CHAPTER 4: FORMS OF BUSINESS ORGANIZATION

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
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.b

 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
 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.

 Legal point of view - the owner of a proprietorship is not separable from the business and is personally
liable for all the business.

 Accounting prospective - the business is debts of 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 supporting schedule.

 Advantages of a sole proprietorship:

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:

 Disadvantages of the proprietorship:

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
obligation.

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.
 The proprietorship may be an ideal form of business organization when the following conditions exist:
1. The anticipated risk is minimum and adequately covered by insurance

2. The owner is either unable or unwilling to maintain the necessary organizational documents
and tax returns of more complicated business entities.

3. 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.

1. 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.

2. 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:
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:
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:
1. Incorporators
2. Name of the corporation
3. Purpose of the corporation
4. Capital stock
5. 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:
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 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:
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 from the
business. Shareholders can not just withdraw assets from the business. They can only receive
corporate assets when dividends declare 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.

CONCLUSION
 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, of the corporate form not, only locally but also in world economies.

 A few financial management issues, such as dividend policy are unique to corporations.

 Businesses of all types and sizes need financial management, so the majority of the subjects we
discuss bear on any form of business.