Reading: Lesson 2 - Forms of business organizations

Accountants frequently refer to a business organization as an accounting entity or a business entity. A business entity is any business organization, such as a hardware store or grocery store, that exists as an economic unit. For accounting purposes, each business organization or entity has an existence separate from its owner(s), creditors, employees, customers, and other businesses.1 This separate existence of the business organization is known as the business entity concept. Thus, in the accounting records of the business entity, the activities of each business should be kept separate from the activities of other businesses and from the personal financial activities of the owner(s).

Assume, for example, that you own two businesses, a physical fitness center and a horse stable. According to the business entity concept, you would consider each business as an independent business unit. Thus, you would normally keep separate accounting records for each business. Now assume your physical fitness center is unprofitable because you are not charging enough for the use of your exercise equipment. You can determine this fact because you are treating your physical fitness center and horse stable as two separate business entities. You must also keep your personal financial activities separate from your two businesses. Therefore, you cannot include the car you drive only for personal use as a business activity of your physical fitness center or your horse stable. However, the use of your truck to pick up feed for your horse stable is a business activity of your horse stable.

As you will see shortly, the business entity concept applies to the three forms of businesses—single proprietorships, partnerships, and corporations. Thus, for accounting purposes, all three business forms are separate from other business entities and from their owner(s). Since most large businesses are corporations, we use the corporate approach in this text and include only a brief discussion of single proprietorships and partnerships.

A single proprietorship is an unincorporated business owned by an individual and often managed by that same person. Single proprietors include physicians, lawyers, electricians, and other people in business for themselves. Many small service businesses and retail establishments are also single proprietorships. No legal formalities are necessary to organize such businesses, and usually business operations can begin with only a limited investment. In a single proprietorship, the owner is solely responsible for all debts of the business. For accounting purposes, however, the business is a separate entity from the owner. Thus, single proprietors must keep the financial activities of the business, such as the receipt of fees from selling services to the public, separate from their personal financial activities. For example, owners of single proprietorships should not enter the cost of personal houses or car payments in the financial records of their businesses.

A partnership is an unincorporated business owned by two or more persons associated as partners. Often the same persons who own the business also manage the business. Many small retail establishments and professional practices, such as dentists, physicians, attorneys, and many CPA firms, are partnerships. A partnership begins with a verbal or written agreement. A written agreement is preferable because it provides a permanent record of the terms of the partnership. These terms include the initial investment of each partner, the duties of each partner, the means of dividing profits or losses between the partners each year, and the settlement after the death or withdrawal of a partner. Each partner may be held liable for all the debts of the partnership and for the actions of each partner within the scope of the business. However, as with the single proprietorship, for accounting purposes, the partnership is a separate business entity.

A corporation is a business incorporated under the laws of a state and owned by a few stockholders or thousands of stockholders. Almost all large businesses and many small businesses are incorporated. The corporation is unique in that it is a separate legal business entity. The owners of the corporation are stockholders, or shareholders. They buy shares of stock, which are units of ownership, in the corporation. Should the corporation fail, the owners would only lose the amount they paid for their stock. The corporate form of business protects the personal assets of the owners from the creditors of the corporation. 2 Stockholders do not directly manage the corporation. They elect a board of directors to represent their interests. The board of directors selects the officers of the corporation, such as the president and vice presidents, who manage the corporation for the stockholders.

Accounting is necessary for all three forms of business organizations, and each company must follow generally accepted accounting principles (GAAP). Since corporations have such an important impact on our economy, we use them in this text to illustrate basic accounting principles and concepts.

Types of activities performed by business organizations

The forms of business entities discussed in the previous section are classified according to the type of ownership of the business entity. Business entities can also be grouped by the type of business activities they perform—service companies, merchandising companies, and manufacturing companies. Any of these activities can be performed by companies using any of the three forms of business organizations. 

• Service companies perform services for a fee. This group includes accounting firms, law firms, and dry cleaning establishments. The early chapters of this text describe accounting for service companies. 
• Merchandising companies purchase goods that are ready for sale and then sell them to customers. Merchandising companies include auto dealerships, clothing stores, and supermarkets.
  
• Manufacturing companies buy materials, convert them into products, and then sell the products to other companies or to the final consumers. Manufacturing companies include steel mills, auto manufacturers, and clothing manufacturers.
  

All of these companies produce financial statements as the final end product of their accounting process. These financial statements provide relevant financial information both to those inside the company—management—and to those outside the company—creditors, stockholders, and other interested parties. The next section introduces four common financial statements—the income statement, the statement of retained earnings, the balance sheet, and the statement of cash flows.