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What is an Economic Entity?
An economic entity is a unit separate from all other entities — whether individual or a business — that has some financial activity. The term comes from accounting as many national accounting standards define entities based on the economic or financial activity conducted by the firm. A proper economic entity will have to separate its transactions from the individuals within the firm, such as owners or managers. Mixing transactions between multiple entities can result in serious legal implications and harmful penalties levied by government agencies.
National accounting standards typically dictate a few different business forms that may represent an economic entity. The most common forms include a sole proprietorship, partnership, and corporation. Each one has specific attributes that set them apart from each other.
A business form results when an individual starts a company and operates it through his own ability to work and create value. Under each business form, the individual must keep all transactions from the business separate from personal transactions. The business will result in a separate economic entity that has its own traceable activity and will often be liable for taxes and other fees associated with its business actions.
The economic entity concept also applies to public sector units and government agencies. Each agency must operate under its own guidance and keep its transactions separate from other agencies or the different levels of government, such as federal, state, or local municipalities. Government entities are important because the funds received from taxpayers are often designated for specific use. Co-mingling funds will often result in significant audits from watchdog groups as the misuse of government funds is often a serious problem. Corruption charges are possible if an official working in a government agency misuses or misappropriate funds.
Companies operating under mergers and acquisitions also must operate within the economic entity concept. Properly accounting for transactions between these closely related companies is necessary to avoid an investigation by the government. For example, a company that simply states it has an investment in another company cannot be seen as controlling the other business. Directing another company's actions results in a controlling interest and can change the dynamic of the economic entity principle. The accounting process is different for those companies with a controlling interest and can change the tax structure of the two companies. Violating this principle can also result in a larger investigation that results in penalties and reduces the capital of each company.
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Discussion Comments
@indemnifyme - I don't mean to be disagreeable but it doesn't sound like your agency is its own economic entity. After all, it isn't a totally separate unit from the parent company.
I find it interesting that government agencies are their own economic units. For some reason I figured their finances would be intermingled. I suppose it's easier to investigate fraud if you keep the funds for each agency separate though.
The idea of an economic entity is very interesting to me. I work for a small insurance agency, and we are sort of our own economic entity. However, we have ties to our parent company, too.
For example, when a customer buys an insurance policy through our office, we (and by we I mean the agent) gets a commission off the premium. But our parent company gets most of that money. However, people make payments through our office and it is our responsibility to deposit that money in the account the parent company has set aside for that purpose. The parent company then pays the agency their part of the commission and keeps the rest.
In that instance our money is sort of intermingled, but in other instances such as the day to day running of the agency we are definitely our own economic entity. The agency owner is responsible for paying all of our salaries and taking care of taxes and everything-the parent company has no part of that.
@alisha - I agree; economic entities can be companies or countries.
So far, the United States is among the 100 largest economic entities – we are number one, I believe. The question that I wonder is how long we will stay that way.
China is eating at our heels; the Euro is chipping away at the value of the dollar and gold prices continue to climb. Personally, I believe no nation or empire enjoys permanent dominance, but given that the United States is still relatively young, I would think we’d have at least another 200 years to go before slipping from our strong economic position.
@nony - The GAAP requirements for separation of funds not only apply to governments and businesses, as the article points out, but also to nonprofit organizations.
In our church the pastor makes it clear that if we are to give towards a certain project like a building fund, missions work or something like that, we have to indicate which project we are targeting in our offering envelope.
He said if you have funds targeting one thing and those funds are used for something else, the IRS will go after you in a heartbeat. I think churches try to be especially conscientious in these matters, lest they lose their nonprofit status.
@hamje32 - You can claim the deduction; you just have to make sure that personal and business expenses are kept separate. This is the economic entity assumption that accountants like to talk about. Business is one thing, personal is another, and never the twain shall meet.
I would just buy another computer and set it up in a family room; let the other family members use that. You can be sure that the IRS will ask you if you use the home office exclusively for business or if family members use it for personal use.
Just keep it all business and you should be okay. Also, if you have an Internet connection, get one for your business and one for the family; in other words, have two accounts, assuming you claim your Internet fee as part of your expenses.
I operate a simple economic entity, but it’s one that I run on the side. It’s a programming and consulting business.
The employees are me, myself and I – in other words, it's a sole proprietorship. Nonetheless, I have to operate by the same basic principles that would govern any economic entity.
The chief of these is that I have to keep business exceptions and personal expenses separate, especially for tax purposes. This becomes challenging with some exemptions that I would like to claim, like the home office deduction.
For the most part, I have a dedicated office at home where I do most of my work. I would like to claim the deduction, but sometimes the kids and my spouse will use the office too.
I know that the IRS is especially suspicious of anyone claiming the home office deduction. The last thing I would need is an audit.
I think economic entity is also used to talk about geographic regions who have their own economy. This could be like individual districts in a country, or the states in the U.S. since each state does have it's own funds and economy that it's responsible for. It can also be larger regions with multiple countries, like the European Union for example, which is an economic entity.
A professor of mine also thinks that capitalist nations are more of an economic entity than political entities nowadays. The economy is so vital and foremost in what a government manages, that if we look at it from this point of view, we can say that all political entities (including organizations, institutions, etc.) are also economic entities. I think I agree with this argument.
What do you think? Is the definition of economic entity is getting wider and more flexible? I feel that it is.
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