Individuals, Sole Traders and Partnerships

Accounting entity…

Before going to express more about individuals, sole traders and partnership, we will first explain about accounting entities. The Business dictionary defines an accounting entity distinct from the personal dealings of its owners or employees. To ensure that the fundamental accounting equation always refer to the same distinct entity the boundaries of the units, once established ,must not be arbitrarily. Accounting entity also called reporting entity or separate entity.

On the other hand, an accounting entity can be either a business or subdivision of a business that engages in economic activities, has economic assets and resources that must be accounted, and is separate from the personal dealings of its owners. Once an accounting entity is determined, transactions within the specific unit are accounted. The entity should not be flexible or regularly changed, in order to insure the accuracy of accounting. For example, a proprietor’s accounting entity might be the business whereas the legal entity would include personal assets. Also, in the corporate environment, affiliated companies can be differently organized for legal and accounting purposes (e.g., industry segments).

From the Investopedia, accounting entity is clearly defined as economics unit that is accounted for separately. An accounting entity can be either a business or subdivision of a business that engages in economic activities, has economic assets and resources that must be accounted, and is separate from the personal dealings of its owners. Once an accounting entity is determined, transactions within the specific unit are accounted. The entity should not be flexible or regularly changed, in order to insure the accuracy of accounting.

In short, accounting entity is any organisational unit for which accounting records are kept and about which accounting reports are prepared. Any business is seen as a separate entity for accounting purposes, regardless of its form of ownership. It is also known as reporting entity.

Profit-making Non-for-profit

Organisation Organisation

The economics,social&political environment&technological change

Private limited companies

Charities

Public sector bodies

Voluntary organisation

Quangos

Partnerships

Public limited companies (plc)

Sole traders

Types of business entity

Individuals

Individuals are separate accounting entities. They will always keep their own financial records of varying sophistication. Besides, they will also produce financial reports that may include lists of income, expenditures, assets, and liabilities for loan application or Social Welfare means tests, tax returns or personal budgets. It is actually depends on every person because some of the people would like to have their own budget as they think it will waste a lot of time.

Advantages of individuals

It is to prevent the confusion between the personal activities and the business activities. The accountants can determine whether the company is making profit or loss money in one whole year. If the owner takes out the money without recording, it will make the accountant confuse and difficult to make decision about the business for the future.

It is also to recognize legal liabilities of the business entity. The taxation commissioner is one of the good examples. For some expenditure, there may be some allowable tax deduction in business expenses but not tax deductible for personally.

By doing our own account or budget, we can easily know the financial position of our own. It is safe and it can be an evidence for our future reference.

It can help us to estimate whether we should use more or less money for the following months. If we used too much of money on expenses for the last month, we can actually plan by reducing the money uses on the coming month in order to balance our account.

Disadvantages of individuals

By doing a budget, one may waste his or her time because he or she needs to do it every month.

Sole trader

Definitions of Sole Traders

The simplest and easiest way to set up in business is to commence as a sole trader. The word ‘sole’ means one and only. A sole trader also known as a sole proprietorship or simply proprietorship is a type of business entity which is owned and run by one individual and where there is no legal distinction between the owner and the business. A sole trader is a business enterprise which is owned by one person. It is the responsibility of this owner to supply the necessary funds to commence the business. The sole trader’s business will trade under the owner’s name or a name chosen by the sole trader. Any person may form a sole-trader business. It requires no legal formalities and is simple, flexible and inexpensive. Sole traders are the oldest and most common form of business organisation. They can vary considerably in size and in the number of employees, and are commonly found in small retailing, farming and the service industry. Examples of sole trader businesses include small retailers, plumbers, builders, internet entrepreneurs, beauticians, market traders, grocers and butchers.

Some of the important definitions of sole proprietorship are as follows:

1) Paterson and Plowman

“A sole proprietorship is a business unit whose ownership and management ace vested in one person. The individual assumes all risk of loss or failure of the enterprise and receives all profits from its successful operation.”

James Stephenson

“A sole trader is a person who carries on business exclusively by and for himself. He is not only the owner of the capital of the undertaking but is usually the organizer and manager and takes all the profits or responsibilities for losses.”

Characteristics of Sole Proprietorships

Ownership…

The ownership is owned by a single individual but the organisation may employ more than one person in order to assist the owner. All the business assets are owned by the sole trader.

Management and Control…

The sole trader has full control over the whole management of the business and the success or otherwise of the business is very much dependent on the performance of the owner.

No legal formalities…

A sole trader business is the simplest type of business organisation and the easiest to establish. Any person can form a sole-trader business. It requires no legal formalities, and is simple, flexible and inexpensive. There are no legal restrictions affecting the establishment of a sole trader business.

