Financial accounting is used by a wide variety of organizations, including businesses organized to earn a profit, nonprofit organizations, and governmental entities. This tutorial focuses on profit-oriented enterprises, which can be organized in one of the four ways described next.
Sole traders are businesses that are owned by one individual and usually operated by that individual. They are not separate legal entities apart from the owner, and no special legal steps are required to launch or operate this form of business. As another example, if you decided to earn money by mowing lawns during the summer, your business would probably be organized as a sole proprietorship
Because no legal procedures are needed to begin operating sole proprietorships,their primary advantage is ease of formation. The major disadvantage is unlimited legal liability. Because owners are not legally distinct from their businesses, any claims against sole proprietorships are also claims against the owners’ personal assets. Although sole traders are not separate legal entities, they are separate accounting (or economic) entities. The entity assumption indicates that the actions of the owner, serving as an agent of the business, can be (and should be) separated from the personal affairs of the owner. Based on this distinction, information about the transactions of the business can be accumulated via the financial accounting process. This enables the owner to assess the status and performance of the business on a stand-alone basis.
Partnerships are very similar to sole proprietorships, except that partnerships have more than one owner. Partnerships are not separate legal entities apart from their owners, but they are separate accounting entities. They are almost as easy to form as sole proprietorships, yet because of multiple owners, care must be taken to specify the rights and responsibilities of each owner. This is usually done in a partnership agreement, which is a legal contract among the partners.
Company differ substantially from sole proprietorships and partnerships because they are separate legal entities. They are granted their right to exist by the individual states. A corporation must develop bylaws governing its operation, issue stock to its owners (shareholders) to represent their ownership interests, elect a board of directors who are responsible for the management of the corporation, pay taxes, and adhere to a variety of laws and regulations. Most large and many smaller businesses are organized as corporations. As might be expected, forming a corporation is a relatively cumbersome and expensive process. Costs include filing fees paid to the state of incorporation, legal fees, and amounts paid for corporate records, such as stock certificates, bylaws, and so on. Corporations, unlike sole proprietorships and partnerships, must pay income taxes. Moreover, shareholders are also taxed on any dividends paid to them. Thus, corporations are subject to double taxation. Because sole proprietorships and partnerships are not separate legal entities, they do not pay income taxes; sole proprietors and partners include the income of their businesses on their individual income tax returns. The corporate form of organization has certain advantages that can outweigh the costs. Perhaps the primary benefit is the limited liability offered to shareholders. Because the corporation is a legal entity, the corporation itself is responsible for its actions. Although shareholders risk losing their investment, their personal assets are protected from claims against the corporation. Such is not the case for sole proprietorships and partnerships.