1. FORMS OF BUSINESS ORGANIZATION
Appendix C
FORMS OF BUSINESS ORGANIZATION
Appendix C: Forms of business organization. 2

2. To describe the basic characteristics of a sole proprietorship.
Learning Objective
To describe the basic characteristics of a sole proprietorship.
Learning objective 1 is to describe the basic characteristics of a sole proprietorship.
LO1

3. Importance of Business Form
Proprietorship
Partnership
Corporation
Three primary forms of business organizations are generally found in the United States – sole proprietorships, partnerships, and corporations.

4. Sole Proprietorships
A sole proprietorship is an unincorporated business owned by one person. Proprietorships are the most common form of business organization because they are so easy to start.
Creating a sole proprietorship requires no authorization from any governmental agency. Often the business requires little or no investment of capital. For example, you could start a lawn-mowing business to earn money during the year. This business entity is classified as a sole proprietorship.

5. Characteristics of a Sole Proprietorship
The owner is personally liable for the debts of the business.
Ease of formation.
Business pays no income taxes.
Besides being easy to form, a proprietorship pays no income taxes. Taxable income or loss flows directly to the owner who pays the tax due. The owner has unlimited personal liability for the debts of the business.
Business pays no salary to the owner.
Business assets actually belong to the proprietor.

6. Accounting Practices of Sole Proprietorships
Withdrawals of assets by the owner.
Total owner’s equity is represented by the balance in the owner’s capital account. At the end of the accounting period, the drawing account is closed to the owner’s capital account and presented as a single amount.

7. Learning Objective
To identify factors to consider in evaluating the profitability and liquidity of a sole proprietorship.
Learning objective 2 is to identify factors to consider in evaluating the profitability and liquidity of a sole proprietorship.
LO2

8. Adequacy of Net Income
The net income of a sole proprietorship should be sufficient to compensate the owner for:
Personal services rendered to the business
Capital invested
The degree of financial risk that the owner is taking
The owner of a sole proprietorship does not receive a salary and assumes all the risks associated with operating a business. Therefore, the income earned by the business should be sufficient to compensate the owner for the value of the personal services rendered to the business, the capital invested, and the degree of financial risk assumed by the owner.

9. Evaluating Liquidity
In evaluating liquidity of a sole proprietorship, creditors must look beyond the balance sheet to the ability of the owner to pay any debt.
The assets listed on the balance sheet are owned by the proprietor, not the business. Creditors must look to the debt-paying ability of the owner in evaluating the liquidity of the business.

10. Learning Objective
To describe the basic characteristics of a general partnership and of partnerships that limit personal liability.
Learning objective 3 is to describe the basic characteristics of a general partnership and of partnerships that limit personal liability.
LO3

11. Partnerships
A partnership is an unincorporated business owned by two of more partners. A partner may be either an individual or a corporation.
Partnerships are the least common form of business organization, but are widely used for professional practices.
For accounting purposes, we view the partnership as an entity separate from the other activities of its owners. Each partner has a separate capital and drawing account. At law, partners are held jointly and personally liable for the activities of the business.

12. General Partnerships Mutual Agency
Each partner has rights and responsibilities similar to those of a sole proprietor. Unless restricted by agreement, each partner may withdraw assets from the business at will.
Mutual Agency
Any general partner may negotiate contracts for the business and withdraw assets at will. The concept is called mutual agency. Every partner also has unlimited personal liability for the debts of the firm.

13. Partnerships That Limit Personal Liability
Limited Partnerships The partnership has a general partner who has the right to make managerial decisions and has unlimited liability for the obligations of the partnership. In addition, the partnership has limited partners who are basically passive investors.
Limited Liability Partnerships Each partner has unlimited personal liability for his or her own professional services, but not for the actions of other partners.
Part I
Limited partnerships usually have one partner who is designated as the general partner. The general partner negotiates agreements for the partnership and carries out the day-to-day management activities. Other partners are viewed as passive investors in the partnership.
Part II There is a class of partnerships known as limited liability partnerships. This is a relatively new form of partnership and is usually associated with professional activities like law firms, public accounting firms, and medical practices. The practitioners have individual liability for the services they perform, but liability does not extend to other practicing partners.

14. Accounting Practices of Partnerships
In this partnership, income and losses are divided equally between the two partners.
Separate capital and drawing accounts are maintained for each partner in the partnership. Amounts paid to partners are recorded in that partner’s drawing account. The equity section of a partnership balance sheet is very similar to that of a sole proprietorship. In the partnership shown on your screen, income is divided evenly between the two partners. This is not always the case. The partnership agreement specifies how profits and losses will be divided.

