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ACCT 2105 Introductory Accounting

Unit 2 - Different Accounting Entities

Learning Objectives
Discuss the nature of sole proprietorships
Discuss the nature of partnerships
Discuss the nature of companies
Distinguish between public and private companies
Discuss corporate governance and the role of directors
Analyse the capital of companies
Identify and discuss the role of the alternative regulatory bodies in company operations and
financial reporting

Types of business entities

Sole proprietorship

Partnership

Company

Sole Proprietorships

The nature of sole proprietorships:


No separate legal entity (as distinct from a separate accounting entity)
Limited life (restricted to the period the owner continues to operate the business in)
Unlimited liability (the owner is fully responsible for the debts and obligations of the business)
Minimum reporting regulations (minimal compared with other entity structures)
Limited access to funds (restricted to the personal resources of a single owner)
Low establishment costs (comparatively much lower compared to other entity structures)

Some advantages of sole proprietorships include:


Simple and inexpensive to establish and operate
Minimal financial reporting regulations
Ownership and management are normally combined
Financial rewards flow directly to the owner
Timely decision-making is possible

Partnerships

The nature of partnerships:

A partnership may be formally described as the relationship that exists between two or more
persons carrying on a business with a view to profit.

The relationship may be established by a formal partnership agreement or an informal


arrangement between the parties, or it may be inferred by the actions of two or more individuals.

The partnership maintains individual records of each partners transactions according to:

Resource contributions (capital)


Resource withdrawals (drawings)
Share of undistributed profits
ACCT 2105 Introductory Accounting
Unit 2 - Different Accounting Entities
ACCT 2105 Introductory Accounting
Unit 2 - Different Accounting Entities
The characteristics of partnerships:

No separate legal entity


Limited life
Unlimited liability
Mutual agency (each partner is responsible for the actions of the other partners)
Co-ownership of assets
Co-ownership of profits (equally or in agreed proportions)
Limited membership (a restriction on the number of partners allowed. Normally twenty is the
limit. Some exemptions exist e.g. accounting practices)
Increased regulation (most states have Partnership Acts for direction of activities and rights
and responsibilities of partners)

Partnership Agreements:

Important to have a detailed and formal agreement so that most potential problems can be
avoided
Issues not covered by the partnership agreement will be governed by law

Some examples of default legal rules that an agreement may cover include:
No entitlement of partners to a salary or wage
Partners not entitled to interest on capital contributed
Equal shares of profits and losses

Companies

The nature of companies:

There are a number of company types, the most common being the company limited by shares
(limited company).

A limited company may be defined as: An artificial legal person who has an identity separate
from that of those who own and manage it. Ownership interest is broken down into shares
hence the term shareholders to describe the owners, who have invested in the business.

Characteristics of companies:

Separate legal entity


Unlimited (perpetual) life and not related to the life of the owners
Limited liability of owners (shareholders obligations cease upon full payment of the agreed
price of their shares.)
Company ownership of assets
Company profits belong to the shareholders (profits are either distributed or retained for the
benefit of shareholders)
Extensive membership (some forms of companies may be limited, but public companies e.g.
Westpac, Telstra often exceed 250,000 initial shareholders)
Separation of ownership and management (usually a separate management team exists
outside the ownership interest, although increasingly managers are also shareholders)
Extensive regulation (much stricter requirements due to limited liability benefit granted to
owners. Regulation via Corporations Act, ASIC (Australian Securities and Investment
Commission), ASX (Australian Securities Exchange), accounting standards all govern
reporting to shareholders and markets)
ACCT 2105 Introductory Accounting
Unit 2 - Different Accounting Entities
Advantages of companies:

Separation of ownership and management


Perpetual existence
Separate legal entity
Owners have limited liability
Greater access to ownership funding
Potentially greater access to debt funding
Potential taxation advantages
Potential increases in share values when listed on the ASX (Australian Stock Exchange)

Disadvantages of companies:

Extensive regulation
Higher establishment costs
Subject to more public scrutiny
Owners not able to watch everything
Pressure for short-term performance
Loss or dilution of original ownership control
Income tax is paid on every dollar of profit earned (no tax-free threshold)

Corporate Governance and the Role of Directors

Corporate governance: The system by which corporations are directed and controlled
Directors: Individuals elected to act as the most senior level of management in a company

The Board of Directors is the most senior level of management in a company


A limited company must have at least one director
Directors are elected by the shareholders
Shareholder interests should be the guiding principle for a directors governance decisions
Directors are also subject to a framework of rules based on the principles of Disclosure,
Accountability and Fairness

Disclosure, Accountability and Fairness:

Disclosure (lies at the heart of good corporate governance, is all about adequate and timely
information being available to investors)
Accountability (involves defining the roles and duties of directors and establishing an
adequate monitoring process which may include external auditing)
Fairness (is about directors not benefiting from inside information. The law and ASX have
imposed regulations that restrict directors ability to buy and sell shares of the business)

Public and Proprietary (Private) Companies

Different types of companies:

Public Proprietary

Company name includes Ltd Pty Ltd

Public sale of shares Yes No


ACCT 2105 Introductory Accounting
Unit 2 - Different Accounting Entities

Typical size Large Smaller


Extent of regulation Extensive Moderate
Raise monies from public Yes Some restrictions

Subject to reporting requirements Yes Depends on size

Proprietary (private) companies are categorized as either small or large proprietary


companies

Public companies and large proprietary companies must prepare annual financial reports -
including financial statements and directors reports

Small proprietary companies do not have these requirements unless requested by ASIC or
by at least 5% of members

To be small, they must satisfy at least 2 of:


