Introductory Accounting

Chpt 2: Different Accounting Entities

Notes

1. Sole proprietorship
- Represents a form of business that has a single owner called the
proprietor.

Characteristics

a) No separate legal entity

- Business is a separate accounting entity but not a separate legal entity
- It cannot enter contractual arrangements i.e. borrow, sell, lend,
purchase, sue and be sued in its own right
- Legal owner must negotiate such contracts

b) Limited life
- Life of business restricted to period in which owner continues in that
position
- Activity of business may not stop when owner dies, retires or leaves
business, instead sole proprietorship business cease and possibly
another commences under a new name and new owner.

c) Unlimited liability
- Owner has unlimited liability wrt activities of business
- Fully responsible for the obligations and debts of business
- i.e. may have to use personal assets to pay off debts in the event of
bankruptcy

d) Minimum reporting regulation

- Regulations for financial recording and reporting are minimal compared
with those for other entity structures.

e) Limited access to funds

- Ownership funding is restricted to personal resources of a single owner
- Certain forms of borrowing are not available to sole proprietors that
maybe available to companies and lenders may be more reluctant to
provide credit or funds to sole proprietorships.

f) Costs of establishment
- Lower than for other entity structures
- Costs = those involved in setting up the business entity and NOT
operational costs (e.g. necessary resources, property, plant,
equipment, inventories, staff and other expenditure)

Advantages Disadvantages
Simple and inexpensive to Limited access to capital,
establish and operate expertise
Minimal financial reporting Unlimited liability ( not a problem
regulation if there are no creditors involved)
Ownership and management are
normally combined
Financial rewards flow directly to
owner
 Timely decision-making
2. Partnerships
- Business entity structure represents the relationship that two or more
individuals share with the aim of generating a financial profit.
- Relationship established by a formal partnership agreement or an
informal agreement between parties or may be simply inferred by the
actions of two or more individuals
- Represents a separate accounting entity distinct from owners
- No separate legal entity- only individual owners from viewpoint of law

Financial record-keeping, partnership maintains individual records of

each partner’s transactions with the partnership as follows:
- Resource contributions (capital)
- Resource withdrawals ( drawings)
- Share of undistributed profits ( either current or retained earnings-
earnings made in earlier periods but not withdrawn by owners)

Characteristics:

a) No separate legal entity

- Partnership is separate accounting entity but no legal distinction
between the business and partners.
- Partners NOT partnership that enters into all contractual agreements.

b) Limited life
- Change in ownership (partners leave, new partners introduced) current
partnership concludes and a new partnership commences

c) Unlimited liability
- Liability of partners jointly and separately is unlimited wrt debts of
business
- Each partner’s assets can be called upon to satisfy the claims of
business creditors, well beyond the amount of the individual partner’s
share of business

d) Mutual agency
- Each partner is responsible for business actions of all other partners as
if they had taken the action themselves.

e) Co-ownership of assets
- Partnership assets are owned by partners in aggregate rather than
individually

f) Co-ownership of profits
- Partnership profits belong to partners equally or in otherwise agreed
proportions.

g) Limited membership
- Restriction on the number of partners allowed
- Normally 20.
Note: greater number of owners, greater access to ownership funds.

h) Increased regulation
 - Most states have Partnership Acts which provide direction for the
activities of partnerships and the rights and responsibilities for
partners.
- Important to have detailed and formal agreement so that most
potential problems can be avoided.
- Issues not covered by the partnership agreement will be governed by
law.
- Eg. Of default legal rules that an agreement may cover include:
• No entitlement of partners to s salary or wage
• Partners are not entitled to interest on capital contributed
• Equal shares of profits and losses

Disadvantages: Partnership VS Sole Disadvantages: Partnership VS

proprietorship
Higher level of regulation
Giving up profit share to other owners
(co-ownership)
Giving up individual asset ownership
(co-ownership)
Reduced decision-making authority
(shared management)
Mutual agency imposes extra
responsibility for the business actions
of other partners
Company
Limited life may affect LT planning
Unlimited liability causes greater risk
for ownership investment
Absence of a specialist management
team
Mutual agency imposes extra
responsibility for the business actions
of the partners
Limited access to both ownership funds
and debt funds

3. Company
- Business entity owned by many people who have invested in the
business.
- Ownership interest is broken down into small shares; hence the use of
the term ‘shareholders’ to describe the owners.

Characteristics:
a) Separate legal entity
- A limited company that has the legal capacity of a person and has a
separate legal status from those who own the entity (shareholders).
- Company in its own right is able to enter into contracts with external
parties( buy sell borrow etc)

b) Unlimited (perpetual) life

- Life of company is indefinite and not related to the life of individuals
who own it.
- Ownership interest may change over time as shares are transferred or
sold from one shareholder to another.

c) Limited liability
- Company is a legal person hence must take responsibility for its own
debts and losses
- Means that once shareholders have paid what they agreed to pay for
the shares, their obligation to the company, and to the company’s
creditors  fulfilling their responsibility.
- May pose problems to external parties providing goods and services to
the company.
d) Company ownership of assets
- Company assets are owned by company in its own right as a legal
person

e) Company profits belong to shareholders

- Company profits are either distributed or retained for benefit of
shareholders
- Other things being equal, fact that profits are retained in the business
and reinvested in more assets, or to reduce debt, would tend to
increase the value of shares.

f) Extensive membership
- Larger membership depending on private company or public company
- With large number of owners, corporate entity structures can raise
significant amounts of ownership funds.
- Public companies have access to certain types of debt funding that is
not available to other entity structures.

g) Separation of ownership and management

- Sole proprietorship and partnerships, owners and managers are by and
large the same.
- Companies: generally a separate specialist management team outside
the ownership interest.
- Growing trend for key personnel in a management team to be
allocated shares (ownership interests) on the basis of the company’s
performance, so they may become managers and owners at the same
time.

h) Extensive regulation
- Corporate entity subjected to much stricter regulation compared to
sole proprietorship and partnership entity structure due to the ‘limited
liability’ benefit granted to owners (shareholders) and the fact that
most shareholders are widely removed from day-to-day activities of the
business and management.

