Transcript Document

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
Human Activities
Non-Economic Activities
Economic Activities
Profession
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
governmental agency.
requires
no
authorization
from
any
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Hence, any money withdrawn form the business by its owner should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.
2.
The Adequacy of Net Income and
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.
2.
3.
Personal services rendered to the business,
Capital invested , and
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.
2.
3.
General Partnership
Limited Partnership
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 CROSS
Statement 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 )…
$ 160,000
10,000
30,000
$ 160,000
20,000
30,000
$ 320,000
30,000
60,000
Sub-totals……………………………………
Less: Drawings……………………………..
$ 200,000
(24,000)
$ 210,000
(16,000)
$ 410,000
(40,000)
Balance, Dec 31st, 2008……………………
$ 176,000)
$ 194,000)
$ 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
1.
Legal status
1.
2.
Liability of
owners for
business debts
2.
Not a separate
legal entity
Personal liability
for business
debts
Partnership
Not a separate
legal entity
Personal liability
for partnership
debts
Separate entity
1.
4.
Income taxable to
partners
4.
Files a corporate
tax return
5.
Every partner
5.
Hired
professional
managers
6.
New partnership
is formed with a
change in
partners
6.
Indefinite
existence
1.
2.
3.
3.
Accounting
status
3.
4.
4.
Tax status
5.
Persons with
managerial
authority
6.
Continuity of the
business
Corporation
2.
3.
Separate legal
entity
No personal
liability for
corporate debts
Separate entity
Separate entity
Income taxable to
owner
5.
Owner
6.
Entity ceases
with retirement or
death of owner
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…………………………………………....
$ 370,000
(145,000)
Gross profit…………………………………………………….
Expenses: (other than income tax)…………………….......
$ 225,000
(75,000)
Net Income before income taxes……………………………
Income taxes expenses……………………………………….
$ 150,000
(9,750)
Net Income after taxes………………………………………..
$ 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)….
$ 65,000
Net loss………………………………………………………………….
$ 60,775
* Taxes expenses = $ 65,000 x 6.5% = $ 4,225
(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
corporate assets.
withdrawals of
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………………………………………………
$ 100,000
$ 120,000
Total Stockholders’ equity…………………………………………….
$ 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:
One on Dec 1st to record the declaration of the dividend, and
Second on Dec 15th to record payment of dividend.
1.
2.
Date
Description
R/No
Dec 1st dividend
Dec 15
Dividend Payable
(Dividend Declared $ 1 per share)
_______________________________
Dividend Payable
Cash
(Paid Dividend declared on Dec 1st)
Dr.
Cr.
$ 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…………………………………..…………
$ 80,000
$ 60,000
Sub-total……………………………………………………………………..
Less: Dividends…………………………………………………………….
$ 140,000
$ (20,000)
Retained earnings, Dec 31st, 2008………………………………………
$ 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 salary
The 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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