Legal status…

In law, the sole trader and his business are considered as one, In other words, all the assets and liabilities of the business are the personal assets and liabilities of the proprietor. We can say that the owner and the business exist together. In other words, the two are considered as one in the eyes of law. A sole trader cannot operate a bank, a building society or an insurance firm. Other than this, it is necessary for the sole trader to obtain a licence in order to operate certain types of business activity such as taxi services and hotels. A further requirement is that if owner does not operate the business under his or her own name, the business name must be registered under the Business Names Act. Registration is relatively inexpensive and once a name is registered it prevents others from using that name. Business not affected by the above restrictions can be commenced without official permission or legal formalities by a sole trader. Not being a separate entity, the business is not subjected to tax, but the owner must pay tax on the business’s profits

Finance …

The necessary capital to run the business is provided by the sole owner. However, he may borrow from other sources such as friends or bank as need arises. The growth of the business is limited to the owner’s personal wealth and capacity to raise the funds and, unless this is considerable, it usually places limits on the business’s ability to grow. However, the owner has sole entitlement to the profits of the business which means all the profits will go to the owner.

Risk…

The proprietor himself bears all the risks. No body else has any stake in the business. Although the owner may employ someone else to assist him or her, but at last the owner will still be the only one who bears all the risk.

Unlimited liability…

The sole trader is personally liable for debts of the business. Because the sole-trader type business is not regarded as separate legal entity, so the liability of the owner is unlimited. The creditor can lay claim not only on his business assets but also his personal property such as car, houses, furniture etc to recover the loan.

Relationship with customers…

The sole trader tries to keep good relationship with his customers. The customers are generally personally known to the proprietor and their orders are higher valued.

Ease of dissolution…

The sole trading business is as easy to end or dissolve as is its formation. The decision of the proprietor alone ends the business. It dissolves with the death of the owner.

Advantages of Sole Traders

The main advantages of a sole-trader business are that:

It is quick, ease to start up and inexpensive to establish. This is because there is no need to make contract with other owners and also no charter to obtain from the state government and few legal restrictions-one may need a license from the local government ;

A sole proprietor usually has a quick decision process and doesn’t have any opposition when taking a decision as he full control over the management, decision, and policy making and operation of the business;

The sole trader is entitled to all profits made and is not required to share the profit with others. In other words, the profit serves as a strong incentive and gives the owner maximum satisfaction;

It requires a small amount of capital to establish. Subsequently, it is because of no charter fee to be paid, and the local license is small. In other words, the main costs of getting started are those for equipment and merchandise;

The sole proprietorship also does not have to be concerned with double taxation, as a corporate entity would;

Disadvantages of Sole Traders

The main disadvantages associated with this form of organisation are that:

The sole trader has to assume full responsibility for the operation of the business –the success of the business is determined by the expertise and ability of the owner and lack of expertise is the most common cause of failure of new business;

The business may be hindered by the limited amount of finance that can be normally be raised by one person. In other words, he or she will likely have a hard time raising capital since he or she has to make up for all the business’s funds;

The sole trader has unlimited liability for the debts of the business. Subsequently, the debts might exceed the value of its assets. This is the most serious weakness of the proprietorship;

It is very demanding of time and imposes a heavy personal commitment on the owner-any sudden illness or personal difficulty experienced by the owner could have serious consequences for the business. For instance, when there is no family member is ready, willing, or able to carry on, it must be sold. If the family member is not prepared to manage it, bankruptcy most likely will be the result ;

As if a business becomes successful, the risks accompanying the business tend to grow. To minimize those risks, a sole proprietor has the option of forming a partnership or a corporation.

Partnership

Definition of partnership

Partnership or firm as it is often called is the 2nd stage in the evolution of forms of business organization. Partnership as a form of business organization grew out of the limitations of individual proprietorship. As we all know, in sole proprietorship, the financial resources, managerial skill, risk bearing capacity were limited. When business activities started expanding, the arose a need for more capital, more persons to supervise the business affairs, The partnership form of organization was developed to overcome the draw backs of sole trading organization and to meet the expanding needs of a business requiting a moderate amount of capital. Hence, two or more persons form a partnership by making a written or oral agreement that they will jointly assume full responsibility for the conduct of business.

L H. Haney defines partnership in the following words: Partnership is the relationship between persons who agree to carry on a business in common with a view to private gain.”

However, section of the Partnership Act of 1932 as adopted in Pakistan defines partnership in the following words “Partnership Is the relation between persons who have agreed to share the profits of a business carried on by all or any one of them acting for all. Persons forming partnership are individually known as partners and collectively ‘a firm’. The important points to note about this definition are:

that the partnership is formed to carry on a business – not just an isolated venture or business transaction

‘in common’ mean by, or on behalf of, all the partners

It should be the intention of the partners to make a profit.