Advantages
Separation of the ownership and
management and the existence of
the specialist team
Perpetual existence of the entity,
ensuring the stability of operations
and LT planning
The existence of a separate legal
entity, which gives the entity
operational and financial freedom
Limited liability for owners
(shareholders), which removes
significant barriers to investment
Greater access to ownership
funding, enhancing the business’s
Disadvantages
Managers may have too much
freedom and be fixated on making
profits that they ignore ethical
practices; loss or dilution of
original ownership control
Extensive regulation
Higher establishment costs
Subject to more public scrutiny
Owners not able to watch
everything
 ability to operate and expand
Potentially greater access to debt Pressure for ST performance
funding
Potential taxation advantages, Income tax is paid on every dollar
given the company tax rate is less of profit earned (no tax-free
than the maximum personal threshold); Corporate tax is a flat
taxation rate tax, no personal relief granted
Potential increases in share values
where shares are listed on the
stock exchange

4. Directors
- Elected by shareholders
- Individuals who are elected to act as the most senior level of
management of a company

5. Corporate governance
- System by which corporations are directed and controlled
- Important as shareholders are normally divorced from the day-to-day
control of the business
- Since shareholders employ directors to manage the company for them,
it seems reasonable to assume that the best interests of shareholders
will guide the directors’ decisions
- In practice, this does not always occur.
- Directors may be more concerned with pursuing their own interests at
the expense of the shareholders and the interests of directors may
conflict.
• Pose a problem to shareholders and society
• If shareholders feel that their funds may be mismanaged, they
will be reluctant to invest. A shortage of funds would restrict the
investment choices and the costs of funds will increase as
businesses compete for available funds. Thus, a lack of concern
for shareholders can profoundly affect the performance of the
economy.

Framework of rules to help monitor and control the behavior of directors:

a) Disclosure
- Adequate and timely information about corporate performance enables
investors to make informed buy-and-sell decisions and helps the
market reflect the value of a corporation under present management.

b) Accountability
- Defining roles and duties of directors and establishing an adequate
monitoring process.
- Includes external auditing
- Directors cannot use their position and knowledge to make gains at the
expense of the shareholders.

c) Fairness
 - Directors should not be able to benefit from ‘inside’ information that is
not available to shareholders.

6.
Public Proprietary
Company name Ltd Pty Ltd/ Pte Ltd
includes
Public sale of shares Yes No
Typical size Large Small (SME- Small
Medium Enterprise)
Extent of regulation Extensive Moderate
Raise monies from Yes Some restrictions
public
Subject to reporting Yes Depends on size
requirements Annual financial
reports including
financial statements
and directors’ reports

7. Capital of limited companies

- Balance sheet sets out things that are owned, and deducts from this
figure the amounts owed to outsiders.
- Difference represents wealth of business
- Wealth = owners’ claim
- Business makes more profit, increase in wealth, owners’ claim
increases

Owners’ claim in different settings:

a) Sole proprietorship
- Normally encompassed in one figure on the balance sheet, labeled as
capital
- Figure increased by further injections of funds or by making profits, or
reduced by incurring losses or by drawings made by owner

b) Companies
- Owners’ claim divided between shares (original investment) on one
hand, reserves (profits and gains subsequently made).
- Capital and reserves generally referred to as shareholders’ equity
- May be further subdivisions within the basic divisions of share capital
and reserves

Note: Reserves are known as retained profits. Profit cannot be added to the
share capital. Two amounts must be kept separate due to Corporations Act as
there is a legal restriction on the maximum drawings of capital/ dividends.

8. Share capital
- Shares represent the basic units of ownership of business.
- Ordinary shares: the main risk-bearing shares
- Preference shares: usually guarantee that if a dividend is paid, the
preference shareholders will be entitled to the first part of p to a
 maximum value. Max value is usually defined as a fixed percentage of
the preference shares.
- Only ordinary shareholders are allowed to vote on issues that affect
company

9. Reserves
- Profits and gains that have been made by the company that still form
part of the shareholders’ (owners’) claim.
- Profits and gains tend to lead cash flowing into the company.
- Retained profits represent the largest source of finance for Australian
companies.
- Not all reserves result from profits earned and therefore reserves may
not be distributable as a cash dividend.

10.Bonus shares
- Reserves converted into shares and given ‘free’ to shareholders.
- Involve no cost to shareholders
- May indicate that management has reason to believe that future
earnings will improve and if market supports this position than the
bonus issue may be associated with increased overall share value.
- Takes one part of the owners’ claim (part of reserve) and puts it into
another part of the owners’ claim (share capital).

11.Rights issue
- An issue of shares for cash to existing shareholders on the basis of the
number of shares already held.
-