LESSON 5 Flashcards
FORMS OF ORGANIZATION
The three most common forms of business organizations are sole proprietorships, partnerships and corporations.
SOLE PROPRIETORSHIP
Sole Proprietorship is a business enterprise owned by a single individual.
It is the simplest form of business organization and is the most common type of business enterprise in service industries.
One of the consequences of operating a proprietorship is that the owner is personally liable for all of the debts incurred by the proprietorship. If the proprietorship is unable to pay its debts, the proprietorship’s creditors may collect from the personal assets of the owner. This is referred as to unlimited liability. A proprietorship is not regarded as a separate legal entity and does not pay income taxes. Instead, the profits of the proprietorship accrue to the owner and are taxed as part of their personal income.
PARTNERSHIPS
General partnership is a form of organization in which two or more persons carry on a business with a view to profit.
Usually the parties will agree to form a partnership by means of a contract, known as a partnership agreement, spelling out the complete terms of their relationship. This will be registered under the Partnership Act.
A partnership is not a taxable separate entity; it is a conduit through which any income flows through to the partners according to their partnership agreement. The income is not taxed at the partnership level, but as part of each partner’s personal tax return.
For both sole proprietorship and partnerships, personal liability insurance is a key business consideration.
LIMITED PARTNERSHIP
Limited partnership is a form of organization similar to general partnership, consisting of one or more general (managing) partners and one or more limited partners.
A limited partnership consists of one or more general (or managing) partners, and one or more limited partners. The general partners activity carry on the business of the partnership and have unlimited liability (the same as the partners in general partnerships).
While a key legal difference exists between a general and a limited partnership in terms of the liability of the general and limited partnerships, both entities have the same income tax status.
One of the main benefits of limited partnerships for real estate investment has been to gain these tax advantages, without exposing the investors (the limited partners) to unlimited liability.
LIMITED LIABILITY PARTNERSHIP
A limited liability partnership is a variation of a general partnership, often used in professional services firms. Each limited partner in an LLP can make management decisions for the enterprise. In other words, the partners are active, rather than passive investors. However, similar to the limited partners in a limited partnership, each partner’s liability for the overall debts of the LLP and the wrongful actions of other partners is limited to their investment, with two caveats:
1. each partner remains personally liable for their own negligent or wrongful acts or omissions, beyond their investment in the LLP; and
2. any partner may lose this limited liability and be held personally liable for the acts of another partner or an employee of the partnership if they had knowledge of these acts and failed to take reasonable actions to prevent them.
There are two main reasons for the use of LLPs:
1. partners are accountable to their clients or customers; and
2. all partners have the ability to be active in their business without exposing themselves to personal liability for the acts of their other partners (beyond the value of their investment in the partnership).
CORPORATIONS
Corporation is a business entity that is owned by shareholders who decide on the general policies of the company through their elected Board of Directors; a separate legal entity with the rights and liabilities of an individual.
The limited company, or corporation, is a business entity that is created by a Certificate of Incorporation issued by the provincial or federal government.
The company is owned by one or more shareholders. A company whose shares are traded on a stock exchange is referred to as a public company, whereas one whose shares are not traded on an exchange is classified as a private company.
The liability of a common shareholder is quite different from that of general partner; shareholders are liable only of the value of shares purchases or agreed to be purchased.
A corporation can also borrow money (debt) in a variety of ways, including bank loans, bond issues or mortgages. Lenders often require directors or shareholders to personally guarantee repayment of the loan.
A corporation is a separate legal entity; it has its own personally separate from the shareholders or owners, and its own income tax status. Tax advantages are a second reason that small business owners often consider incorporating.
In summary, important issues with regard to corporations include the following:
- the company is a separate legal entity it may acquire, hold and dispose of assets; enter into contracts; and sue or be sued;
-the company is subject to income tax, unlike partnerships, which are not;
-individuals who acquire share in a company do not own the assets of the company; they only own the shares and the rights and obligations that go with ownership of the shares; and
-the shareholders do not share directly in the income of the company; shareholder’s earnings arise either from capital gains on the resale of the shares, from dividends (a distribution of profits), or from participation in the surplus in the event the company is wound up.
IMPORTANCE OF FINANCIAL REPORTING
Income statement is a listing of revenue and expenses of a business for a given period.
Balance sheet is a listing of the assets, liabilities, and owner’s equity or a business at a specific point in time.
It is strongly recommended that licensees working on such transactions consults with other licensees who are experienced in the purchase or sale of a business, as well as obtain expect financial legal advice.
Financial reporting is how businesses summarize and report their success, failures, strengths, and weaknesses. Financial reporting should meet the following objectives and provide information that:
-is useful to current and potential stakeholders in the organization and other users (e.g. creditors) in making rational investment, credit and related decisions;
-assists stakeholders in assessing the performance of those engaged to manage the assets and activities of the entity; and
-is about the economic resources of an enterprise, the claims on those resources (i.e. obligations of the enterprise to transfer resources to other entities and owner’s equity) and the effects of transactions, events and circumstances that change resources and claims on those resources.
