Sole Proprietorships, Partnerships, Corporations

1. Sole Proprietorships, Partnerships, Corporations Chapter 15

2. Sole Proprietorships • A business owned by one person who is legally responsible for all its debts and legal obligations • This means that the owner’s personal property is at risk if the business is in financial difficulty

3. Advantages of Sole Proprietorships • Pride of ownership • Simplified decision-making • Ease of formation and dissolution • All net income to owner • Freedom of action • Personal satisfaction • Privacy • Possible tax savings

4. Disadvantages of Sole Proprietorship • Unlimited personal liability • Lack of continuity • Limited capital • Limited talent pool • Heavy personal responsibilities

5. Taxation and the Sole Proprietorship • A sole proprietorship does not pay income tax on its net income • The owner must add the net income of the business to his or her personal income and then pay personal income tax on the total • There can be a tax advantage with this form of ownership when the combined net income is low • When net income becomes fairly high, there may be a tax advantage in switching to a corporate form of ownership

6. PARTNERSHIPS • A business owned by two or more persons • Frequently formed by doctors, lawyers, dentists, accountants and small retail and service businesses • Similarities to sole proprietorship • Net income or loss belongs to the owners and they have unlimited personal liability for the debts of the business • Net income of business becomes the personal income of the individual partners for income tax purposes

7. ADVANTAGES OF PARTNERSHIPS • Ease of formation • Low start-up costs • Additional sources of investment capital—each contribute personal savings and borrowing capacities to the business • Shared work and responsibilities—between them they may possess many of the skills and talents required to operate a business successfully • Broader management base

8. DISADVANTAES OF PARTNERSHIPS • Unlimited liability—partners have unlimited personal liability for the debts of the business • Lack of continuity—if one partner dies the partnership may have to be dissolved to settle the estate of the deceased partner • Divided authority • Difficult to find suitable partners • Potential for conflict between partners—when two people work closely together day in and day out and are responsible for the success of a business, there is a good possibility of personality conflict

9. TYPES OF PARTNERSHIPS • Limited—a form of partnership where there is not unlimited personal liability • Two types of partners: • General partner(s) must assume unlimited liability for the debts of the partnership • Usually manage the limited partnership • Other partners have no personal liability except for their investment • Invest in the business but have little or no part in running it • General—all partners have unlimited liability

10. Accounting procedure for partnerships • Partnership Agreement outlines the rights and responsibilities of the partners

11. Partnerships and income taxes • As a business, a partnership does not pay income taxes on its net income • Each partner is taxed on his or her share of the partner’s income, in addition to any income received from other sources

12. Ledger accounts of a partnership • Drawings Accounts—used in the same way in a partnership as in a sole proprietorship • Debited whenever a partner withdraws assets from the business • Typical transactions that involve Drawings accounts are: • Payment of salaries to partners—salaries paid to partners during the year must be recorded in the Drawings accounts and cannot be treated as a company expense and debited to Salaries Expense; • Withdrawal of assets or cash by a partner; and • Payments of a personal nature for a partner using partnership funds • One of the difficulties encountered by accountants is to decide if a transaction involves a legitimate business expense or should be treated as a personal withdrawal and recorded in the owner’s Drawings account • Personal expenses charged to the business have the effect of lowering the net income of the business and therefore the income taxes paid by the owners

13. Closing the Partnership books • The balance in the Income Summary account is closed into each partner’s Capital account according to the partnership agreement for dividing net income and net loss

14. Dividing net income • Partners may make any agreement they wish for the division of the partnership’s net income or net loss • One of the most important clauses of the partnership contract is the one stating how these will be shared • Four factors considered by partners are: • A payment for amount of work performed—if one partner is very actively engaged in running the business while another contributes money but does not work in the business it seems fair that the working partner should be paid for the work performed; • Return on capital—if a partner invested money in government bonds, term deposits, or mortgages, interest would be earned on that money so if a partner invests in a partnership it seems reasonable to pay interest on the money invested • Amount of capital invested—if one partner contributes more money that partner could expect to receive a greater share of net income; and • Individual skills, talent, and reputation—it can be argued that if a net income is earned it is because of the personal contributions of the partners

