Types of business entity
The word entity means ‘something that exists independently’. A business entity is a
business that exists independently of those who own the business. There are three main
categories of business which will be found in all countries, although with different titles
in different ones. This chapter uses the terminology common to the UK. The three
main categories are: sole trader, partnership and limited liability company. This list is
by no means exhaustive but provides sufficient variety to allow explanation of the
usefulness of most accounting practices and their application.
An individual may enter into business alone, either selling goods or providing a service.
Such a person is described as a sole trader. The business may be started because the
sole trader has a good idea which appears likely to make a profit, and has some cash to
buy the equipment and other resources to start the business. If cash is not available, the
sole trader may borrow from a bank to enable the business to start up. Although this
is the form in which many businesses have started, it is one which is difficult to expand
because the sole trader will find it difficult to arrange additional finance for expansion.
If the business is not successful and the sole trader is unable to meet obligations to
pay money to others, then those persons may ask a court of law to authorise the sale
of the personal possessions, and even the family home, of the sole trader. Being a sole
trader can be a risky matter and the cost of bank borrowing may be at a relatively
unfavourable rate of interest because the bank fears losing its money.
From this description it will be seen that the sole trader’s business is very much
intertwined with the sole trader’s personal life. However, for accounting purposes,
the business is regarded as a separate economic entity, of which the sole trader is the
owner who takes the risk of the bad times and the benefit of the good times. Take as
an example the person who decides to start working as an electrician and advertises
his or her services in a newspaper. The electrician travels to jobs from home and has
no business premises. Tools are stored in the loft at home and the business records
are in a cupboard in the kitchen. Telephone calls from customers are received on the
domestic phone and there are no clearly defined working hours. The work is inextricably
intertwined with family life.
For accounting purposes that person is seen as the owner of a business which provides
electrical services and the business is seen as being separate from the person’s
other interests and private life. The owner may hardly feel any great need for accounting
information because he or she knows the business very closely, but accounting
information will be needed by other persons or entities, mainly the government (in the
form of HM Revenue and Customs) for tax collecting purposes. It may also be required
by a bank for the purposes of lending money to the business or by another sole trader
who is intending to buy the business when the existing owner retires.
One method by which the business of a sole trader may expand is to enter into
partnership with one or more people. This may permit a pooling of skills to allow
more efficient working, or may allow one person with ideas to work with another who
has the money to provide the resources needed to turn the ideas into a profit. There
is thus more potential for being successful. If the business is unsuccessful, then the