Types of Legal Business Entities

Types of Legal Business Entities

            Generally, accounting is known to be the language of business. Financial accounting is a particular branch of accounting that systematically analyzes data and keep track of all the transactions of a company. Therefore, financial accounting is a significant branch of accounting which plays a vital role in the success of a company. Also, financial accounting helps one to understand different types of legal business entities and analyze their differences and similarities as well as their strengths and weaknesses. For instance, one can analyze the features and strengths and weaknesses of sole proprietorship and partnership by carefully studying their relations to financial accounting. These business entities are legal and do not exist as separate entities, which makes them very appropriate for people to join. Also, these entities are uniquely differentiated from each other by particular characteristics, which makes it easier for people to decide on the business entity to join. For instance, the difference between the number of members required to start a sole proprietorship or partnership enables one to determine the entity they want to join. That is, if one wants to start a business alone, then sole proprietorship fits them well, and if a group of two or more people wants to start a business, then they will join a partnership business entity. This paper will discuss sole proprietorship and partnership as they are discussed in financial accounting, and how financial statements are used to account for their daily transactions.

Sole Proprietorship

A sole proprietorship is the oldest form of business entity. A sole proprietorship is owned by one person who is the sole proprietor, and therefore it lacks a separate legal entity as compared to other legal business entities. Thus, the owner and the business are the same. Also, a sole proprietorship does not need to be registered or incorporated, which makes it the simplest form of legal business entity and ideal for running small and medium scale business. “Forms of Business Organizations”(n.d.) describes the features of a sole proprietorship.

Features of a sole proprietorship.

            Since sole proprietorship does not require registration and incorporation of any kind, it does not have any law to govern it. That makes it easy to start since only a license is needed to start and run the business. So its closure is just as its formation, no legal procedures required. Also, as the owner and the business are the same, business liability is unlimited, which means that if the business fails to meet its liabilities, the obligation falls to the owner. Therefore, his assets, such as house, car, and other properties, have to be put on sale so that the business liabilities can be met. Besides, the sole proprietor is the only risk bearer since he is the sole investor in the business. Therefore, if the business suffers any losses or risks, he is directly affected and bears them alone. Also, the sole proprietor enjoys all the profits of the business since he does not have to share with anyone else as he is the sole investor.

Advantages of Sole Proprietorship

There are several advantages of a sole proprietorship, which makes it unique and popular. “U.S. Small Business Administration” (n.d.) analyzed the various advantages of a sole proprietorship. First, a sole proprietorship form of business is the simplest and cheapest legal business entity to establish. Because the costs to obtain the necessary permits are minimal. Also, the sole proprietor has full control of the business as he is the owner of the business. Therefore, decision making is easy as there is no need to consult anyone else when decisions need to be made. Besides, all the taxes of the business are calculated as one; thus, it is easy to fulfill all the tax needs, and the tax paid is low because the business has a simple structure.

Disadvantages of Sole Proprietorship

A sole proprietorship has several disadvantages as it is a business entity run by only one person. “U.S. Small Business Administration” (n.d.) analyzed the disadvantages of a sole proprietorship. First, sole proprietorship has unlimited personal liability because the owner and the businesses are the same. Therefore, all the debts of the business are settled by the owner by selling his assets. Also, the sole proprietor often faces the difficulty of raising the capital required to start the business. The lack of partners to contribute towards raising money to start the business is a big challenge towards sole proprietorship. Besides, sole proprietorship has a heavy burden. Since the sole proprietor is in full control of the business, the whole responsibility is on him, and therefore he may lack time for social life as he must look after the business. Also, he suffers all the losses the business faces alone.

Accounting for a Sole Proprietorship

In a sole proprietorship, accounting does not necessarily need a separate set of accounting records because the owner and the business are the same. Nonetheless, maintaining business records is an excellent way to judge whether the business is generating profits. According to Braggs (2018), a sole proprietorship tends to incur lower levels of expenses and generate smaller amounts of revenue as compared to large organizations. Consequently, starting with small accounting records that target only on the cash-flow in and out of bank account can make sense. Therefore, an income statement can be produced because this is considered a single entry accounting system. Also, cash disbursement journals and cash receipts can be maintained separately. Finally, since sole proprietorship uses a single entry accounting system, it suits the cash basis accounting system, where cash received is recorded as revenue and cash paid out is recorded as expenses.

Partnership

A partnership is a legal business entity that involves two or more people who come together and agree to share losses and profits arising from the business. Typically, the minimum number of members is two, and the maximum is one hundred members. “Business Jargon” (n.d.) describes the features of a partnership.