15. Methods of dividing net income or net loss • Fixed Ratio— divide net income and net loss equally • Capital Ratio— used when the success of the business depends to some extent on the contribution of capital • E.g. J. Ibarra and D. Amato have invested $200,000 and $400,000 respectively in their partnership • They agree to share net income and net loss in the ratio of their beginning capital • The ratio is determined as follows:

16. Calculation of Share of Net Income and Entry to Record Division • Net Income of $100,000 • Entry to record division of net income Dec. 31 Income summary Debit 100,000 J. Ibarra, Capital Credit 33,300 D. Amato, Capital Credit 66,700 To divide the net income between partners

17. Salaries and Remaining Profits in a Fixed Ratio • E.g. F. Chari and B. Yew agreed to the following in their partnership agreement: • A salary of $50,000 is to be paid to Chari and $60,000 is to be paid to Yew per year • Any remaining net income after salaries is to be shared equally • At the end of the year, there is a net income of $150,000

18. Interest, Salaries, and fixed ratio • W. Gordon and W. Mugabe agreed on the following division of net income and net loss: • Each partner is to receive a $50,000 salary per year • Each partner is to be credited from net income annually with 12% interest on the beginning capital. Gordon invested $75,000 and Mugabe invested $125,000 • Any remaining net income or net loss after interest and salaries is to be divided equally • Net income for the fiscal year was $150,000

19. Financial statement • In a partnership, the following four financial statements may be prepared: • The income statement • The statement of distribution of net income • The balance sheet; and • The statement of changes in partners’ equity

20. Income statement • Similar to that of a sole proprietorship with the possible addition of a section at the bottom being added to show the division of the net income or net loss

21. Statement of distribution of net income • If the division of the net income or net loss is not shown as a note to the income statement, a statement of distribution of net income (see slide 18) is prepared

22. Balance sheet • There are at least two people in every partnership • For every partner there is a Capital account which appears in the equity section of the balance sheet

23. Statement of changes in partners’ equity • Shows additional investments in the business during the year, all withdrawals and each partner’s share of the net income or net loss • E.g.

24. Assignment • Page 783 Apply Your Knowledge--#1, 2, 3, 4, 5, 7

25. The Corporation • A corporation has a legal existence of its own • It is separate from its owners so it has the right to sue and can be sued by others

26. Advantages corporations • Limited liability • Specialized management • Transferrable ownership • Continuous business existence • Separate legal entity • Possible tax advantage (i.e. lower small business tax) • Easier access to capital • Can also sell more shares if it requires more financing

27. Disadvantages of corporations • More legal requirements; closely regulated by governments • Most expensive form to organize • Extensive record keeping required • Double taxation of dividends

28. Forming a corporation • Application to the provincial or federal government for a certificate of incorporation • Application is signed by one or more persons and must include the following information: • The name and address of the corporation; • The types and number of shares to be authorized for issue; • The number of directors; • The nature of the business to be conducted • Generally a corporation that will do business in only one province will apply to that province for incorporation • A business that will operate in more than one province usually applies to the federal government for incorporation

29. Corporation name • Corporation laws require the words Limited, Limitee, Incorporate or Incorporee to be part of the name • Other requirements for the corporation name are: • The proposed name must differ from that of any other Canadian business; • The name must be acceptable to the public • The name must be clearly displayed in all contracts, invoices, and other negotiable transactions involving the corporation • After the application has been accepted by the government and the incorporation fee paid, the limited company or corporation comes into existence • The persons who applied for incorporation receive a charter or certificate of incorporation • A board of directors is a group of persons, elected by the shareholders, who are responsible for the operation of the corporation • The directors hire people to manage the business • Shares are sold or exchanged for assets and the company is in business

30. Types of business corporations • Private— limited in the number of shareholders they may have and in the way they raise capital • May not have more than 50 shareholders and must obtain funds privately • Corporate shares and bonds may not be sold to the public • Many small sole proprietorships and partnerships are transformed into private corporations for the owners to take advantage of the limited liability feature of corporations • Owners still control and own the business yet protect their personal assets • Public— can have any number of shareholders • Can sell shares and bonds to the public • Share certificate— a form issued by a corporation indicating the number of shares owned • The person purchasing the shares is called a shareholder (stock and stockholder are terms sometimes used in place of share and shareholder)

