security whose value is determined by an underlying asset or assets, such as a benchmark.
Special purpose vehicles, sometimes known as special purpose entities (SPEs), can be used intentionally to conceal accounting errors or excessive risks the parent corporation takes. As a result, special-purpose vehicles may hide key information from investors and analysts who want a complete financial picture of a firm.
What are the requirements for something to be considered an "Accounting Entity"?
The following are the primary requirements for something to be considered an "accounting entity":
In general, any business or organization generating revenue and filing taxes, and generating financial reports can be considered an accounting entity. Some examples of accounting entities are corporations, clubs, trusts, partnerships, and individuals.
Example of an Accounting Entity
Suppose J, T, and P form a company called JTP Ltd. Then, in the views of the law, J, T, and P, as well as JTP Ltd., are two distinct accounting companies, each of which can possess property in its name(s), sue and be sued in its capacity, and enter into contracts in its own right. J, T, and P are natural persons. In contrast, JTP Ltd., despite having the same name as the owners taken together, is an artificial person. J, T, and P are natural persons. In contrast, JTP Ltd., despite having the same name as the owners taken together, is an artificial person.
Consider the following events:
J, T, and P each paid $20,000 for one vehicle.
JTP Ltd. also spent $20,000 each on three vehicles.
Finally, the transactions for the owners (J, T, and P) and JTP Ltd. will be carefully recorded in separate books of accounts.
Why do some companies set up additional accounting units?
Some divisions or sub-groups of a corporation may be legally established as independent accounting units to segregate cash flows, risks, and profits from the parent company. They may do so because the sub-group is involved in operations that are radically different from the primary business of the parent corporation. It can also be done to lessen the riskiness of the sub-group or parent to have access to better credit terms or more readily acquire extra capital.
Why is it used for unethical practices?
Certain accounting entities, such as SPVs, can be structured to conceal losses or launder money. These must be scrutinized to ensure that nothing nefarious is going on. Enron is an example of a bad SPV that mistreated an accounting entity with unethical practices, resulting in one of the biggest bankruptcies in history. It concealed the deficit by using different accounting records.
The Bottom Line
Accounting entities are well-defined economic units that separate accounting for individual transactions from accounting for other subdivisions or accounting entities. Accounting entities are part of the business entity concept, which states that owners' and entities' financial transactions and accounting records should not be intermingled.
Although maintaining separate accounting entities provides useful information to management, as the number of entities grows, more company resources are required to maintain the financial reporting structure. An accounting entity is a separate and distinct business unit for accounting purposes.