Module No.

and Title MODULE 1 – Introduction to Financial Management

Lesson No.
Lesson 4: Forms of Business Organization
and Title
 Identify the advantages and disadvantages of adopting forms of business
Learning
organization
Outcomes
Time Frame 1 HOUR

Introduction

Activity

Analysis

Abstraction THE ORGANIZATION OF THE BUSINESS FIRM

The business firm is an entity designed to organize raw materials, labor, and
machines with the goal of producing goods and/or services. Firms

1. purchase productive resources from households and other firms,

2. transform them into a different commodity, and

3. sell the transformed product or service to consumers

For business firms engaged in retail or trading activities, transforming purchased

goods into a different commodity does not necessarily take place.

Every society, no matter what type of economy it has, relies on business firms
to organize resources and transform them into products. In market economies, most
firms choose their own price, output level, and methods of production. They get the
benefits of sales revenues, but they also must pay the costs of the resources they
use.

Business firms can be organized in one of three ways: as a proprietorship, a

partnership, or a corporation. The structure chosen determines how the owners
share the risks and liabilities of the firm and how they participate in making
decisions.

LEGAL FORMS OF BUSINESS ORGANIZATION

PROPRIETORSHIP

A sole proprietorship is a business owned by a single person who has

complete control over business decisions. This individual owns all the firm's assets
and is responsible for all its liabilities. More businesses are sole proprietorship than
any form of business organization. From a legal point of view, the owner of a
proprietorship is not separable from the business and is personally liable for all debts
of the business. From an accounting prospective, however, the business is an entity
separate from the owner (proprietor). Therefore, the financial statements of the
business present only those assets and liabilities pertaining to the business.
 The owner cannot be paid salary or wages from the business. Instead, the
owner may withdraw funds or other property from the business. These withdrawals
are treated as reduction of owner's equity or financial interest of the owner in the
business. The business itself does not pay any income taxes. The income or loss of
the business is reported on the owner's personal income tax return on a supporting
schedule.

Among the advantages of a sole proprietorship are:

1. Ease of entry and exit

A sole proprietorship requires no formal charter and is inexpensive to form

and dissolve.

2. Full ownership and control

The owner has full control, reaps all profits and bears all losses.

3. Tax savings

The entire income generated by the proprietorship passes directly to the

owner. This may result in a tax advantage if the owner's tax rate is less than the tax
rate of a corporation.

4. Few government regulations

A sole proprietorship has the greatest freedom as compared with nay form of
business organization.

Major disadvantages of the proprietorship form include:

1. Unlimited liability

The owner is personally liable or responsible for any and all business debts.
Thus, the owner's personal assets can be claimed by the creditors if the firm defaults
on its obligations.

2. Limitations in raising capital

Fund-raising ability is limited. Resources may be limited to the assets of the

owner and growth may depend on his or her ability to borrow money.

3. Lack of continuity

Upon death or retirement of the owner, the proprietorship ceases to exist.

Therefore, the proprietorship may be an ideal form of business organization

when the following conditions exist:

 The anticipated risk is minimum and adequately covered by insurance.

 The owner is either unable or unwilling to maintain the necessary
organizational documents and tax returns of more complicated business
entities.
 The business does not require extensive borrowing.

PARTNERSHIP
 A partnership is a legal arrangement in which two or more persons agree to
contribute capital or services to the business and divide the profits or losses that may
be derived therefrom. Partnership may operate under varying degrees of formality.
For example, a formal partnership may be established using a written contract
known as the partnership agreement which is filed with the Securities and Exchange
Commission.

Partnership may be either general or limited.

A general partnership is one in which each partner has unlimited liability for
the debts incurred by the business. General partners usually manage the firm and
may enter into contractual obligations on the firm's behalf. Profits and asset
ownership may be divided in any way agreed upon by the partners.

