Financial reporting and business entities

This chapter provides an overview of financial reporting - what it means and what it covers. It also introduces common forms of business entities and compares their advantages and disadvantages.

Learning objectives

By the end of this chapter, you should be able to:

• define financial reporting: recording, analysing, and summarising financial data.
• identify and define types of business entity: sole trader, partnership, limited liability company.
• explain the legal differences between a sole trader, a partnership, and a limited liability company.
• identify the advantages and disadvantages of operating as a sole trader, partnership, or limited liability company.

Definition of financial reporting

Definitions

Financial reporting

The process of recording, analysing and summarising an entity’s financial data and presenting it, mainly in financial statements, to users outside the business.

Financial reporting starts with recording, where all business transactions measurable in monetary value are recorded in journals (also known as books of prime entry). The recorded information is then classified, with transactions of a common nature grouped into a general ledger account using double-entry bookkeeping. The classified information is then summarised in a trial balance. The summarised financial information is reported to users in the form of financial statements. The reported financial statements are then analysed and interpreted for decision-making.

For accountability purposes, all business entities, in one way or another, report their financial activities to their stakeholders.

Business entities

Definitions

Organisation

A person or a group of persons who work together in a structured and coordinated manner to achieve a common goal or purpose.

Business entity

An organisation that engages in business activities to make a profit. Profit motive is what distinguishes business entities from other forms of organisation, such as not-for-profit organisations.

Types or forms of business entities

There are three (3) major types of business entities.

1. Sole trader
2. Partnership
3. Limited liability company

Sole trader

Definitions

Sole trader

A business entity, also called a sole proprietorship, owned, managed, and operated by a single individual, with no legal distinction between the owner and the business entity.

Although a sole trader has no legal separation from the business, the accounting records still treat the business as a separate entity from its owner (the business entity concept).

Advantages of a sole trader

• Ease of formation
• The owner has direct control and quick decision-making
• Since there are no partners or shareholders, all profits belong to the owner, allowing for their full retention and utilisation.
• Offers privacy as there are no legal requirements to disclose financial information publicly.
• Simple tax reporting.

Disadvantages of a sole trader

• The owner has unlimited liability. That is, they are personally responsible for all business debts and legal obligations, which can put personal assets at risk.
• May face challenges in accessing capital and resources compared to larger businesses with multiple owners.
• May lack expertise in certain areas of business operations, leading to potential shortcomings in decision-making or management.
• May face limitations in scalability due to the owner’s time, resources, and expertise constraints.
• Risks of business disruption or closure are high, especially in events where the owner becomes incapacitated, dies, or falls ill.

Partnership

Each partner contributes to the business’s capital. The partners’ rights and duties are usually set out in a written partnership agreement (partnership deed); without one, default partnership law applies.

Definitions

Partnership

An entity in which two or more individuals (partners) share the ownership of the business.

Advantages of a partnership business

• Partnerships can be established quickly with minimal legal requirements as compared to companies.
• Partners have equal rights in management, leading to informed decision-making and collaboration.
• Partners can pool resources, invest more capital, and borrow money collectively, enhancing financial capabilities.
• Business losses and workload are shared among partners (although each partner remains personally liable for all of the firm’s debts).
• Partners can maintain confidentiality in operations as they are not required to publish their financial statements. Where the partnership is a limited liability partnership (LLP: a partnership registered as a separate legal person, giving partners limited liability but requiring public filing of accounts), this advantage will not be applicable.

Disadvantages of a partnership business

• Partners are personally and jointly liable for the firm’s debts, risking personal assets (i.e., unlimited liability). In an LLP, this will not be applicable.
• Capital is limited to what the partners can personally contribute or borrow, because a partnership cannot raise funds by issuing shares, which restricts growth.
• Differences in opinions and management styles among partners can lead to conflicts and potentially slow decision-making
• In the absence of a written agreement, the partnership dissolves if a partner leaves or dies, creating uncertainty in business continuity

Limited liability company

Definitions

Limited liability company

A business entity that is a separate legal person from its owners (shareholders), whose liability for the company’s debts is limited to the amount they have invested, or agreed to invest, in its shares.

Shareholders cannot lose personal assets beyond their shareholding if the company faces debts or legal issues. The company exists as a separate legal entity, can own assets, enter into contracts, and continue operating despite changes in ownership.

By contrast, sole traders and partnerships have no legal separation from their owners, who face unlimited liability for the business’s debts (joint and several, for partners). The next chapter sets the three types side by side in a table.

Advantages of a limited liability company

• Limited liability: Shareholders can lose no more than their investment in shares.
• Separate legal entity: The company exists independently from its owners, so it can own assets, enter contracts, and sue and be sued in its own name.
• Perpetual existence: The company continues to exist regardless of changes in ownership, management, or the death of shareholders.
• Enhanced credibility: Suppliers, customers, and lenders often see a company as more credible, which can bring better credit terms and investment.
• Tax efficiency: Corporate tax rates can be lower than personal income tax rates.

Disadvantages of a limited liability company

• Complex legal and regulatory requirements: Companies must comply with extensive statutory obligations, including annual filings, audited accounts (required for larger companies, though small or dormant companies may be exempt), board meetings, and regulatory reporting.
• Higher formation and operating costs: Incorporation fees, legal costs, accounting expenses, audit requirements, and regulatory filing fees make companies more expensive to establish and maintain than sole traders or partnerships.
• Public disclosure requirements: Financial statements and company information must be filed publicly, so competitors, creditors, and others can see them.
• Loss of direct control: Shareholders act through the board and formal company procedures, so they have less direct control than a sole trader.

The next chapter looks more closely at the scope of financial reporting and the needs of the stakeholder groups who rely on financial statements, in Scope of financial reporting and stakeholder needs.