Financial accounting is based on the premise that the transactions and balances of a business entity are to be accounted for separately from its owners. The business entity is therefore considered to be distinct from its owners for the purpose of accounting.
Therefore, any personal expenses incurred by owners of a business will not appear in the income statement of the entity. Similarly, if any personal expenses of owners are paid out of assets of the entity, it would be considered to be drawings for the purpose of accounting much in the same way as cash drawings.
The business entity concept also explains why owners’ equity appears on the liability side of a balance sheet (i.e. credit side). Share capital contributed by a sole trader to his business, for instance, represents a form of liability (known as equity) of the ‘business’ that is owed to its owner which is why it is presented on the credit side of the balance sheet.
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ABC Bakers is a partnership concern owned and operated by Mr. X and Mr. Y. How should the following transactions be reflected in the books of ABC Bakers?
Mr. X paid his house rent from the business bank account.
The payment of owner's house rent does not represent expense of the business and should therefore be considered as drawings in ABC Bakers' accounts:
Mr. Y purchased an oven for the bakery using his personal credit card.
The purchase of asset by Mr. Y from his personal credit card represents his capital contribution to the business and should therefore be credited as equity in ABC Bakers' accounts:
- Oven (Asset)
- Equity Capital