chapter # 6 forms of business organization. business a business is a legally recognized...
TRANSCRIPT
Chapter # 6
Forms of Business Organization
Business
A business is a legally recognized organizational entity designed to provide goods or services.
A legal action with the intention to get some profit or income is called business
Business
Organization
An organization is a social arrangement which pursues or achieve collective goals
Business Organization
A business organization is defined as an economic entity composed of a group of people who interact with each other for the purpose of achieving a common goal.
Forms of business organization
Sole Proprietor-ship Partnership Corporation Co-operative
Sole Proprietorship
A sole-proprietorship or sole-trader-ship is an un-incorporated business owned by one person.
Creating proprietorship requires no authorization from any governmental agency.
Sole proprietorships are so easy to start that’s why this form of business is most common.
Concept of separate business entity
For accounting purposes, we treat every business organization including a sole proprietorship as an entity separate from the other activities of its owner’s.
This enables us to measure the performance of the business separately from the other financial affairs of its owner’s.
However as per law and from liabilities point of view; sole proprietorship and it’s owner legally are one and the same.
Characteristics of Sole Proprietorship Ease of Formation:
Sole Proprietorship is very easy to start as compare to other form of business organizations.
Business assets actually belong to the proprietor:
Because business is itself not a separate legal entity that’s why it cannot own property.The business assets actually belongs to proprietor, and the proprietor may transfer assets in or out of the business at will.
The business pays no income taxes:
Tax laws do not view a sole proprietorship as separate from the other financial activities of the owner. Therefore, the proprietorship does not file an income tax return or pay income taxes.Instead of this the owner must include the income of the business in his or her personal income tax return.
Characteristics of Sole Proprietorship (cont;)
The business pays no salary to the owner:
The owner of the business does not work in the business for salary. Rather, the owner’s compensation consists of the entire net income (or net loss) of the business.
Hence, any money withdrawn form the business by its owner should be recorded by debiting the owner’s drawing account, not recognized a salaries expense.
The owner is personally liable for the debts of the business:
This concept, also called un-limited personal liability. Unlimited liability is by far the greatest disadvantage of this form of organization.
Accounting Practice of Sole Proprietorship
In the balance sheet of a sole proprietorship, total owner’s equity represented by the balance in the owner’s capital accounting.
Investments of assets by the owner are recorded by debiting asset’s a/c and crediting owner’s capital a/c.
Withdrawals of assets by the owner are recorded by debiting owner’s drawings a/c and crediting asset’s a/c.
At the end of accounting period, the drawings a/c and income summary a/c are closed into the owner’s capital account.
The only financial reporting obligation of many sole proprietorships is the information that must be included in the owner’s personal income tax return.
Evaluating the Financial Statements of a Proprietorship
The basic aims of evaluating the Financial Statements of a proprietorship is to measure ;
1. The Adequacy of Net Income and
2. Solvency of the business.
The Adequacy of Net Income
Sole proprietorship does not recognize any salary expense relating to the owner, nor any interest expense on the capital that the owner has invested in the business.
Thus, if the business is to be considered successful, its net income should at least provide the owner with reasonable compensation for personal services and equity capital that the owner provided to the business.
In short the Net Income should be sufficient to compensate the owner for three factors:
1. Personal services rendered to the business,2. Capital invested , and3. The degree of financial risk that the owner is taking
Evaluating Solvency
For the business organized as a corporation, creditors often base their lending decisions on the relationships between assets and liabilities in the corporation’s balance sheet.
But if the business is organized as a sole proprietorship, the balance sheet is less useful to creditors.
Evaluating Solvency (Cont;)
The assets listed in the balance sheet are owned by proprietor, not by the business.
The owner can transfer assets in and out of the business at will.
It is the owner who is financially responsible for the business’s debts.
Therefore the ability of a sole proprietorship to pay its debts is depending upon the solvency of the owner.
Partnership
A Partnership is an un-incorporated business owned by two or more partners. A partnership often is referred to as “Firm”.
Partnership
A form of business organization Where two or more persons Combine their resources and wealth To do a legally recognized business In which they share profit and loss among themselves As per agreement made between them and Their personal liability for the business's debts remains
un-limited.
Partnership
A form of business organization where two or more persons combine their resources and wealth, to do a legally recognized business in which they share profit and loss among themselves, as per agreement made between them and, their personal liability for the business’s debts remains un-limited.
Types of Partnership
1. General Partnership
2. Limited Partnership
3. Limited Liability Partnership
General Partnership
In General Partnership each partner has the rights and responsibilities similar to those of a sole proprietor.
For example:
Each general partner can withdraw cash and many other assets from the business at will.
