Accounting Entity

What Is an Accounting Entity?

An accounting entity is a clearly defined economic unit that isolates the accounting of certain transactions from other subdivisions or accounting entities. An accounting entity can be a corporation or sole proprietorship as well as a subsidiary within a corporation. However, the accounting entity must have a separate set of books or records detailing its assets and liabilities from those of the owner.

An accounting entity is part of the business entity concept, which maintains that the financial transactions and accounting records of owners and entities cannot be intermingled.

How an Accounting Entity Works

Although maintaining separate accounting entities provides management with useful information, more company resources are needed to maintain the financial reporting structure as the quantity of entities grows.

Accountants must maintain separate records for separate accounting entities and determine the specific cash flows from each entity. Cash flow is the cash being transferred in and out of a business as a result of its day-to-day operations.

Once an accounting entity is established, it should not be changed, as this sacrifices the future comparability of financial data.

The separation of accounting entities is important because it helps with proper tax accounting and financial reporting. However, multiple accounting entities can be aggregated into companywide financial statements.

Internal Accounting Entities

Accounting entities are arbitrarily defined based on the informational needs of management or grouped based on similarities in their business operations. Once the entity is defined, all related transactions, assets, and liabilities are reported to the accounting entity for reporting and accountability purposes.

Accounting entities can be established for specific product lines or geographical regions where a company's products are sold. Also, specific accounting records can be maintained based on the core principles of an entity or segregated by customer base, if each customer base is distinguishable from the next. Examples of internal accounting entities include the investment division of a bank or the sales department of a corporation.

External Accounting Entities

A business is required to maintain financial records that are separate from those of its owners and investors. For this reason, a business is an accounting entity for legal and taxation purposes. An accounting entity allows for taxing authorities to assess proper levies in accordance with tax rules.

Different accounting entities have different financial reporting requirements. Separate financial reporting is important because it specifies who owns what assets in the event that the accounting entity must liquidate in bankruptcy. Also, auditing an organization's financial statements is easier with separate accounting entities. Examples of larger accounting entities include corporations, partnerships, and trusts.

Special Purpose Vehicles (SPVs)

A special purpose vehicles (SPV) is an accounting entity that exists as a subsidiary company with an asset and liability structure as well as a legal status that makes its obligations secure even if the parent company goes bankrupt.

An SPV may also be a subsidiary of a financial corporation designed to serve as a counterparty for swaps and other credit-sensitive derivative instruments. A derivative is a security whose value is determined or derived from an underlying asset or assets, such as a benchmark.

Sometimes, special purpose vehicles — also called special purpose entities or (SPE)s — can be used nefariously to hide accounting irregularities or excessive risks undertaken by the parent company. Special purpose vehicles may thus mask critical information from investors and analysts, who may not be aware of a company’s complete financial picture.

Investors must analyze a parent company’s balance sheet as well as its special purpose entities' balance sheets before deciding whether to invest in a business. Enron’s accounting scandal is a prime example of how companies can hide losses by using separate accounting records.

What Are Some Examples of Accounting Entities?

In general, any business or revenue-generating organization is considered to be an accounting entity — filing its own taxes and preparing its own financial statements. These can include corporations, sole proprietorships, partnerships, clubs, and trusts, as well as individual taxpayers.

Why Do Some Companies Create Additional Accounting Units?

Companies may legally structure certain divisions or sub-units as their own distinct accounting units in order to separate the cash flows, risks, and profits from the parent company. They may do this because the sub-unit is involved with operations that differ greatly from the parent company's core business. It can also be done to decrease the riskiness of the sub-unit or parent in order to gain access to more favorable credit terms or more easily raise new capital.

How Can Accounting Entities Be Used for Unethical Practices?

Certain accounting entities, like SPVs, can be structured in order to hide losses or launder money. These need to be scrutinized in order to be sure there is nothing nefarious going on. One SPV gone wrong is exemplified by Enron, which misused an accounting entity such as this, ultimately leading to one of the largest bankruptcies in history.