Types of business entity

The simplest business structures are the sole trader and the partnership. A sole trader is a business owned and operated by one person. A partnership is owned by two or more people (usually up to 20) who share profits and responsibilities. The defining financial characteristic of both is unlimited liability. This means the law does not see the business and the owner(s) as separate. If the business incurs debts it cannot pay, the owners are personally responsible for paying them, and their personal possessions (like their house or car) can be seized to settle the business debts. Accounting records are kept separate based on the 'business entity' concept, but legally, there is no separation.

A limited company is a more complex business structure that is legally recognised as a separate legal entity from its owners. The owners are called shareholders. Because the company is a separate 'person' in the eyes of the law, it can own assets, incur debts, and sue or be sued in its own name. The most significant advantage of this is limited liability for the shareholders. This means that if the company fails, the shareholders' maximum loss is limited to the amount they have invested in their shares. Their personal assets are protected. Companies are run by directors, who are appointed by the shareholders to manage the business on a day-to-day basis. A person can be both a director and a shareholder.

Because shareholders' funds are at risk and they may not be involved in running the company, strict rules are in place to protect them and other stakeholders like lenders and suppliers. These rules ensure that the financial information published by a company is reliable and presented in a standard way. Key regulations include:

1. National Legislation (e.g., UK Companies Act 2006): This is the law of the land that governs how a company is formed, its legal duties, the responsibilities of its directors, and the requirement to produce and file annual financial statements.

1. Accounting Standards (e.g., IAS 1): International Accounting Standard 1, 'Presentation of Financial Statements', dictates the precise format and content of a company's financial statements. Its goal is to ensure statements are consistent and comparable between different companies and across different years, giving a 'true and fair view' of the company's performance and position.

Companies raise long-term finance by issuing shares. This finance is known as share capital. There are two main types of shares:

• Ordinary Shares: These are the primary risk-taking shares. Ordinary shareholders are the true owners of the company. They have voting rights (e.g., to appoint directors) and receive a dividend, but only after preference shareholders have been paid. The amount of their dividend is not fixed and depends on the profit made and the directors' decision.
• Preference Shares: These shares offer a lower risk. They carry a right to a fixed-rate dividend (e.g., '8% Preference Shares'), which must be paid before any dividend is given to ordinary shareholders. They usually do not have voting rights.

Shares are issued with a nominal value (or par value), which is their legal face value (e.g., $1). If they are sold for more than this, the excess amount is recorded in a Share Premium account. Share premium is part of equity but is a capital reserve, meaning it cannot be distributed as cash dividends.

Besides share capital, a company's equity includes reserves, which are essentially profits kept within the business.

• Retained Earnings: This is the cumulative total of all profits made by the company over its lifetime, less any dividends it has paid out. It is a vital source of finance for reinvestment and growth.
• Other Reserves: These include the Share Premium account (a capital reserve) and the Revaluation Reserve, which is created if the company revalues its non-current assets upwards.

Companies can also raise finance through debt. A key form of long-term debt is a debenture. A debenture is a loan certificate issued by a company. Debenture holders are lenders, not owners. They have no voting rights. Key differences from shares:

• Interest vs. Dividends: Debentures pay a fixed rate of interest. This interest is an expense of the business and must be paid regardless of whether a profit is made. It is deducted before calculating profit before tax. Dividends are a distribution of profit and are only paid if the company is profitable and the directors decide to do so.
• Liability vs. Equity: Debentures are a non-current liability in the Statement of Financial Position. Shares are part of equity.

As per IAS 1, a company's financial statements must follow a specific structure. The key statements are:

Statement of Profit or Loss: This shows the company's financial performance over a period. The layout is crucial: Revenue Less: Cost of Sales = Gross Profit Add: Other Income Less: Distribution Costs Less: Administrative Expenses = Profit from Operations Less: Finance Costs (e.g., Debenture Interest) = Profit Before Tax Less: Income Tax Expense = Profit for the Year

Statement of Financial Position: This shows the company's financial position at a single point in time, following the accounting equation. ASSETS *Non-current Assets* (Property, Plant, Equipment) *Current Assets* (Inventory, Trade Receivables, Bank) TOTAL ASSETS

EQUITY AND LIABILITIES *Equity* Share Capital Share Premium Retained Earnings *Non-current Liabilities* (Debentures, Bank Loans > 1 year) *Current Liabilities* (Trade Payables, Tax Payable) TOTAL EQUITY AND LIABILITIES