Each partner has the full authority of an owner to negotiate contracts binding upon the business.
Each partner has unlimited personal liability
Limited Partnership
A limited partnership has one or more general partners and one or more limited partners.
The limited partners are basically passive investors. They share in the profits and loss of the business, but they do not participate actively in management and are not personally liable for debts of the business.
In such type of partnership the general partners are partners in traditional sense; means with un-limited personal liability.
Limited Liability Partnership
In this type of partnership each and every partner has unlimited personal liability for his or her own professional activities, but not for the actions of other partners.
Unlike a limited partnership, all of the partners in a limited liability partnership may participate in management of the firm
Accounting Practice for Partnership
In most respects, partnership accounting is similar to that in a sole proprietorship, except there are more owners.
As a result, a separate capital account and a separate drawing account are maintained for each partner.
Statement of Partners’ Equity
BLAIR AND CROSSStatement of Partners’ Equity
For the year ended December 31st , 2008
Blair Cross Total
Balances, Jan. 1st, 2008……………………Add: Additional Investments…………….Net Income for the year ($ 60,000 / 2 )…
Sub-totals……………………………………Less: Drawings……………………………..
Balance, Dec 31st, 2008……………………
$ 160,000 10,000 30,000
$ 200,000 (24,000)
$ 176,000)
$ 160,000 20,000 30,000
$ 210,000 (16,000)
$ 194,000)
$ 320,000 30,000 60,000
$ 410,000 (40,000)
$ 370,000
Allocating Net Income/Loss among the Partners
Net Income or Net loss of the business for the accounting period is the be distributed among the partners as per agreed ratio.
In the absence of partnership agreement net income or loss is to be equally split among the partners.
Every partner will pay tax on their individual share of income.
Importance of Partnership Agreement
It tell us how to distribute profit or loss among the partners
It spells out the responsibilities and rights of the partners
Evidence of the rules & regulation of the Partnership
Provide a foundation to partners disputes’ solutions.
Evaluation the Financial Statements of a Partnership
1. The Adequacy of Net Income
2. Evaluating Solvency
The Adequacy of Net Income
The net income of a partnership is similar to that of a sole-proprietorship.
It represent the partner’s compensation for;
1. Personal services
2. Invested Capital &
3. Assuming the risks of ownership.
The Adequacy of Net Income
The services and capital provided by individual partners may vary, as may the degree of financial risk assumed.
Therefore, it is quite difficult to evaluate of adequacy of the net income of a partnership.
Rather, the individual partners must separately evaluate their respective shares of the partnership net income.
Hence, some partners may find the partnership quite rewarding, while others may consider their share of the partnership net income in-adequate.
Evaluating Solvency
The balance sheet of a partnership is more meaningful than that the balance sheet of a sole-proprietorship.
This is because there are legal distinctions between partnership assets, which are jointly owned, and the personal assets of individual partners.
Creditors should understand the distinctions among the types of partnerships.
In a general partnership, all partners have unlimited personal liability for the debts of the business.
This situation affords creditors the maximum degree of protection and vice versa.
Corporation A corporation is a legal entity, having an existence separate and
distinct from that of its owners.
It is just like an artificial person created by law.
As a separate legal entity, a corporation may own property in its own name. The assets of a corporation belong to the corporation itself, not to the stockholders.
A corporation has legal status in court- it may sue and be sued as if it were a person.
As a legal entity, a corporation may enter into contracts, is responsible for its own debts, and pays income taxes on its earnings.
Corporation (continued…)
The owners of a corporation are called stockholders (or shareholders), and their ownership is evidenced by transferable shares of capital stock
On a daily basis, corporations are run by salaried professional managers, not by their stockholders. Thus the stockholders are primarily investors, rather than active participants in the business.
The top level of a corporation’s professional management is the board of directors. These directors are elected by the stockholders
Characteristics of Forms of Business Organization
Sole Proprietorship Partnership Corporation
1. Legal status
2. Liability of owners for business debts
3. Accounting status
4. Tax status
5. Persons with managerial authority
6. Continuity of the business
1. Not a separate legal entity
2. Personal liability for business debts
3. Separate entity
4. Income taxable to owner
5. Owner
6. Entity ceases with retirement or death of owner
1. Not a separate legal entity
2. Personal liability for partnership debts
3. Separate entity
4. Income taxable to partners
5. Every partner
6. New partnership is formed with a change in partners
1. Separate legal entity
2. No personal liability for corporate debts
3. Separate entity
4. Files a corporate tax return
5. Hired professional managers
6. Indefinite existence
Stockholder’s Liability for Debts of a Corporation
Stockholders in a corporation have no personal liability for the debts of the business. If a corporation fails, stockholders’ potential losses are limited to the amount of their equity in the business.