A limited partnership is one containing one or more general partners and one
or more limited partners. The personal liability of a general partner for the firm's debt
is unlimited while the personal liability of limited partners is limited to their
investment. Limited partners cannot be active in management.

Advantages of a partnership include among others the following:

1. Ease of formation

Forming a partnership may require relatively little effort and low start-up costs.

2. Additional sources of capital

A partnership has the financial resources of several individuals.

3. Management base

A partnership has a broader management base or expertise than a sole

proprietorship.

4. Tax implication

A partnership like a proprietorship does not pay any income taxes. The
income or loss of the business is distributed among the partners in accordance with
the partnership and each partner reports his or her portion whether distributed or not
on personal income tax return.

Disadvantages of partnership are:

1. Unlimited liability

General partners have unlimited liability for the debts and litigations of the
business.

2. Lack of continuity

A partnership may dissolve upon the withdrawal or death of a general partner,

depending on the provisions of the partnership.

3. Difficulty of transferring ownership

It is difficult for a partner to liquidate or transfer ownership. It varies with

conditions set forth in the partnership agreement.

4. Limitations in raising capital

A partnership may have problems raising large amounts of capital because

many sources of funds are available only to corporations.

CORPORATION

A corporation is an artificial being created by law and is a legal entity separate

and distinct from its owners. This legal entity may own assets, borrow money and
engage in other business entities without directly involving the owners. In many
corporations, owners who are also called shareholders do not directly manage the
firm. Instead they select managers designated as the Board of Directors to run the
firm for them. The Board of Directors is authorized to act in the corporation's behalf.

The incorporation process is initiated by filing the articles of incorporation and

other requirements with the Securities and Exchange Commission (SEC). The
articles of incorporation includes among others the following:

• Incorporators

• Name of the corporation

• Purpose of the corporation

• Capital stock

• Authorized shares

After the corporation is legally formed, it will then issue its capital stock.
Ownership of this stock is evidenced by a stock certificate. The corporate bylaws
which are rules that govern the internal management of the company are established
by the board of directors and approved by the shareholders. These bylaws may be
amended or extended from time to time by shareholder.

Advantages of a corporation are:

1. Limited liability

Shareholders are liable only to the extent of their investment in the

corporation. Thus, shareholders can only lease what they have invested in the firm's
shares, not any other personal assets. However, limited liability is not all-
encompassing. Government may pass through the corporate shield to collect unpaid
taxes. Also, it is not uncommon for creditors to require that major shareholders
personally co-sign for credit extended to the corporation. Thus, upon default by the
business, the creditors may sue both the corporation and shareholders who have co-
signed.

2. Unlimited life

Corporations continue to exist even after death of the owners.

3. Ease in transferring ownership

Shareholders can easily sell their ownership interest in most corporations by

 selling their stock without affecting the legal form of business organizations. The
ability to sell stock provides corporations with a stronger financial base and the
capital needed for expansion.

4. Ability to raise capital

Corporations can raise capital through the sale of securities such as bonds to
investors who are lending money to the corporations and equity securities such as
common stock to investors who are the owners.

Disadvantages of a corporation include:

1. Time and cost of formation

Registration of public companies with the SEC may be time-consuming and

costly.

2. Regulation

Corporations are subject to greater government regulations than other forms

of business organizations. Shareholders cannot just withdraw assets from the
business. They can only receive corporate assets when dividends are declared and
these amounts may be subject to limits imposed by law.

3. Taxes

Corporations pay taxes on income they have earned. The complexity of the
subject of taxation demands the advice of a qualified tax accountant.

The need of large businesses for outside investors and creditors is such that,
the corporate form will generally be the best for such firms. We focus on corporations
in the chapters ahead because of the importance the corporate form not only locally
but also in world economies. Also, a few financial management issues, such as
dividend policy are unique to corporations. However, businesses of all types and
sizes need financial management, so the majority of the subjects we discuss bear on
any form of business.

1.
Application
Closure