Read Understanding Business Accounting For Dummies, 2nd Edition Online
Authors: Colin Barrow,John A. Tracy
Tags: #Finance, #Business
Understanding Business Accounting For Dummies, 2nd Edition (84 page)
A business issues additional shares at the going market value, but doesn't really need the additional capital - the business is in no better profit-making position than it was before issuing the new shares. For example, a business may issue new shares in order to let a newly hired chief executive officer buy them. The immediate effect may be a dilution in the market value per share. Over the long term, however, the new CEO may turn the business around and lead it to higher levels of profit performance that increase the share's value.
Where profit goes in a company
Suppose that your business earned £1.32 million in net income for the year just ended and has issued a total of 400,000 shares of capital stock. Divide net income by the number of shares, and you come up with earnings per share of £3.30.
The cash flow statement reports that the business paid £400,000 total cash dividends during the year, or £1 per share. (Cash dividends are usually paid half-yearly or sometimes quarterly, so the business most likely paid £0.25 dividends per share each of the four quarters.) The rest of the net income - £920,000 - remains in the retained earnings account. (
Remember:
Net income is first entered as an increase in the retained earnings account, and distributions are taken out of this account.) The retained earnings account thus increased by £2.30 per share (the difference between the net income, or earnings per share, and the dividends per share).Although shareholders don't have the cash to show for it, their investment is better off by £2.30 per share - which shows up in the balance sheet as an increase in the retained earnings account in owners' equity. They can just hope that the business will use the cash flow provided from profit this year to make more profit in the future, which should lead to higher cash dividends.
If the business is a publicly-owned company whose shares are actively traded, its shareholders look to the change in the
market price
of the stock shares during the year. Did the market value go up or down during the year? You may think that the market value should increase £2.30 per share, because the business earned this much per share that it kept in the business and did not distribute to its shareholders. Your thinking is quite logical: Profit is an increase in the net assets of a business (assets less liabilities). The business is £2.30 per share richer at the end of the year than it was at the start of the year, due to profit earned and retained.Yet it's entirely possible that the market price of the stock shares actually
decreased
during the year. Market prices are governed by psychological, political, and economic factors that go beyond the information in the financial reports of a business. Financial statements are one - but only one - of the information sources that stock investors use in making their buy-and-sell decisions. Chapter 14 explains how stock investors use the information in financial reports.
Partnerships and limited partnerships
Suppose you're starting a new business with one or more other owners, but you do not want it to be a company. You can choose to form a
partnership
or a
limited partnership
,
which are the main alternatives to the corporate form of a business.
Note
:
A partnership is sometimes also called a
firm
.
(You don't see this term used to refer to a company nearly as often as you do to a partnership.) The term firm connotes an association of a group of individuals working together in a business or professional practice, as in a
firm of lawyers
.
Compared with the relatively rigid structure of companies, partnership and limited partnership ownership structures allow the division of management authority, profit sharing, and ownership rights among the owners to be very flexible. Here are the key features of these two ownership structures:
Partnerships avoid the double-taxation feature that companies are subject to (see ‘Choosing the Right Legal Structure for Tax Purposes', later in this chapter, for details). Partnerships also differ from companies with respect to liability. A partnership's owners fall into two categories:
•
General partners
are subject to
unlimited liability
. If a business can't pay its debts, its creditors can reach into general partners' personal assets. General partners have the authority and responsibility to manage the business. They are roughly equivalent to the managing director and other high-level managers of a business company. The general partners usually divide authority and responsibility among themselves, and often they elect one member of their group as the senior general partner or elect a small executive committee to make major decisions.
•
Limited partners
escape the unlimited liability that the general partners have hanging around their necks. You can reduce the more painful consequences of entering a partnership by having your involvement registered as a limited partnership. A limited partnership is very different from a ‘general' partnership. It is a legal animal that, in certain circumstances, combines the best attributes of a partnership and a corporation.
A limited partnership works like this. There must be one or more general partners with the same basic rights and responsibilities (including unlimited liability), as in any general partnership, and one or more limited partners who are usually passive investors. The big difference between a general partner and a limited partner is that the limited partner isn
'
t personally liable for debts of the partnership. The most a limited partner can lose is the amount that he or she paid or agreed to pay into the partnership as a capital contribution; or received from the partnership after it became insolvent.