Creditors also know that shareholders are not personally liable for the debts of a corporation. Creditors have claims against only the assets of the corporation, not the personal assets of the corporation's owners.
Limited Personal Liability is the greatest advantage of the corporate form of business organization.
What types of business choose the corporate form of organization?
The answer is all kinds.
Limited shareholder liability, transferability of ownership, professional management, and continuity of existence make the corporation the best form of organization for pooling the resources of a great many equity investors.
Accounting for Corporate Income Taxes
One of the principal difference between a corporation and an un-incorporated business is that the corporation must pay income taxes on its own earnings.
Corporate income tax are usually payable in four quarterly installments.
Income tax for corporation is to be calculated as follows;
Taxable Income x Tax rate = Income taxes expenses $ 150,000 x 6.5 % = $ 9,750
Accounting for Corporate Income Taxes
A journal entry is to be required when the income tax expenses are recognized.
Date Description R/No Dr. Cr.
Dec 31st
Income Tax Expense Income Tax Payable (income tax expenses are recognized)
…..….. $ 9,750$ 9,750
Income Statement of a Corporation
MUSICLAND, INC.Income Statement
For the year ended Dec 31st , 2008
Net sales…………………………………………………………Cost of goods sold…………………………………………....
Gross profit…………………………………………………….Expenses: (other than income tax)…………………….......
Net Income before income taxes……………………………Income taxes expenses……………………………………….
Net Income after taxes………………………………………..
$ 370,000 (145,000)
$ 225,000 (75,000)
$ 150,000 (9,750) $ 140,250
Note:- Income taxes expense differs from other business expenses in that income taxes do not help to generate revenue. For this reason, income taxes are often shown separately from other expenses.
Income Tax in unprofitable periods
What happens to income taxes expenses when losses are incurred?
In the situation of corporation losses, the corporation recognize a negative amount of income taxes expenses.
The “Negative” income taxes expenses means that the corporation expects to recover from the government some of the income taxes recognized as expenses in the earlier profitable periods.
Income Tax in unprofitable periods
For example the company faces a loss of $ 65,000 & the tax rate applicable at that time is 6.5%.
Taxes expenses = $ 65,000 x 6.5% = $ 4,225
The adjusting to record income taxes in an un-profitable accounting period ;
Date Description R/No Dr. Cr.
Dec 31st
Income Tax Payable Income Tax expenses (income tax expenses are recognized)
…..….. $ 4,225$ 4,225
Income Tax in unprofitable periods
A credit balance in the Income taxes expenses account is offset against the amount of the before-tax loss, as follows;
Partial Income Statement ---- for Unprofitable Accounting Period
Net Loss before income taxes………………………………………Income tax benefit (recovery of previously recorded taxes)….
Net loss………………………………………………………………….
$ 65,000
(4,225)*
$ 60,775
* Taxes expenses = $ 65,000 x 6.5% = $ 4,225
Salaries Paid to Owners
Unincorporated businesses record payments to their owners as drawings, not as salaries expenses.
But the owners of a corporation cannot make withdrawals of corporate assets.
Many of corporate employees may also be stockholders. But the corporate make no distinction between employees who are stockholders and those who are not.
Thus all salaries paid to employees (including stockholders employees) are recognized by the corporation as salaries expenses
Owner’s equity in a Corporate Balance Sheet
In every form of business organization, there are two basic sources of owner’s equity:
1. Investment by the owner &
2. Earning form profitable operations.
Law require corporation to distinguish in their balance sheet between the amount of equity arising from each source.
Owner’s equity in a Corporate Balance Sheet
On January 4th, 2005, May Foster and several investors started Mary’s Cab Co.. a closely held corporation, by investing $ 100,000 cash. In exchange, the corporation issued to these investors 10,000 shares to its capital stock.
It is now December 31st, 2008. over its three year life. Mary’s Cab Co, has earned total net income of $ 180,000, of which $ 60,000 has been distributed to the stockholders as dividends.
The stockholders’ equity section of the corporation’s Balance Sheet will be as follows;
Stockholders’ equity: Capital Stock…………………………………………………….. Retained Earnings………………………………………………
Total Stockholders’ equity…………………………………………….
$ 100,000$ 120,000
$ 220,000
The Issuance of Capital Stock
When a corporation receives cash or other asset from its owners, it issues capital stock (shares) in exchange.
The entry will be as follows;
Date Description R/No Dr. Cr.
Jan 1st
Cash Capital Stock (Shares)(Issued 10,000 shares of capital stock)
$ 100,000$ 100,000
Retained Earnings
Retained earnings represent the owners’ equity created through profitable operation of the business.