15. Evaluating the Financial Statements of a Partnership
Like a sole proprietorship, partnership net income should be sufficient to compensate the partners for:
The value of personal services rendered
Capital invested
The degree of financial risk that the partner is taking
Just like a sole proprietorship, partnership income must be sufficient to compensate partners for the value of the services rendered by the partnership, the capital invested by the partner, and the risks assumed by the partner.

16. Evaluating the Financial Statements of a Partnership
The risk assumed by creditors depends upon the type of partnership.
All partners have unlimited personal liability.
In a general partnership, the general partner(s) has personal liability.
In a limited liability partnership, liability extends to partner(s) directly involved.
In a regular partnership, all partners have unlimited liability for the debts of the partnership. A partnership can be structured as a general partnership where the general partner negotiates agreements for the partnership and is liable for the debts of the group. The other partners are viewed as passive investors.
For example, one could setup a general partnership to explore for oil. The general partner is responsible for obtaining the lease rights and making arrangements for drilling of the well. The other partners merely invest in the partnership.
Professional organizations, like lawyers, doctors, and public accountants often setup limited liability partnerships. In a limited liability partnership each partner is liable for the services provided, but is not responsible for any losses as a result of services provided by another partner.

17. To describe the basic characteristics of a corporation.
Learning Objective
To describe the basic characteristics of a corporation.
Learning objective 4 is to describe the basic characteristics of a corporation.
LO4

18. Corporations
A corporation is a legal entity, having an existence separate and distinct from that of its owners.
Owners
A corporation is viewed as a separate legal entity at law. It can sue and be sued. Owners of a corporation are called stockholders and capital stock certificates are evidence of their ownership interest. Some stocks are traded on public exchanges like the New York Stock Exchange. Shareholders are only liable to the extent of their investment in the corporation.
Evidence of
Ownership
Stockholders
Capital Stock

19. Publicly Owned Shares traded on the NYSE or NASDAQ.
Corporations
Corporations may be publicly owned or closely held.
Publicly Owned Shares traded on the NYSE or NASDAQ.
Closely Held Shares of stock not publicly traded.
Corporations whose shares are traded on the New York Stock Exchange (NYSE) or over-the-counter by the National Association of Securities Dealers Automated Quotations (NASDAQ) are referred to as “publicly owned” corporation. If a corporation’s shares are not traded on an exchange, we refer to it as a closely held corporation. Closely held corporations can be quite large.

20. Characteristics of Forms of Business Organizations
Here is a review of the major characteristics of the three types of business organizations we have discussed. This summary will help you contrast the types of organizations and to study for your next examination.

21. Learning Objective
To account for corporate income taxes; explain the effects of these taxes on before-tax profits and losses.
Learning objective 5 is to account for corporate income taxes; explain the effects of these taxes on before-tax profits and losses.
LO5

22. Accounting for Corporate Income Taxes
Taxable Income
× Tax Rate =
Income Tax Expense
Determined according to tax regulations
Because corporations are viewed a separate legal entities, they are taxed as an entity. There are special tax rates that apply only to corporations. We determine the amount of taxable income earned by a corporation by applying all of the tax regulations of the Internal Revenue Service and Congress. Once we determine the amount of taxable income, we apply the appropriate tax rate, as set by law, to determine the income tax expense.
As set by law

23. Accounting for Corporate Income Taxes
Part I
On your screen is the 2007 partial income statement of Barton Incorporated. Notice that the corporation earned income before taxes of $150,000. If the financial income is equal to taxable income, let’s calculate the income tax expense assuming a 35% income tax rate.
Part II
The income tax expense is $52,500, and Barton will report net income of $97,500, after deducting the tax expense.
If financial income is equal to taxable income and the tax rate is 35%, what is Barton’s income taxes expense?

24. Accounting for Corporate Income Taxes
Barton will record its income tax accrual with the following entry:
To record the income tax accrual at the end of the year, Barton will debit income taxes expense for $52,500, and credit income taxes payable for the same amount.

25. Owners’ Equity in a Corporate Balance Sheet
Lifetime earnings of the business less dividends paid to stockholders.
The equity section of a corporation’s balance sheet is comprised of capital stock and retained earnings. Retained earnings represents the lifetime earnings of the business less dividend paid to stockholders.

26. To account for the issuance of capital stock.
Learning Objective
To account for the issuance of capital stock.
Learning objective 6 is to account for the issuance of capital stock.
LO6

27. The Issuance of Capital Stock
Barton Incorporated would make the following entry when it issued 20,000 shares of capital stock in exchange for $200,000 cash.
In our example, Barton Incorporated issued 20,000 of its capital shares of stock for $200,000 cash. The journal entry to record the transaction is to debit cash for $200,000, and credit capital stock for the same amount.