Characteristics of Partnership

A partnership is an organization which is an unincorporated association. As said earlier, it is owned by two or more individuals who equally share the profits or losses of the business. There are various small businesses which can be considered as example of partnership like retail, service, and professional practitioners. A partnership has limited number of years depending upon the agreement. Secondly, it is a mutual agency and the partners act as the agents of partnership and they are also responsible for running the operations of the business. In addition, partnerships can be easily formed and dissolved and there are no legal issues involved.

The essential elements of partnership as a form of business organization are as follows:-

The community is initiated by one or more individuals and develops organically, responding to the needs and the interests of the organizers.

The community is committed to Partnership Principles as described in this manual

There is strong, focused leadership and clear accountability. We know that behind the success of any initiative or project is a person that had a vision along with the time and skills to lead a group;

Some kind of flexible structure that promotes creativity and offers a pleasant environment is created to guide the work. This might include identifying a leader, co-leaders or facilitator. It also might include identifying individuals that assume important roles of providing meeting space or being a liaison with a sponsoring organization, in charge of logistics. Share the work and find a role for every person to play. This will assure a shared responsibility for accomplishing your goals.

All voices are heard and recognized within the structure that supports moving the community forward

Engaged listening is built into every aspect of the community, to benefit and learn from all of the people who are onboard with the partnership efforts.

Positive relationships are fostered within the community, as well as with funders, participants and the public.

There is an atmosphere of hospitality and caring.

Everyone contributes to the knowledge about partnership and has the opportunity to participate in decision-making.

Information flows up and down the community, with many points of contact so that community members know what is happening and what future plans are.

The unique talents of everyone are valued and utilized.

Teamwork is valued and expressed in every phase of the work

Leaders empower people to actively and individually engage in partnership work

Environmental stewardship is practiced, including green practices such as using dishes instead of throw always; excessive use of paper copies is avoided, etc.

Volunteer contributions are honoured and recognized.

Develop a way to deal with challenging issues that everyone agrees to. Without doubt, there will be disagreements.

By default, profits are shared equally amongst the partners.

By default a partnership will terminate upon the death, disability, or even withdrawal of any one partner. However, most partnership agreements provide for these types of events, with the share of the departed partner usually being purchased by the remaining partners in the partnership.

By default, each general partner has an equal right to participate in the management and control of the business. Disagreements in the ordinary course of partnership business are decided by a majority of the partners, and disagreements of extraordinary matters and amendments to the partnership agreement require the consent of all partners. However, in a partnership of any size the partnership agreement will provide for certain selectees’ to manage the partnership along the lines of a company board.

Partnership agreement

An agreement to form a partnership may be either express (ie in writing or orally), or implied (i.e. resulting from the conduct of the partners). It is usual for a written agreement to be drawn up.

A partnership agreement is a written agreement setting out the rights, liabilities and duties of the partners.

This agreement should contain clauses covering such thing as:

Names of the partners

Name of the firm

Objectives or purposes of the partnership

Rights, duties and liabilities of the partners

Capital introduced by each partner

How profits and loses are to be divided

Whether drawing, salaries to partners, interest on drawings, interest on capital and interest on advances are to be allowed

Voting and decision-making producers to be followed

Procedures to be followed on death or retirement of partners.

This list is not complete as each particular partnership may require its own set of special clauses. However, the list gives some idea of the contents of clauses that should appear in a partnership agreement.

Partnership Act

Where a partnership agreement is not drawn up the partnership is governed by the Partnership Act in force at the time. If partners do not want to be governed by this act they must draw up their own partnership agreement. Where no partnership agreement exists the Partnership Act provides that:

Partners will share equally in profits and losses of the business

A partner is not entitled to remuneration for working in the business

All partners must consent before a new partner is introduced

A majority decision by partners is required on ordinary business matters

Partners are entitled to interest on advances (other than capital) to the partnership

Mutual agency exists, i.e. each partner can act on behalf of the firm in normal business transactions

On the death of a partner the partnership is dissolved.

Advantages and disadvantages of partnerships

There are several advantages in forming a partnership rather than another type of business:

Formation is easier than for a company. In some state, the firm is not necessary to register. A simple agreement or partnership deed, either oral or in writing. The only required is for the people concerned to agree to share the decisions within a business, or start to work together as joint owners of a business.

Partners with specialist skills can get together to use their skills in every aspect of business. For example, two people working together have different complimentary skills, which can be very cost-effective as people specialise and become more efficient in certain aspects of their creative business. One partner might be good at selling work and presenting to clients, while another is better at bookkeeping. So they can manage the company in a better way.

Since the partnership firm is a flexible organisation, the partners can decide to change the size or nature of the business. In partnership agreements, the partners are free to set their responsibilities and benefits as they see fit or as the needs of the business dictate. There is no legal procedure and only need the consent of all the partners.

