The Business Entity

Accountants frequently refer to a business organization as an accounting entity or a business entity. A business entity is any business organization, such as a hardware store or grocery store, that exists as an economic unit. For accounting purposes, each business organization or entity has an existence separate from its owner(s), creditors, employees, customers, and other businesses. This separate existence of the business organization is known as the business entity concept. Thus, in the accounting records of the business entity, the activities of each business should be kept separate from the activities of other businesses and the personal financial activities of the owner(s).

Classifying Businesses

Businesses are classified by the type of business activities they perform—service companies, merchandising companies, and manufacturing companies. Any of these activities can be performed by companies using any of the three forms of business organizations.

• Service companies perform services for a fee. This group includes accounting firms, law firms, and dry cleaning establishments.
• Merchandising companies purchase goods that are ready for sale and then sell them to customers. Merchandising companies include auto dealerships, clothing stores, and supermarkets.
• Manufacturing companies buy materials, convert them into products, and then sell the products to other companies or the final consumers. Manufacturing companies include steel mills, auto manufacturers, and clothing manufacturers.

One thing that differentiates merchandising and manufacturing companies from service companies is that merchandising and manufacturing companies carry inventory. Inventory is the goods held for sale. For instance, Ford Motor Company has automobiles in inventory, as do the independent car dealers. In addition, manufacturing companies have raw materials inventory that they use to make their products. Raw materials for Ford Motor Company would include tires, metal for fabricating the bodies, and all kinds of component parts, from screws to fuel injectors.

Regardless of what type of business they are, all companies produce financial statements as the final end product of their accounting process. These financial statements provide relevant financial information both to those inside the company—management—and to those outside the company—creditors, stockholders, and other interested parties.

The next section introduces four common financial statements—the income statement, the statement of retained earnings, the balance sheet, and the statement of cash flows.