AS Level Financial Accounting (9706) Study Notes
Chapter 1.1: Types of Business Entity
Hello future accountant! Welcome to the very start of your journey. This chapter is fundamental because the legal structure of a business dictates how we prepare its financial accounts, how much tax it pays, and how risky it is for the owner. Think of this as choosing the foundation before you start building a house!
1. The Sole Trader
A sole trader is the simplest form of business organization. It is owned and controlled by one person. Imagine your local baker or a freelance graphic designer – they are usually sole traders.
Key Feature: Unlimited Liability
This is the most critical concept to understand for sole traders (and traditional partnerships).
- Definition: There is no legal distinction between the owner and the business.
- What this means: If the business runs into debt and cannot pay its creditors, the owner's personal assets (like their house or car) can be seized and sold to settle the business debts.
Memory Aid: Unlimited Liability = Unlimited Risk to the owner!
Advantages of a Sole Trader
- Easy to Set Up: Minimum legal requirements and administrative paperwork.
- Full Control: The owner makes all the decisions quickly.
- Owner Keeps All Profit: All profit, after tax, belongs directly to the owner.
Disadvantages of a Sole Trader
- Unlimited Liability: Highest risk exposure (as explained above).
- Limited Capital: Difficult to raise large amounts of finance.
- Limited Expertise: The owner must manage all aspects (accounting, marketing, production).
- Lack of Continuity: If the owner dies or retires, the business usually ends.
Quick Review: Sole traders are simple and cheap to run, but the owner carries the greatest personal financial risk (unlimited liability).
2. The Partnership
A partnership involves two or more people (up to a legal maximum, often 20, though this varies by country) who agree to own and run a business jointly to make a profit.
Partnership Agreement (or Deed)
While partnerships can be formed informally, it is highly recommended to have a written Partnership Agreement (or Deed of Partnership). This document outlines vital matters, such as:
- How profits and losses will be shared.
- Interest allowed on capital invested and charged on drawings.
- Salaries and commissions due to partners.
If no agreement exists, the rules of the Partnership Act 1890 apply (e.g., profits are shared equally, no interest on capital or drawings). We will study this Act in detail later!
Liability in a Partnership
Like sole traders, traditional partners usually have unlimited liability. Each partner is also responsible for the business debts incurred by any other partner (this is known as joint and several liability).
Did you know? The syllabus specifically excludes Limited Liability Partnerships (LLPs). When discussing partnerships in this course, assume unlimited liability unless stated otherwise.
Advantages of a Partnership
- More Capital: Partners pool their resources, increasing funding available.
- Shared Skills and Expertise: Partners can specialise in different areas (e.g., one manages finance, one manages operations).
- Shared Risk: Losses are divided among partners.
- Easier to Start: Still relatively few legal requirements compared to companies.
Disadvantages of a Partnership
- Unlimited Liability: Partners remain personally responsible for business debts.
- Potential Disagreements: Conflicts between partners can damage the business.
- Profit Sharing: Profits must be split according to the agreement.
- Lack of Continuity: If a partner leaves, retires, or dies, the partnership is technically dissolved (though a new one might be formed immediately).
Key Takeaway: Partnerships offer more resources than a sole trader but still carry the major drawback of unlimited liability.
3. Limited Companies
When a business becomes a company, it undergoes incorporation (it is registered with the government). The law recognises the business as a separate legal entity, distinct from its owners.
The Crucial Distinction: Separate Legal Entity
Once incorporated, the company itself can own assets, incur liabilities, and be sued in its own name. This leads to the key feature:
Key Feature: Limited Liability
- Definition: The financial responsibility of the shareholders (owners) is limited to the amount they originally invested in the shares.
- What this means: If the company fails, creditors cannot touch the shareholders' personal wealth. This significantly reduces investor risk.
Types of Limited Companies
- Private Limited Company (Ltd): Shares cannot be offered to the general public. These are usually smaller, family-run companies. Shares can only be sold privately.
- Public Limited Company (PLC): Can advertise and sell shares to the public on the Stock Exchange. This allows them to raise huge amounts of capital. They face much stricter legal and financial regulations.
Ownership vs. Control (Separation of Roles)
In a limited company:
- Owners: The shareholders. They invest capital and receive dividends.