There are two statements in particular where the transactions of a business are summarized, classified and communicated to interested parties:
1. the income statement (sometimes called the revenue and expense statement or the profit and loss statement) and
2. the balance sheet (sometimes called the statement of financial position or statement of the assets and liabilities).
ACCOUNTING FUNDAMENTALS
Accounting is the systematic recording, reporting and analysis of financial transactions.
Its the medium through which an entity records, summarizes, classifies and communicates its activities and transactions for a given period of time.
Financial statements is the end result of the recording, summarizing, and classifying of the accounting process.
They represent the medium through which information about transactions that occurred over a certain period of time (usually one year) is communicated to interested parties.
Financial statements provide quantitative information about an entity that is intended to be useful in making economic decisions.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
To understand and interpret financial statements, it is important to be familiar with the following accounting principles. SEE THE FOLLOWING.
COST PRINCIPLE
Cost principle is a GAAP principle that holds that when a business acquires an asset, the asset’s historical cost is the appropriate amount to record in the financial statements.
It holds that when a business enterprise acquires and asset, the asset’s historical cost (i.e. the amount of consideration given up for the assets) is the appropriate amount to record in the financial statements of the enterprise. While this seems obvious, at time an enterprise may acquire an asset for an amount that is greater or less than the asset’s fair market value on the date of the transaction. To conform to the cost principle, it is not appropriate the record the asset at what might be considered its fair market value; the asset should be recorded at what the enterprise paid for it.
REVENUE RECOGNITION PRINCIPLE
Revenue recognition principle is a GAAP principle that holds that revenue should be recognized by an organization when it is earned, not when cash is received.
This is referred to as the accrual basis of accounting as opposed to the cash basis. For example, under the accrual method of accounting, a licensee may record the commission earned from the sale of a house on their accounting records when the subject clauses were removed from the contract of purchase and sale, even though the money for the commission may not be received until the completion date - this is assuming that all other services that are required by the agent contract have been fulfilled.
On the other hand, the cash basis would not allow the commission to be recorded until the cash was actually received. The accrual basis of accounting is required by generally accepted accounting principles and will be used throughout the chapter.
Revenue is usually the amount received or receivable by an entity for the provision of goods or services.
The timing of revenue recognition is highly dependent on the terms of the agent contract that the seller and licensee have agreed to. For example, if the contract specifically states that “if the transaction is not completed for any reason, then the gent is not entitled to the fee”, then revenue should not be recognized until transfer of title has occurred. On the other hand, if the agent contracts states that the agent has rendered/fulfilled the services once the subjects have been removed, then revenue recognition can be considered at that time. Therefore, commissions earned from the sale of a property may be recognized at either title transfer or a subject removal, depending on the circumstances.
MATCHING PRINCIPLE
Matching principle is a GAAP principle that holds that expenses directly associated with particular revenues should be recognized in the same period in which the revenue is recognized.
Other expenses should be recognized in the period in which the goods or services are consumed. In other words, insurance costs covering a calendar year should be recognized each month and not all in the month in which the insurance begins or the month in which premium is paid.
Costs that benefit more than one month should be recognized over the period benefited by the costs, to the extent practical. As with the revenue principle, the matching principle requires that the accrual basis of accounting be used for maintaining records of the entity; that is, expenses are recorded when incurred, which is not necessarily when they are paid.
MATERIALITY PRINCIPLE
Materiality principle is a GAAP principle that hold that purchases with a relatively low cost that are used up over a period of several months may be expenses when acquired; an exception to the matching principle.
The effort involved to allocate these costs over the period of use exceeds any conceivable benefit. The threshold for materiality is if the cost is likely to impact any decisions or judgments made by the users of the financial statements. If the cost of the stationary and supplies is below that threshold, the items should be expensed when acquired and not spread over the months they are used Conversely, where a large cost is incurred that benefits the entire year, the cost should be allocated in accordance with the matching principle.
OBJECTIVITY PRINCILPE
Objectivity principle is a GAAP principle that holds that all accounting information should be reported on objectively determined and verifiable data.
This principle is closely aligned with the cost principle. The best source of objectivity information in accounting transactions is the amount of consideration given up at the date of the transaction.
If accounting information is recorded on a cost basis, this info could, if required, be certified by an independent party.
CONSISTENCY PRINCIPLE
Consistency principle is a GAAP principle that holds that once an organization adopts one generally accepted accounting principle, it should follow that principle in the ensuing years.
This does not mean that a business enterprise is prohibited from changing from one generally accepted accounting principle to another that is more appropriate.
However, if a business were to do this on a continuous basis, it would render the financial statements virtually meaningless since users would not be able to assess performance from one year to the next.
Changes in accounting principles should be made only when the change will result in more relevant information being provided to the users of the financial statements.
