Accounting

Forms of Business Organization

What organizational form should you choose for your business? You have three choices—sole proprietorship, partnership, or corporation.

Sole Proprietorship

You might choose the sole proprietorship form for your outdoor guide service.

A business owned by one person is a sole proprietorship.

It is simple to set up and gives you control over the business.

An illustration displays a textbox titled, Sole Proprietorship, with an illustration of a cyclist on the left and a list on the right that reads as follows: Simple to establish; Owner-controlled; Tax advantages.

Small owner-operated businesses such as barber shops, law offices, and auto repair shops are often sole proprietorships, as are farms and small retail stores.

Partnership

Another possibility is for you to join forces with other individuals to form a partnership.

A business owned by two or more persons associated as partners is a partnership.

Partnerships often are formed because one individual does not have enough economic resources or other unique skills or resources to initiate or expand the business.

An illustration displays a textbox titled, Partnership, with an illustration of two tennis players, followed by a list at the bottom that reads as follows: Simple to establish; Shared control; Broader skills and resources; Tax advantages.

You and your partners should formalize your duties and contributions in a written partnership agreement. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certified public accountants), often organize as partnerships.

Corporation

As a third alternative, you might organize as a corporation.

A business organized as a separate legal entity owned by stockholders is a corporation.

Investors in a corporation receive shares of stock to indicate their ownership claim.

An illustration displays a textbox titled, Corporation, with an illustration of a football team, followed by a list at the bottom that reads as follows: Easier to transfer ownership; Easier to raise funds; No personal liability.

Buying stock in a corporation is often more attractive than investing in a partnership because shares of stock are easy to sell (transfer ownership). Selling a proprietorship or partnership interest is much more involved. Also, individuals can become stockholders by investing relatively small amounts of money (see Alternative Terminology).

ALTERNATIVE TERMINOLOGY

Stockholders are sometimes called shareholders.

Alternative Terminology notes present synonymous terms that you may come across in practice.

Therefore, it is easier for corporations to raise funds compared to sole proprietorships or partnerships. Successful corporations often have thousands of stockholders, and their stock is traded on organized stock exchanges like the New York Stock Exchange. Many businesses start as sole proprietorships or partnerships and eventually incorporate.

Other factors to consider in deciding which organizational form to choose are taxes and legal liability. Sole proprietorships or partnerships, generally receive more favorable tax treatment than corporations. However, proprietors and partners are personally liable for all debts and legal obligations of the business; corporate stockholders are not. In other words, corporate stockholders generally pay higher taxes but have no personal legal liability. We will discuss these issues in more depth in a later chapter.

Hybrid Forms of Organization

Finally, while sole proprietorships, partnerships, and corporations represent the main types of business organizations, hybrid forms are now allowed in all states.

Hybrid business forms combine the tax advantages of partnerships with the limited liability of corporations.

Probably the most common among these hybrid types are limited liability companies (LLCs) and subchapter S corporations (these forms are discussed extensively in business law classes).

The combined number of proprietorships and partnerships in the United States far exceeds the number of corporations. However, the revenue produced by corporations is many times greater. Most of the largest businesses in the United States—for example, Apple, Google, Verizon, Visa, and Microsoft—are corporations. Because the majority of U.S. business is done by corporations, the emphasis in this text is on the corporate form of organization.

Users and Uses of Financial Information

The purpose of financial information is to provide inputs for decision-making.

Accounting is the information system that identifies, records, and communicates the economic events of an organization to interested users.

Users of accounting information can be divided broadly into two groups: internal users and external users.

Internal Users

Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, finance directors, and company officers. In running a business, managers must answer many important questions, as shown in Illustration 1.1.

ILLUSTRATION 1.1 Questions that internal users askA question asked by an internal user in the finance department is: Is cash sufficient to pay dividends to our stockholders? Illustrated by a woman wearing a t-shirt bearing an apple logo and sitting in front of a laptop. A question asked by an internal user in the marketing department is: What price should we charge for an iPhone to maximize the company's net income? Illustrated by a man wearing a t-shirt bearing an apple logo and sitting at a table. A question asked by an internal user in the human resources department is: Can we afford to give its employees pay raises this year? Illustrated by a woman wearing a t-shirt bearing an apple logo and sitting at a table. Questions asked by an internal user that are part of management include, Which product line is the most profitable? Should any product lines be eliminated? Illustrated by a man wearing a t-shirt bearing an apple logo and sitting at a table.

To answer these and other questions, you need detailed information on a timely basis. For internal users, accounting provides internal reports, such as financial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year. In addition, companies present summarized financial information in the form of financial statements.

Ethics in Financial Reporting

People won’t gamble in a casino if they think it is “rigged.” Similarly, people won’t “play” the stock market if they think stock prices are rigged. At one time, major financial scandals at Enron, WorldCom, HealthSouth, and AIG led to a mistrust of financial reporting in general.

A Wall Street Journal article noted that “repeated disclosures about questionable accounting practices have bruised investors’ faith in the reliability of earnings reports, which in turn has sent stock prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared. Information would have no credibility. A well-functioning economy depends on accurate and reliable financial reporting.

U.S. regulators and lawmakers were very concerned that the economy would suffer if investors lost confidence in corporate accounting because of unethical financial reporting.

Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals (see Ethics Note).

As a result of SOX, top management must now certify the fairness of financial information.

In addition, penalties for fraudulent financial activity are much more severe.

Also, SOX increased both the independence of the outside auditors who review the accuracy of corporate financial statements and the oversight role of boards of directors.

ETHICS NOTE

Circus-founder P.T. Barnum is alleged to have said, “Trust everyone, but cut the deck.” What Sarbanes-Oxley does is to provide measures that (like cutting the deck of playing cards) help ensure that fraud will not occur.

