Accounting entity assumption states that the activities of a business entity be kept separate from its owners and all other entities. In other words, according to this assumption business unit is considered a distinct entity from its owners and all other entities having transactions with it. For example, in the case of proprietorship, the law does not make any distinction between the proprietorship firm and the proprietor in the event of firm's inability to pay its debts. Hence, in this situation, to meet the deficit, law requires the proprietor to pay firm's debts from his/ her personal assets. But, these two are treated as separate entities while recording business transactions and preparing the financial statements.
This assumption enables the accountant to distinguish between the transactions of the business and those of the owners. Consequently, the capital brought into the business and withdrawals from the business by the owners will also be recorded in the same manner as that of transaction with other entities. For example, if the owner brings in cash or any other asset, it will result in increase in assets of the business and capital of the firm. This capital represents firm's liability to the owner. The expenses of the owner paid by the firm assets are recorded as withdrawals from the business. This means the profit and loss account will show the revenues and expenses related to the business entity only. Consequently, balance sheet will show the assets and liabilities of the business entity only. This assumption is followed in all organizations irrespective of their form, i.e., sole proprietorship, partnership, cooperative, or company.

ACCOUNTING ENTITY ASSUMPTION states that a business is a separate legal entity from the owner. In the accounts the business' monetary transactions are recorded only.

Assumptions are traditions and customs, which have been developed over a period of time and well-accepted by the profession. Basic accounting assumptions provide a foundation for recording the transactions and preparing the financial statements there from. There are four basic assumptions that are considered as cornerstones of the foundation of accounting.
These are:

1. Accounting entity,
2. Money measurement,
3. Going concern and
4. Accounting period.

Accounting entity assumption states that the activities of a business entity be kept separate from its owners and all other entities. In other words, according to this assumption business unit is considered a distinct entity from its owners and all other entities having transactions with it. For example, in the case of proprietorship, the law does not make any distinction between the proprietorship firm and the proprietor in the event of firm's inability to pay its debts. Hence, in this situation, to meet the deficit, law requires the proprietor to pay firm's debts from his/ her personal assets. But, these two are treated as separate entities while recording business transactions and preparing the financial statements.

Accounting however takes the concept of entity one step further than the law. In accounting, every business (including sole traders), becomes its own ‘accounting entity’. So, while the law does not recognise the sole trading business as a separate legal entity distinct from the owners, accounting does recognize the sole trader's business as a separate 'accounting entity'.

So, the accounting system records the financial affairs of each 'accounting entity' separately, that is;

1. the owner of the firm as one 'accounting entity'
2. the firm itself as a separate and distinct 'accounting entity'

Financial transactions are then separated between the business owner's financial affairs and those of the sole trading firm which the owner may well operate. Under the accounting entity assumption then, a business entity, regardless of its legal status, is treated as being separate and distinct from the owners or managers of that business.