In a partnership firm, every partner has an equal right in decision making and the management of the business. If any decision goes against the interest of any partner, the partner can prevent the decision from being taken. In extreme cases an unsatisfied partner may withdraw from the business. In such extreme cases the “partnership deed” is required. In absence of the partnership deed, there is no legal protection is given to the partners.

The business is not taxed in its profits; rather the partners are taxed personally. General partnership is normally a “pass through” tax entity — meaning the partners, and not the partnership, are taxed — filing income tax returns is relatively easy. Unlike a regular corporation, there is no need to file separate tax returns for the corporate entity and its owners.

In a partnership firm all the partners “share” the business risks. If the business experiences financial difficulties there will be other people to share the costs. This reduces the risk of losing money. For example, if there are three partners and the firm makes a loss of RM12,000 in a particular period, then all partners may share it and the individual burden will be RM4000 only. Because of this, the partners may be encouraged to take up more risk and hence expand their business more.

Expanding the business can be made easier as new partners can be introduced. It is possible to bring together larger amounts of capital than as a sole trader. They may put money into the partnership which could be used for buying new instruments, or updating existing, machinery.

Some financial details can be kept private from others, as you don’t have to publish your accounts – many people do not like others to know how much they earn.

Partnerships provide moral support and will allow for more creative brainstorms

Partners need to be more organised than when you run your business solo, which often means that partnerships have better administration and financial systems in place than sole traders

A partnership is not a separate legal entity, but is a separate accounting entity. The firm must lodge a taxation return although no tax is payable by the firm. The profit made by the partnership and given to each partner forms part of the taxable income of the individual partners.

The disadvantages in this form of business enterprise are:

The partnership has a limited life. It is dissolved when one of the partners pass away if there is no provision for this in the partnership agreement, or on the occurrence of an event stated in the partnership agreement. Further, any unsatisfied or discontent partner can also give notice at any time for the dissolution of the partnership.

Owners have unlimited liability. As the partnership is not a separate legal entity, the owner is liable for partnership debts. In the event of bankruptcy of the partnership the partners’ private assets can be used to settle partnership debts. So if the business fails and incurs debts, and one of the partners doesn’t pay his or her share, the other partners will still be required to pay for it. This is even the case if debts were incurred by the partner’s dishonesty or mismanagement without knowledge.

Partners may have different visions or opinion for the business. At some time, there most certainly will be disagreements in management plans, operational procedures, and future vision for the business. There may also be personal disputes. Difference of opinion may lead to unsatisfied between the partners and the end of the partnership and the business.

A partnership is for the long term, the change of expectations and situations can lead to dramatic split ups. Partners might spend more time with the business partners than with anybody else, so losing that very intimate and personal business relationship can lead to major problems when splitting up

Partner has to consult each other and negotiate more as the partner cannot take decisions by himself.

Partner has to share the company profits and decide on how to value each other’s time and skills. For examples, what happens if one person puts in 60 hours a week and the other one turns up late very regularly and what happen if one partner can put in less time due to personal circumstances, such as caring responsibilities or illness?

There is no transferability of share in partnership. Partner cannot transfer the share or the part of the company to outsiders, without the consent of other partners. This creates inconvenience for the partner who wants to leave the firm or sell part of his share to others.

The partnership has limited capital. Since the total number of partners cannot exceed 20, the capital to be raised is always limited. It may not be possible to start a very large business in partnership form.

The decision on the most appropriate form of business organisation is obviously taken after consideration of the advantages, disadvantages and circumstances of the particular situation.

Conclusion

Comparison between sole trader and partnership

Feature

Sole trader

Partnership

Ownership

One owner

2-20 partners(some exceptions)

Transfer of ownership

Only possible through sale of business

All partners must agree before any changes in ownership is instigated

Capital contributions upon establishment

Sole trader makes equity contributions

Each partner contributes equity as agreed by the partnerships

Formation

Easy to establish, no formal requirements

Relatively easy to form-in accordance with Partnership Agreement or Partnership Act

Statutory requirements

Business name to be registered under the Business Names Act if it does not include the sole trader’s name

Partnership name must be registered under the Business Names Act if it does not contain names of all partners

Legal status

Not a separate entity; legal entity is the sole trader personally

Not a separate legal entity ;each partner is the legal entity

Liability

Unlimited liability

Unlimited liability

Perpetual succession

Only if the business is sold or passed on, eg: through inheritance

Only will continue to exist if provisions are made in the partnership agreement

Management

Owner may manage or appoint a manager

Each partner may manage or as stated in the agreement

Distribution of profits

Receives all profits and bears all losses

Division of profits as per partnership agreement ,or equally in accordance with Partnership Act

Taxation

Owners are individually taxed on business profits

Owners are individually taxed on business profits