Businesses engage in three types of activity—financing, investing, and operating. For example, consider Gert Boyle’s parents, the founders of Columbia Sportswear.

The Boyles obtained cash through financing (from personal savings and outside sources like banks) to start and grow their business.

The family then invested the cash in equipment to run the business, such as sewing equipment and delivery vehicles.

Once this equipment was in place, they began the operating activities of making and selling clothing.

The accounting information system keeps track of the results of each of the various business activities—financing, investing, and operating. Let’s look at each type of business activity in more detail.

Financing Activities

It takes money to make money. Financing activities involve raising money from outside sources. The two primary sources of outside funds for corporations are borrowing money (debt financing) and issuing (selling) shares of stock in exchange for cash (equity financing).

An illustration depicting financing activities is titled, Equity Financing and shows three people; a man in the center ringing a gong; with a woman and a man standing on either side, applauding. An illustration depicting financing activities is titled, Debt Financing and shows a woman and a man having a conversation with an employee of the National Bank.

Columbia Sportswear may borrow money in a variety of ways. For example, it can take out a loan at a bank or borrow directly from investors by issuing debt securities called bonds. Persons or entities to whom Columbia owes money are its creditors.

Amounts owed to creditors—in the form of debt and other obligations—are called liabilities.

Specific names are given to different types of liabilities, depending on their source. Columbia may have a note payable to a bank for the money borrowed to purchase delivery trucks.

Debt securities sold to investors that must be repaid at a particular date some years in the future are bonds payable.

Corporations also obtain funds by selling shares of stock to investors. Common stock is the term used to describe the total amount paid in by stockholders for the shares they purchase.

The claims of creditors differ from those of stockholders. If you loan money to a company, you are one of its creditors. In lending money, you specify a payment schedule (e.g., payment at the end of three months). As a creditor, you have a legal right to be paid at the agreed time. In the event of nonpayment, you may legally force the company to sell property to pay its debts. In the case of financial difficulty, creditor claims must be paid before stockholders’ claims.

Stockholders, on the other hand, have no claim to corporate cash until the claims of creditors are satisfied. Suppose you buy a company’s stock instead of loaning it money. You have no legal right to expect any payments from your stock ownership until all of the company’s creditors are paid amounts currently due. However, many corporations make payments to stockholders on a regular basis as long as there is sufficient cash to cover required payments to creditors. These cash payments to stockholders are called dividends.

Investing Activities

Once the company has raised cash through financing activities, it uses that cash in investing activities. Investing activities involve the purchase of the resources a company needs in order to operate. Resources owned by a business are called assets. A growing company purchases many assets, such as computers, delivery trucks, furniture, and buildings.

Different types of assets are given different names; Columbia Sportswear’s sewing equipment is a type of asset referred to as property, plant, and equipment (see Alternative Terminology).

Cash is one of the more important assets owned by Columbia or any other business.

If a company has excess cash that it does not need for a while, it might choose to invest in securities (stocks or bonds) of other corporations, a type of asset referred to as investments.

ALTERNATIVE TERMINOLOGY

Property, plant, and equipment is sometimes called fixed assets.

An illustration of investing activities shows a van with a logo of a pine tree. The van is parked in front of a building with the same logo.

Operating Activities

Once a business has the assets it needs to get started, it begins operating activities. Operating activities are the day-to-day actions taken by a company to produce and sell a product, or provide a service. Columbia Sportswear is in the business of selling outdoor clothing and footwear. It sells TurboDown jackets, Millennium snowboard pants, Sorel® snow boots, Bugaboots™, rainwear, and anything else you might need to protect you from the elements. We call amounts earned from the sale of these products revenues.

Revenue is the increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business; Columbia records revenue when it sells a footwear product.

Revenues arise from different sources and are identified by various names depending on the nature of the business; Columbia’s primary source of revenue is the sale of sportswear (but it also generates interest revenue on debt securities held as investments).

Sources of revenue common to many businesses are sales revenue, service revenue, and interest revenue.

An illustration of operating activities shows a female employee stitching and a male employee standing in the background holding a jacket in his hand.

The company purchases its longer-lived assets through investing activities as described earlier. Other assets with shorter lives, however, result from operating activities.

Supplies are assets used in day-to-day operations (rather than sold to customers).

Goods available for future sales to customers are assets called inventory.

The right to receive money in the future is called an account receivable. If Columbia sells goods to a customer and does not receive cash immediately, then the company has a right to expect payment from that customer in the near future.

Before Columbia can sell a single Sorel® boot, it must purchase wool, rubber, leather, metal lace loops, laces, and other materials. It then must process, wrap, and ship the finished product. It also incurs costs like salaries, rents, and utilities. All of these costs, referred to as expenses, are necessary to produce and sell the product.

In accounting language, expenses are the cost of assets consumed or services used in the process of generating revenues.

Expenses take many forms and are identified by various names depending on the type of asset consumed or service used.

For example, Columbia keeps track of these types of expenses: cost of goods sold (such as the cost of materials), selling expenses (such as the cost of salespersons’ salaries), marketing expenses (such as the cost of advertising), administrative expenses (such as the salaries of administrative staff, and telephone and heating costs incurred at the corporate office), interest expense (amounts of interest paid on various debts), and income tax expense (corporate taxes paid to the government).

Columbia may also have liabilities arising from these expenses.

For example, Columbia may purchase goods on credit from suppliers. The obligations to pay for these goods are called accounts payable.

Additionally, Columbia may have interest payable on the outstanding amounts owed to the bank.

It may also have wages payable to its employees and sales taxes payable, property taxes payable, and income taxes payable to the government.

Columbia compares the revenues of a period with the expenses of that period to determine whether it earned a profit. When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss results.