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Economic Entity Assumption

by Jackson B

An economic entity assumption is a common accounting practice in which the financial accounting assumptions associated with any particular economic entity are assumed to be wholly accurate without the presence of any other information. For example, if an accounting analysis is performed on the assets of a corporation, the analysis may conclude that the corporation has a net worth of $1 million. However, the financial accounting assumptions used in the corporate finance analysis may indicate that there may be another source of data, such as the owner’s data, that indicates the company has more than a one million dollar net worth.

What is the effect of such assumptions? Well, if the corporation was able to obtain access to an owner’s data that indicated the company was actually worth over one million dollars, it could argue that the owner’s data was erroneous and the company was in fact worth much more than a million dollars. In this instance, the owners’ data would be considered to be a non-contributory element of the corporation’s net worth. This scenario illustrates the power of the economic entity assumption in corporate finance analysis.

How do such assumptions influence the practice of corporate finance? If a financial accountant uses an economic entity assumption for his/her financial statements, he/she may have an incomplete understanding of what a corporation’s underlying assets actually are, which can lead to an inaccurate determination of the value of the assets. This in turn may result in the undervaluing of assets by the accounting firm, leading to a large profit margin or an undervaluing of assets resulting in a loss of profits, which can adversely affect the overall financial health of the corporation.

How can such assumptions affect the practice of corporate finance? A corporation may use the economic entity assumption to obtain additional funding in the form of tax credits, thereby offsetting the negative impact on the corporation’s profit.

What are some situations where an economic entity assumption may be inappropriate? One situation where the assumption may be inappropriate is in the case of businesses that are sole proprietorships. Such a business may not actually own the assets it is reporting its net worth, therefore there would be no benefit in the use of an economic entity assumption. Another situation in which an economic entity assumption may be inappropriate is for businesses that may hold multiple assets and where, in reality, only one asset holds the economic entity’s net worth, so that the assumption would fail in this situation.

How can this affect the practice of corporate finance? In most cases, in most states, the use of the assumption to increase profit is not permitted unless the business’ assets are held by another entity. This is because in most jurisdictions, if there is more than one entity holding the assets of the business, the other entity is deemed to hold a majority of the ownership interest in the business. However, some jurisdictions will allow the assumption to apply to businesses that have a single entity if there are sufficient assets owned by the business and one of the entities holds a majority interest.

Can an economic entity assumption negatively affect the practice of corporate finance? There are a number of instances where this assumption can negatively impact the practice of corporate finance, including situations where a business may not need to obtain funding, the assumption may provide false accounting information, the assumption provides a false perception of the value of the business’s assets, or the assumption’s results in the assumption being too low or too high.

How does the practice of corporate finance affect an entity? A business’s ability to borrow is affected by the assumption’s results, which can potentially reduce the business’ viability when borrowing is needed.