28. Learning Objective
To explain the nature of retained earnings, account for dividends, and prepare a statement of retained earnings.
Learning objective 7 is to explain the nature of retained earnings, account for dividends, and prepare a statement of retained earnings.
LO7

29. Retained Earnings
Retained earnings represent the stockholders’ equity created through profitable operation of the business. Net income causes the retained earnings account to increase and the payment of dividends causes the account to decrease.
The retained earnings of a corporation is increased by the net income earned by the company. It can be reduced if the corporation reports a loss for the period. In addition, the payment of dividends reduces retained earnings. Let’s see how dividends impact retained earnings.
Net Income
Dividends

30. Accounting for Dividends
On December 1, 2007, Barton Incorporation declares a $1 per share cash dividend on its 20,000 capital shares outstanding. The dividend will be paid on December 24, 2007.
December 1 - Date of Declaration
Part I
On December 1, 2007, the board of directors of Barton Incorporated declares a $1 per share cash dividend to it shareholders. The company has 20,000 shares of capital stock outstanding. The dividend will be paid to stockholders on December 24, 2007, just in time for the holiday season.
Part II
December 1st is known as the “date of declaration.” On this date the company will debit an account called “dividends” for $20,000, and credit dividends payable for the same amount. The dividends account will be closed to retained earnings at the end of the year.
Part III
December 24th is known as the date of payment. On this date the company will debit dividends payable for $20,000 and credit cash for the same amount. The dividends payable account now has a zero balance.
December 24 - Date of Payment

31. Closing Entries
During 2007, Barton Incorporated earned net income of $150,000, and paid cash dividends of $20,000. The closing entries would be as follows:
Barton earned net income of $150,000, and paid the cash dividend of $20,000. Income and expense accounts are closed to the income summary. In turn, the income summary is closed to retained earnings. In our example, we will debit the income summary for $150,000 (the amount of net income), and credit retained earnings for the same amount. We have now transferred net income into retained earnings. Retained earnings has a normal credit balance, so net income will increase this amount.
The final closing entry is to close the dividends accounting into retained earnings. We do this with a debit to retained earnings for $20,000 (thus reducing retained earnings), and credit the dividends account for the same amount. The balance in the dividends account is now zero.

32. Statement of Retained Earnings
At the beginning of 2007, Barton reported an $800,000 balance in Retained Earnings.
If Barton had beginning retained earnings of $800,000, we will add net income for the year and subtract the dividends paid to stockholders to arrive at the ending balance of $930,000.

33. Learning Objective
To explain why the financial statements of a corporation are interpreted differently from those of an unincorporated business.
Learning objective 8 is to explain why the financial statements of a corporation are interpreted differently from those of an unincorporated business.
LO8

34. Evaluating the Financial Statements of a Corporation
Stockholder
Risk
Taken
Service Rendered
Taxes Paid
If a stockholder renders service for the corporation, he or she is compensated with a salary. The risk assumed by a stockholder is limited to the amount of the original investment. Unlike a sole-proprietorship or partnership, a corporation is a legally taxable entity. Taxes are paid by the corporation. The shareholder must pay taxes on the dividends received from the corporation.
Paid a salary
Limited to amount of investment
Only on dividends not net income

35. Evaluating the Financial Statements of a Corporation
When lending funds to a corporation, creditors generally look only to the business entity for repayment.
From the viewpoint of a creditor, the financial strength of a corporation is extremely important. Creditors must evaluate the ability of a corporation to repay amounts loaned to the business.

36. Learning Objective
To discuss the principal factors to consider in selecting a form of business organization.
Learning objective 9 is to discuss the principal factors to consider in selecting a form of business organization.
LO9

37. Selecting an Appropriate Form of Business Organization
Personal liability of owners
Income tax considerations
Before an individual starts a business it is essential that all the pros and cons of each form of business be evaluated. On this screen we have identified four important factors that should be considered in the decision process.
Factors to Consider.
Need to raise large amounts of capital
Owners’ need to withdraw assets from the business

38. Selecting an Appropriate Form of Business Organization
Owners need for managerial authority
Ease and cost of forming the business
In addition to the factors listed on the previous screen, here are three more important areas to consider.
Factors to Consider.
Need for continuity of business operations

39. To allocate partnership net income among the partners.
Learning Objective
To allocate partnership net income among the partners.
Learning objective 10 is to allocate partnership net income among the partners.
LO10

40. Allocating Partnership Net Income among the Partners
Partners may divide income or loss in any manner agreed upon. Some common approaches include:
A fixed ratio.
Salary allowances with remainder in a fixed ratio.
Interest allowance with remainder in a fixed ratio.
Salary and interest allowance with remainder in a fixed ratio.
While income and loss maybe divided in any manner agreed upon by the partners, we have listed four common methods used. The first method, a fixed ratio, means that the partners agree to divide profits and losses in some agreed upon percent. For example, the partners could agree to divide the profits and losses evenly. If there are two partners in the partnership, each partner would be entitled to 50% of the income or loss. If there were three partners, each would be entitled to one-third of the income or loss. Let’s take a closer look at the remaining three methods used.

