Accounting (9215) | The advantages and disadvantages of different organisations

Welcome to Chapter Notes: The Business Organisation and Its Impact!

Hello future accountants! In this chapter, we are going to explore the different 'hats' businesses wear—the legal structures they choose. Don't worry if this sounds legalistic; understanding these structures is vital because they directly influence how we prepare and read their financial statements, especially concerning who is responsible for the debts.

We will look closely at three main types: Sole Traders, Partnerships, and Private Limited Companies (Ltd).

Why is the legal structure important for Accounting?

The structure determines:
1. Liability: How much the owners are personally responsible for the business’s debts.
2. Capital: How the business raises money.
3. Reporting: How detailed and public the financial statements must be.

1. The Sole Trader (Proprietorship)

Imagine you decide to start a small business selling baked goods from your home. You are the sole owner, the manager, and the decision-maker. This is a Sole Trader.

Definition and Concept

A Sole Trader is a business owned and controlled by just one person. Legally, there is no separation between the owner and the business.

Analogy: The business is simply an extension of the owner's bank account and identity. If the business earns $100, the owner earns $100.

Key Financial Feature: Unlimited Liability

This is the most critical concept for Sole Traders.

• Unlimited Liability means that if the business cannot pay its debts (if it fails), the owner is legally required to use their personal assets (like their house, car, or personal savings) to pay off those debts.
• Don't worry if this seems tricky at first: Just remember that for a Sole Trader, the liability (debt risk) is 'unlimited'—it goes beyond the business and into the owner’s personal life.

Advantages of a Sole Trader

• Easy to Set Up: Very few legal hurdles or formalities to start the business.
• Full Control: The owner makes all the decisions quickly and keeps 100% of the profits.
• Confidentiality: Financial statements (Income Statements and Statements of Financial Position) are generally kept private.
• Simpler Accounts: Accounts preparation is less complex than for a company.

Disadvantages of a Sole Trader

• Unlimited Liability: High personal financial risk if the business fails.
• Limited Capital: Difficult to raise large amounts of money; capital usually comes only from the owner's personal savings or small bank loans.
• Heavy Workload: The owner must manage everything, which can lead to burnout.
• Lack of Continuity: If the owner dies or becomes seriously ill, the business might have to close.

2. The Partnership

What happens if two or more friends decide to pool their money and skills to run a business together? They form a Partnership.

Definition and Concept

A Partnership is a business owned by two or more people (usually 2 to 20, depending on the country’s laws) who agree to share both the profits and the risks.

Did you know? Many professional firms, like accountants and lawyers, use the partnership structure because it allows experts to work together and share risk.

Partners usually create a legal document called a Partnership Agreement (or Deed of Partnership). This agreement details how capital will be contributed, how profits will be split, and what happens if a partner leaves. This agreement is crucial for preparing the financial statements, particularly the Appropriation Account (which shows how profit is divided).

Liability in a Partnership

Like Sole Traders, most partners have Unlimited Liability. The risk is shared, but it remains high:

• This is often called Joint and Several Liability. This means that if Partner A makes a huge mistake that causes a massive debt, the creditor can demand the entire debt payment from Partner B (or C, or D). All partners are individually and collectively responsible for the business’s debts.

Advantages of a Partnership

• Increased Capital: More owners mean more financial investment, allowing the business to grow faster.
• Shared Workload and Expertise: Partners can divide tasks and bring different skills (e.g., one manages marketing, the other manages accounts).
• Easier to Set Up than a limited company.

Disadvantages of a Partnership

• Unlimited Liability: Still high risk, and partners are liable for each other's mistakes.
• Profit Sharing: Profits must be split according to the agreement, meaning individual return is lower than a Sole Trader’s.
• Potential for Conflict: Disagreements between partners can slow down decision-making or even end the business.
• Lack of Continuity: The partnership may need to be dissolved or restructured if a partner leaves, dies, or retires.

3. The Private Limited Company (Ltd)

When a business grows very large or requires significant investment, the owners often look to create a Private Limited Company (Ltd). This structure changes the rules entirely.

Definition and Concept

An Ltd is owned by shareholders, who buy shares in the business. It is a separate legal entity from its owners.

• Separate Legal Personality: The law sees the company as a "person" that can own assets, incur debts, and be sued—all separate from the people who own it.
• Shares can only be sold privately (usually to friends or family); they cannot be offered to the general public on a stock exchange.

Key Financial Feature: Limited Liability (The Shield)

This is the single biggest advantage of forming a company:

• Limited Liability means the financial risk of the shareholders is limited only to the money they invested (the cost of their shares).
• If the company fails, creditors cannot take the personal assets (house, car) of the shareholders. The business acts as a shield protecting the owners.
• Analogy: If you bought a \$100 share, the maximum you can lose is \$100, even if the company owes millions.

Advantages of a Private Limited Company

• Limited Liability: This protects the owners and makes it much easier to encourage large investments.
• Easier to Raise Capital: Money can be raised by selling more shares (share capital).
• Continuity: The company continues to exist even if shareholders or directors change or die.
• Expert Management: Shareholders (owners) can hire specialist directors (managers) to run the business.

Disadvantages of a Private Limited Company

• Complex Setup: The process is expensive, slow, and requires strict legal documentation (Memorandum and Articles of Association).
• Loss of Secrecy: The law requires Ltds to publish their financial statements (annual accounts) and file them with a government agency, making them available for public viewing (less financial confidentiality).
• Strict Regulations: Companies must follow complex regulations, which includes holding formal meetings and often requiring an audit (checking) of the accounts.
• Taxation: Profits are subject to corporation tax, which can be complicated.

Summary Table: Comparing the Organizations

Understanding the difference in liability is essential when preparing the financial statements, especially the Statement of Financial Position, as this determines the level of risk the owners face.

Key Takeaways for Financial Reporting

Final Encouragement

Great job making it through this core chapter! When you are tackling an accounting problem, always ask yourself: "What type of organisation is this?" Knowing the answer will immediately tell you the rules regarding liability, capital, and profit distribution. Keep up the excellent work!