31. Accounting procedures for corporations • Balance Sheet Shareholders’ Equity Share Capital 230,000 Retained Earnings 277,500 Total Equity 507,500 • Share capital is a record of money received from the sale of shares • Retained earnings contains the balance of net income earned by the corporation after dividends have been paid (undistributed net income)

32. Corporate net income • Net income of a corporation increases the shareholders’ equity • The decision about what happens to the net income is made by the board of directors • The board has several alternatives: • Distribute all of the net income to the shareholders • Leave all of the net income in the corporation or • A combination of the above—leave part of the net income in the business and distribute part to the shareholders • Shareholders do not participate directly in deciding what is done with corporate net income but they can attend the annual shareholders’ meeting • The board of directors is elected by the shareholders

33. dividends • The portion of a corporation’s net income paid to the shareholders • Corporate law allows dividends to be paid to shareholders only out of accumulated net income which is recorded in Retained Earnings

34. Closing the Books of a Corporation • Close revenue and expense accounts into Income Summary • Close the Income Summary balance (which is the net income or net loss) into Retained Earnings

35. Distributing dividends • E.g. the board of directors makes a decision to pay a dividend on each of the outstanding shares of Web Design Limited • The dividend is $2/share to all owners on record as of June 25 • Dividend cheques will be issued on July 10 • Entry made on June 15 to establish a liability on the corporate books: June 15 Retained Earnings Debit 20,000 Dividends Payable Credit 20,000 Declared a $2 dividend on the 10,000 outstanding shares • Entry made on July 10 to record payment of dividends July 10 Dividends Payable Debit 20,000 Cash Credit 20,000 Issued dividend cheques to shareholders

36. Shareholder’s Equity Section Shareholder’s Equity Share Capital: Authorized 20,000 shares Issued 10,000 shares 450,000 Retained Earnings 277,500 Total Equity 727,500

37. Statement of Retained Earnings • A complete description of changes in the Retained Earnings account Web Design Limited Statement of Retained Earnings December 31, 2013 Retained Earnings, January 1, 2013 $230,000 Add: Net Income for the Year 67,500 Total 297,500 Less: Dividends 20,000 Retained Earnings, December 31, 2013 $277,500

38. Corporate income tax • A corporation pays income tax on its net income • In 2002 the corporate rate of income tax on net income payable to the federal government was 38% and to the provinces in which it earned its income ranged from 10 to 13% depending on the province • A special federal income tax rate is available to small Canadian-owned corporations • Corporate income tax rules and procedures are complex • Three provinces—Ontario, Alberta and Quebec, require corporations to complete a separate provincial income tax return while other provinces have a joint federal-provincial return completed

39. Income statement Web Design Limited Income Statement For the year ending December 31, 2013 Revenue Sales $350,000 Expenses Selling $200,000 Administrative 70,000 270,000 Operating Income 80,000 Other Income Investments 10,000 Net Income before Income Taxes 90,000 Income Taxes 22,500 Net Income after Income Taxes $67,600

40. The stock market • A place where shares in a corporation are bought and sold after they have been issued • A place where a shareholder who wishes to sell shares may find a buyer willing to purchase the shares • Large public corporations know it is important to make it easy for the public to buy and sell their shares • One reason for this is that these corporations may wish to expand their operations which requires financing and which can be obtained by issuing more shares • Large public corporations list their companies on a stock exchange where shares are bought and sold • To be listed on a stock exchange a corporation must follow detailed regulations and must provide the public with much information concerning the operation of the company • In Canada there are stock exchanges in Calgary, Toronto and Montreal • Stockbrokers act as agents for those who wish to buy and sell shares • The brokers will arrange a sale or a purchase in return for a commission • Stockbrokers also sell large blocks of new shares for corporations in need of funds

41. Assignment • Green textbook Page 794-795 Apply Your Knowledge • #8, 9, 10, 11