41. Salary to Partners, with Remainder in a Fixed Ratio
Able and Baker have formed a partnership and agreed to divide income and loss by allowing a salary of $45,000 to Able and $55,000 to Baker. Any remainder is to be divided equally between the partners. Let’s see how we divide current net income of $150,000.
Part I
In this example Able and Baker agree to provide a salary allowance to the partners and divided the remainder evenly, that is, 50% to each partner. Able is to receive a salary allowance of $45,000 and Baker’s allowance is $55,000. The partnership earned net income of $150,000 during the year. Let’s see how we divide the profits.
Part II
First, we provide for the salary allowance to Able and Baker. When this is complete, the partnership still has $50,000 of net income to divide.
Part III
The final step is to divide the remaining $50,000 evenly between Able and Baker. Each partner will be allocated $25,000. So, the $150,000 net income will be dividend with $70,000 going to Able and $80,000 going to Baker. Notice that we have distributed all the net income.

42. Salary to Partners, with Remainder in a Fixed Ratio
Able and Baker have formed a partnership and agreed to divide income and loss by allowing a salary of $45,000 to Able and $55,000 to Baker. Any remainder is to be divided equally between the partners. The journal entry to record the division of income is:
We need a closing entry to transfer the net income from the income summary to the individual partner’s capital accounts. To do this we debit the income summary for $150,000, and credit Able’s capital account for $70,000 and Baker’s account for $80,000.

43. Interest on Partners’ Capital, with Remainder in a Fixed Ratio
Able and Baker have formed a partnership and agreed to divide income and loss by allowing interest at 20% of each partner’s beginning capital balance, and any remainder is to be divided equally. Able has a beginning capital balance of $100,000 and Baker’s balance is $150,000.
Part I
In this example the partners have agreed to allow interest on the beginning or period invested capital and divide the remainder evenly. Able has a beginning capital balance of $100,000 and Baker’s capital account was $150,000. Interest is allowed at the rate of 20%. Let’s see how we will divide the $150,000 net income under this agreement.
Part II
We begin by calculating the interest allowance for Able and Baker. We multiply Able’s beginning capital balance of $100,000 times 20%, and provide an allowance of $20,000. The calculated allowance for Baker is $30,000. We now have a remainder of $100,000 to be distributed.
Part III The $100,000 remainder is to be divided 50% to Able and 50% to Baker. Once we do this Able will receive credit for $70,000 of net income and Baker will receive credit of $80,000. Now, let’s look at the closing entry to transfer income into the partners’ capital accounts.

44. Interest on Partners’ Capital, with Remainder in a Fixed Ratio
Able and Baker have formed a partnership and agreed to divide income and loss by allowing interest at 20% of each partner’s beginning capital balance, and any remainder is to be divided equally. Able has a beginning capital balance of $100,000 and Baker’s balance is $150,000.
Once again we will debit the income summary for $150,000 – the reported net income for the period. We will credit Able’s capital account for $70,000 and Baker’s capital account for $80,000. Let’s move on and look at a third example.

45. Salary and Interest Allowances, and Remainder in a Fixed Ratio
Able and Baker have formed a partnership and agreed to divide income and loss by allowing a salary of $40,000 to Able and $85,000 to Baker, interest at 6% of each partner’s beginning capital balance, and any remainder is to be divided equally. Able has a beginning capital balance of $100,000 and Baker’s balance is $150,000.
Part I
In this example, the partners have agreed on both a salary and interest allowance and to divide any remainder evenly.
Part II We begin with the salary allowance of $40,000 to Able and $85,000 to Baker.
Part III
Next, we calculate the interest allowance at 6%. Since Able’s beginning capital balance was $100,000, she will receive an interest allowance of $6,000. Baker’s interest allowance is $9,000. After the salary and interest allowances have been granted we have a remainder of $10,000.
Part IV
The $10,000 remainder will be divided $5,000 to Able and $5,000 to Baker. Able will receive a total allowance of $51,000 and Baker will be given credit for $99,000. We have distributed the $150,000 net income between the two partners.

46. Salary and Interest Allowances, and Remainder in a Fixed Ratio
Able and Baker have formed a partnership and agreed to divide income and loss by allowing a salary of $40,000 to Able and $85,000 to Baker, interest at 6% of each partner’s beginning capital balance, and any remainder is to be divided equally. Able has a beginning capital balance of $100,000 and Baker’s balance is $150,000.
The journal entry to close the income summary to the partners’ capital accounts is to debit income summary for $150,000, credit Able’s capital account for $51,000, and credit Baker’s capital account for $99,000.

47. End of Appendix C
End of appendix C. 4