Consolidated gross operating revenue < $25 million
Consolidated gross assets at end of year < $12.5 million
Must employ < 50 employees at end of year

Capital of Limited Companies

Owners' Claim
(Shareholders' Equity)

Shares Reserves
(Investment by(Profits and gains subsequently m
owners)

x x x x x x

Different types of shares Different types of Reserves


ACCT 2105 Introductory Accounting
Unit 2 - Different Accounting Entities
The basic division - an example (refer example 2.1 on page 45):
Several people decide to start a new company
They estimate they will need $50,000 to obtain assets to run the business
Between them, they raise the cash to buy shares in the company, which issues 50,000
shares at $1 each

The Balance Sheet at this point would be:

Net Assets (all in cash) $50,000


Shareholders equity
Share capital - 50,000 shares $50,000

The company buys the necessary assets and inventory and starts to trade
During the first year it makes a profit of $10,000 and the shareholders (owners) are not
provided with any returns (dividends)

At the end of the first year the summarised Balance Sheet is:

Net assets (various assets less liabilities) $60,000


Shareholders equity
Share capital - 50,000 shares $50,000
Reserves (retained profits) $10,000
$60,000

The profit is shown in a reserve known as retained profits and is kept separate from share
capital
Retained profits are not added to share capital due to Corporations Act restrictions on the
maximum drawings of capital (or dividends) the owners can make.

Share Capital

Shares are the basic units of ownership of the business

All companies issue ordinary shares which are the main risk-bearing shares of the
company.
Ordinary shareholders returns come from distributions of profit (dividends) or from increases
in the value of the shares
Normally, retaining profits will increase the value of ordinary shares
Dividends - transfers of assets made by a company to its shareholders
Partly-paid shares - shares on which the full issue price has not been paid, but the balance
is to be paid in a series of installments or calls
Fully paid shares - shares on which the shareholders have paid the full issue price
Preference shares - shares which have a fixed rate of dividend that must be paid before any
ordinary share dividends can be paid. These have higher priority in the event of the company
going in to liquidation
Companies may issue shares of various classes with equally various conditions, but ordinary
and preference shares are the most common
Within each class, all shares must be treated equally
Voting rights are normally only given to holders of ordinary shares. One ordinary share
normally equals one vote
ACCT 2105 Introductory Accounting
Unit 2 - Different Accounting Entities
New shares can be issued at any time and they are priced at, or close to, market price. This
is to ensure no disadvantage to existing shareholders since all have the same rights

Reserves

Reserves - profits and gains made by the company that have not been distributed to
shareholders

The most common type of reserve is retained profits - profits earned by the company
that are held back for use within the company. You might also see the term retained
earnings which means the same thing!

Other reserves may be created in certain circumstances - a reserve is created (asset


revaluation reserve) when assets are re-valued at a value HIGHER than their book value

Bonus Shares

Bonus shares - reserves which are converted into shares and given free to
shareholders

A bonus issue of shares simply takes one form of shareholders equity (reserves) and
transforms it into another form (share capital)

Bonus share issues have no impact on the net assets (total assets less total liabilities) of
a company

Rights Issues

To generate additional share capital for expansion, a company may make a rights issue
These are issues of shares for cash, offered first to current shareholders (who may sell
the right to others) in proportion to their existing holdings
Such shares are normally offered at a price below the prevailing market price to
encourage take-up of the offer
Rights issues differ from bonus issues in that rights issues result in an asset (cash) being
transferred from shareholders to the company

Transfer of Share Ownership

Stock/Securities exchange - a formal marketplace where shares may be bought and sold,
and where new capital can be raised

Prices are determined according to the law of supply and demand, which in turn is
determined by investors perceptions of future economic prospects for the companies
concerned

Transfer of ownership of shares has no direct impact on the companys business or on


shareholders not involved in the transfer

Restrictions on the rights of shareholders to make capital drawings:

Limited companies are required by law to distinguish between capital that may be withdrawn
by shareholders and that which may not
ACCT 2105 Introductory Accounting
Unit 2 - Different Accounting Entities
The balance sheet must clearly identify the amount of non-distributable capital
It is illegal for shareholders to withdraw that part of their claim represented by capital
The legal provisions are in place to prevent unscrupulous activity which may disadvantage
other shareholders as well as creditors and lenders
ACCT 2105 Introductory Accounting
Unit 2 - Different Accounting Entities
The Nature of Regulatory Bodies

The role of alternative regulatory bodies in company operations and financial reporting:

Directors duty to account:


To be accountable for their actions and to demonstrate good stewardship
To provide financial reports that are true and fair and that comply with all relevant laws as
well as accounting standards
Financial reports must include the balance sheet, the income statement, the cash flow
statement, the statement of changes in owners equity and related notes, also the directors
declaration and directors report
Compliance with Corporations Act disclosure requirements
Publish the auditors report (if applicable)

The role of accounting standards:


For most of the 20th century GAAP was the guiding set of principles in Australia
Since 2005, Australia has adopted International Accounting Standards
Accounting standards narrow managements range of methods for recording and reporting
transactions, bringing about greater consistency
There are two types of accounting standard
AASB applies to companies and now sets all standards
AAS applies to other entities

The role of the ASX in company accounting:


The ASX is the Australian Securities Exchange. It used to be called the Australian Stock
Exchange.
Companies listed on the ASX (public companies) are subjected to further rules specified by
the ASX in relation to
more frequent reporting
other matters e.g. corporate mergers/takeovers

Shareholders are responsible for appointing qualified and independent auditors to


audit the companys financial statements
audits are not mandatory for small proprietary companies

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