Corporations follow a policy of distribution such retained earning to its stockholders. these distributions are termed as dividends
Earning net income causes increases in the retained earning balances
Dividends reduces both the assets and retained earning account.
Retained earning is a part of owners’ equity thus the owners’ equity also increase/decrease as well as the retained earning increase or decrease.
Accounting for Dividends
The owners of a corporation may not withdraw profits from the business at will.
Instead, distribution of cash or other assets to the stockholders must be formally authorized by the company’ s board of directors.
The formal distributions are termed Dividends.
By law, dividend must be distributed to all stockholders in proportion to the number of shares owned.
A dividend is officially declared by the board of directors on one date, and then is paid (distributed) in the near future.
Accounting for Dividends To illustrate, assume that on December 1st, the directors declare dividend of
$ 1 per share on the 10,000 shares of outstanding capital stock. The board’s resolution specifies that the dividend will be paid on December 15th to stockholders of record on December 10th.
Two entries are required:
1. One on Dec 1st to record the declaration of the dividend, and
2. Second on Dec 15th to record payment of dividend.
Date Description R/No Dr. Cr.
Dec 1st
Dec 15
dividend Dividend Payable(Dividend Declared $ 1 per share)_______________________________Dividend Payable Cash(Paid Dividend declared on Dec 1st)
…..…..$ 10,000
$10,000
$ 10,000
$10,000
Updating the retained earnings account for profits, losses and dividend
1. Net income causes increase in retained earning account
2. Net losses for the accounting period causes decrease in the retained earning account &
3. Dividend declaration also causes decrease in retained earning account
Net income causes increase in retained earning account
Closing journal entry in case of profitable operation of business in accounting period
For example, corporation gains a profit of $ 60,000
Date Description R/No Dr. Cr.
………
Income Summary Retained Earning(closing income summary account at the end of profitable accounting period)
…..….. $ 60,000$ 60,000
Net losses for the accounting period causes decrease in the retained earning account
Closing journal entry in case of Losses of business in a specified accounting period
For example, corporation faces a loss of $ 20,000 this time
Date Description R/No Dr. Cr.
………
Retained Earning Income Summary(closing income summary account at the end of accounting period for losses)
…..….. $ 60,000$ 60,000
Dividend declaration also causes decrease in retained earning account
Journal entry at the time of declaration of dividend. Dividend declaration caused reduction in retained earning account;
For example, directors declared $ 2 dividend per share for 10,000 outstanding shares
Date Description R/No Dr. Cr.
………
Retained Earning Dividend(closing income summary account at the end of accounting period for losses)
…..….. $ 20,000$ 20,000
Statement of Retained Earning
Instead of “Statement of Owner’s Equity”, corporations prepare a statement of retained earnings
It summarizing the changes in the amount of retained earnings over the year.
Statement of Retained Earning
MARY’S CAB Co.Statement of Retained Earnings
For the year ended December 31st, 2008
Retained earnings, Jan 1st, 2008…………………………………………Add: Net income for the year…………………………………..…………
Sub-total……………………………………………………………………..Less: Dividends…………………………………………………………….
Retained earnings, Dec 31st, 2008………………………………………
$ 80,000 $ 60,000
$ 140,000$ (20,000)
$ 120,000
The Adequacy of Net Income
The income of an un-incorporated business represents compensation to the owners for three distinct factors:
1. Services rendered to the business
2. Capital invested in the business
3. The risk of ownership (un-limited personal liability)
The Adequacy of Net Income
But this is not the case with a corporation.
If stockholders render services to the business, they are compensated with a salaryThe stockholders’ financial risk of ownership is limited to the amount of their in investment
Thus the Net Income of the corporation represents simply the return on the stockholders’ financial investment.
The stockholders need only ask “ Is this net income sufficient to compensate me for risking the amount of my investment?”
This makes it relatively easy for stockholders to compare the profitability of various corporations in making investment decisions.
Evaluating Solvency
For un-incorporated business, creditors look to the solvency of the individual owners, rather than that of the business entity.
This is because the owners often are personally liable for the business’s debts.
But in lending funds to a corporation, creditors generally may look only to the business entity for repayment.
Therefore, the financial strength of the business organization becomes much more important when the business is organized as a corporation.
The concept of “Double Taxation”
Un-incorporated businesses do not pay income taxes. Instead, each owner pays personal income taxes on his or her share of the business net income
Corporation, in contrast, must pay corporate income tax on their taxable income.
But in addition to this, the stockholders must pay personal income taxes on the dividend they receive.
Thus the corporation earning may end up being taxed twice.
This concept of taxing a corporation’s earning on two separate occasions is often called Double Taxation
End of Chapter 6
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