Features of a Partnership

Although a partnership is not a legal entity, its creation requires a legal agreement from all the members involved in the partnership. Also, its operations must accord the law and must generate profit. Therefore, two or more people who come together to carry social or charity work will not be regarded as a partnership. Partners have unlimited liability in the business; thus, their assets can be liquidated and used to settle for the liabilities of the business. Also, if the liabilities are covered by one partner, he can, in turn, sue the rest of the partners in the business if they fail to commit their share of the debt as per the partnership contract.

Moreover, the minimum number of members is two for a business entity to be regarded as a partnership. However, the maximum number of partnership vary according to the nature of the business. For instance, the banking business has a maximum of ten members, while for professionals like teachers and doctors, the members can go up to one hundred. Besides, a partnership has a mutual agency where all the operations in a partnership must be practiced by all the partners together. However, one or several members may decide to carry out the activities of the business on behalf of other members. Therefore, every member of the partnership is an agent of the business and has all the rights regarding the partnership.

Types of Partners

Not all partners have the same roles in the business. “Forms of Business Organizations” (n.d.) describes the types of partners. Some of the partners are the active partners who carry out the daily activities of the business and contribute capital; thus, they have shares in the profits. Active partners have unlimited liabilities. Other partners are the dormant partners who are also referred to as sleeping partners. Dormant partners do not contribute to the daily activities of the business. However, they contribute to the capital, have shares in the profits, and have unlimited liabilities. Also, there are secret partners whose association with the business is not public knowledge, and the partner does not contribute to the daily activities of the business. However, the partner contributes to the capital, have shares in the profits, and have unlimited liabilities. Finally, there are the nominal partners who allow the business to use their names and extend goodwill to the business. Therefore, nominal partners do not contribute to the capital, do not have shares in the capital but have unlimited liabilities.

Advantages of Partnership

The partnership has several advantages which are considered by people before deciding to come together to form a partnership. (Adrian, 2010) Describes the various advantages of a partnership. First, the partners contribute the start-up capital for the business. Therefore, many partners will contribute to a large pool of capital, and more profit will be achieved and shared among the partners. Generally, a partnership is simple to start, manage, and run. A partnership is not strictly regulated as companies because the partners run the business, and the management is made more accessible by the agreement of all the partners. Also, the responsibilities of the business are shared by the partners so that they can make the most of their skills. The partners share their roles according to their skills, which makes management easy and productive. For instance, if a partner is good at accounting, they are held responsible for bookkeeping. Finally, the decision-making process may take a longer time in partnership as compared to a sole proprietorship, but it is usually most effective. Many partners mean more brains, and thus decisions are settled after thorough discussion between the partners.

Disadvantages of partnership

Typically, all business entities have disadvantages. (Adrian, 2010) Describes the disadvantages of a partnership. The greatest weakness of partnership is disagreements between the partners. People have different opinions on every situation, and thus disagreements might come in because many people tend to have confidence in their opinions and underestimate the opinions of others. Therefore, disagreements arise between partners and lead to slow decision making. Also, since the ordinary partners are exposed to unlimited liabilities, they are responsible for the liabilities of the business, and their assets can be liquidated to settle the liabilities of the business. Finally, since the partners share the profits equally, it might be unfair for the partners who put less effort into the running of the business to receive an equal share of profits as those partners who actively participate in the daily activities of the business.

Accounting for Partnership

Essentially, accounting in a partnership is the same as in sole proprietorship, except that partnership has more owners; thus, each partner’s distributions, the share of gains and losses, and investment are tracked on separate accounts. According to Whomakesursmile (2019), the partnership has various distinct transactions not found in other types of legal business entities. For instance, a transaction involves a credit to a separate capital account and a debit to the cash account when a partner invests money in a partnership. A capital account is used to record all the partner’s distributions and investments. Also, a temporary equity account known as the income summary account is used to summarize the profit or loss for the period when a partnership closes its books for accounting. Moreover, a transaction involves a credit to the capital account of the partner and a debit to the asset account when a partner invests some other asset in a partnership.

In the real world, legal business entities are established every day. Thus, the study of these legal business entities is a fundamental requirement for one to understand their features as well as their strengths and weaknesses. For instance, when one understands the advantages and disadvantages of a sole proprietorship, they are in a better position to decide if they want to start such a business entity. Also, when one learns the strengths and weaknesses of a partnership, they are in a better position to decide if they will establish that kind of business. Most importantly is understanding the accounting part of these legal business entities where one understands all the financial statements related to sole proprietorship and partnership. Therefore, the study of these two types of legal business entities in financial accounting is a vital need for one to understand how the world of business operates in the real world.