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 accountant maintains separate records for separate accounting entities and determines the specific cash flows from each entity. However, all accounting entities are often aggregated in companywide financial statements. Special purpose vehicles (or special purpose entities) are a good example of accounting entities regularly used in the financial sector.
BREAKING DOWN Accounting Entity
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. Once an accounting entity is established, it should not be changed or altered, as this sacrifices the future comparability of financial data.
Defining Accounting Entities
Accounting entities are arbitrarily defined based on the informational needs of management. Accounting entities are often grouped based upon a similarity in business operations. For instance, a separate entity can be created for a sales department, investment division or specific summer program. All accounting entities have assets that must be accounted for. Once the entity is defined, all related transactions are reported to this accounting entity for reporting and accountability purposes.
Accounting Entity Examples
Any division or department may be segregated as a separate accounting entity. This is also true for any product line or geographical region in which the products are sold. Accounting entities can be established based on the core principles of an entity or segregated by customer base if each customer base is distinguishable from one another. Finally, a business in its entirety is considered an accounting entity separate from any other business. Examples of larger accounting entities include corporations, partnerships or trusts.
Purpose of Accounting Entity – Internal
The use of internal accounting entities allows management to analyze operations from various sections of a business. Forecasting and other financial analysis are possible through the use of segregating financial data across different entities. This enables deeper strategic positioning, as management is able to determine the market position it wishes to take based on what is reported by each accounting entity. Maintaining different accounting entities allows for decisions about whether to discontinue or expand business operations to be made using relevant information.
Purpose of Accounting Entity – External
A business is required to maintain separate financial records from 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. This financial reporting is important, as it specifies who owns what assets in the event that the accounting entity must liquidate in a bankruptcy.
Special Purpose Vehicles (SPVs)
Special purpose vehicles, or SPVs, are accounting entities that exist as a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt. An SPV/SPE may also be a subsidiary of a financial corporation designed to serve as a counterparty for swaps and other credit-sensitive derivative instruments.
Sometimes, SPVs are used to hide accounting irregularities or excessive risks undertaken by the parent company. Special purpose vehicles/entities may thus mask critical information from investors and analysts who may not be aware of a company’s complete financial picture. Investors must analyze the parent company’s balance sheet as well as the special purpose vehicles/entities balance sheets before deciding whether to invest in a business. For example, Enron’s accounting scandal or Lehman Brothers' and Bear Stearns' massive financial collapses are prime examples of how a lack of careful balance sheet analysis can hurt investors.