- Management/Control: The directors. They are appointed by the shareholders to run the business day-to-day.
Advantages of a Limited Company
- Limited Liability: Protects the personal assets of the owners (investors). This is the biggest advantage!
- Easier Access to Capital: Can raise funds by selling shares or debentures.
- Continuity: The company's existence is perpetual; ownership changes hands simply by trading shares.
- Expertise: Can afford to hire professional managers (directors).
Disadvantages of a Limited Company
- Costly and Complex Setup: High administrative costs and complex legal procedures (e.g., filing extensive accounts).
- Loss of Privacy: Financial statements must usually be made public (especially PLCs).
- Potential Loss of Control: Original owners may lose control if they sell too many shares.
Key Takeaway: Limited companies provide protection to owners (limited liability) and superior access to large amounts of finance, but they come with high compliance and administrative burdens.
4. Sources of Finance and Methods of Funding
Regardless of the entity type, every business needs money to operate and grow. The available sources of finance depend heavily on the legal structure.
General Sources of Finance (Available to all Entities)
These are common ways for any business (sole trader, partnership, or company) to raise funds:
- Loans: Money borrowed from a financial institution (like a bank) that must be repaid over time, usually with interest.
- Secured Loans: Backed by an asset (collateral), like property. If the borrower defaults, the bank can seize the asset. These usually have lower interest rates because the risk to the lender is lower.
- Unsecured Loans: Not backed by specific assets. These carry higher risk and thus higher interest rates.
- Bank Overdrafts: Allows the business to withdraw more money than is currently in its bank account, up to an agreed limit. This is a very short-term, flexible source of finance, useful for covering temporary cash shortages.
- Trade Credit: When suppliers allow the business to take goods now and pay later (e.g., 30 or 60 days). This is essentially a free, short-term loan from the supplier.
- Payment by Instalments (Hire Purchase): Paying for a large asset in fixed monthly payments over time. The business usually owns the asset after the final payment.
- Rental/Leasing: An alternative to buying a non-current asset (like equipment or vehicles). The business pays regular rent for the use of the asset.
- Benefit: Avoids large initial capital expenditure and the risk of the asset becoming obsolete.
Specific Sources of Finance for Limited Companies (Syllabus 1.5.4)
Due to their incorporated status, limited companies have access to unique long-term funding methods:
- Shares (Ordinary Shares):
- Ordinary Shares: Represent ownership in the company. Shareholders receive returns in the form of dividends (a share of the profit). They have voting rights.
- Bonus Issue: The company gives existing shareholders extra shares free of charge, funded by reserves. This converts reserves into share capital. (It does not raise cash for the company).
- Rights Issue: Offers existing shareholders the right to buy new shares at a price below the market rate. This raises significant cash for the company.
- Debentures:
- Long-term borrowing, often secured against the company's assets.
- Debenture holders are creditors (lenders), not owners. They receive fixed interest, regardless of company profit.
- Dividends: Payments made to shareholders from the company's profits (retained earnings).
- The decision to pay dividends is made by the directors.
- Reserves: Profits and surpluses kept within the business rather than paid out.
- Capital Reserves: Funds that cannot be used to pay dividends. They arise from non-trading activities, such as:
- Share Premium: The amount received when shares are sold above their nominal (par) value.
- Revaluation Reserve: Arises when non-current assets are valued upwards. - Revenue Reserves: Funds that can be used to pay dividends. They arise from ordinary trading activities, such as:
- Retained Earnings: Profits kept in the business.
- General Reserve: An appropriation of retained earnings set aside for future unforeseen needs.
- Capital Reserves: Funds that cannot be used to pay dividends. They arise from non-trading activities, such as:
Quick Review Box: Finance & Liability
| Entity Type | Liability | Key Source of Capital |
|---|---|---|
| Sole Trader | Unlimited | Personal Savings, Bank Overdrafts |
| Partnership | Unlimited | Partners' Capital Contributions |
| Limited Company | Limited | Shares (Equity), Debentures (Debt) |
Final Key Takeaway: Understanding the legal entity structure is essential because it determines the owner's risk exposure (liability) and the methods available for raising capital (finance).