What is a sole proprietorship?

A sole proprietorship is the business or an individual who has decided not to carry his business as a separate legal entity, such as a corporation, partnership or limited liability company. This kind of business is not a separate entity. Any time a person regularly provides services for a fee, sells things at a flea market or engage in any business activity whose primary purpose is to make a profit, that person is a sole proprietor. If they carry on business activity to make profit or income, the IRS requires that you file a separate Schedule C "Profit or Loss From a Business" with your annual individual income tax return. Schedule C summarizes your income and expenses from your sole proprietorship business.

As the sold proprietor of a business, you have unlimited liability, meaning that if your business can't pay all it liabilities, the creditors to whom your business owes money can come after your personal assets. Many part-time entrepreneurs may not know this, but it's an enormous financial risk. If they are sued or can't pay their bills, they are personally liable for the business's liabilities.

A sole proprietorship has no other owners to prepare financial statements for, but the proprietor should still prepare these statements to know how his business is doing. Banks usually require financial statements from sole proprietors who apply for loans. A partnership needs to maintain a separate capital or ownership account for each partners. The total profit of the firm is allocated into these capital accounts, as spelled out in the partnership agreement. Although sole proprietors don't have separate invested capital from retained earnings like corporations do, they still need to keep these two separate accounts for owners' equity - not only to track the business, but for the benefit of any future buyers of the business.

What are partnerships and limited liability companies?

Some business owners choose to create partnerships or limited liability companies instead of a corporation. A partnership can also be called a firm, and refers to an association of a group of individuals working together in a business or professional practice.

While corporations have rigid rules about how they are structured, partnerships and limited liability companies allow the division of management authority, profit sharing and ownership rights among the owners to be very flexible.

Partnerships fall into two categories. General partners are subject to unlimited liability. If a business can't pay its debts, its creditors can demand payment from the general partners' personal assets. General partners have the authority and responsibility to manage the business. They're analogous to the president and other officers of a corporation.

Limited partners escape the unlimited liability that the general partners have. They are not responsible as individuals, for the liabilities of the partnership. These are junior partners who have ownership rights to the profits of the business, but they don't generally participate in the high-level management of the business. A partnership must have one or more general partners.

A limited liability company (LLC) is becoming more prevalent among smaller businesses. An LLC is like a corporation regarding limited liability and it's like a partnership regarding the flexibility of dividing profit among the owners. Its advantage over other types of ownership is its flexibility in how profit and management authority are determined. This can have a downside. The owners must enter into very detailed agreements about how the profits and management responsibilities are divided. It can get very complicated and generally requires the services of a lawyer to draw up the agreement.

A partnership or LLC agreement specifies how profits will be divided among the owners. While stockholders of a corporation receive a share of profit that's directly related to how many shares they own, a partnership or LLC does not have to divide profit according to how much each partner invested. Invested capital is only of the factors that are used in allocating and distributing profits.

What is a corporation?

Most businesses start out as a small company, owned by one person or by a partnership. The most common type of business when there are multiple owners is a corporation. The law sees a corporation as real, live person. Like an adult, a corporation is treated as a distinct and independent individual who has rights and responsibilities. A corporation's "birth certificate" is the legal form that is filed with the Secretary of State of the state in which the corporation is created, or incorporated. It must have a legal name, just like a person.

A corporation is separate from its owners. It's responsible for its own debts. The bank can't come after the stockholders if a corporation goes bankrupt.

A corporation issues ownership share to persons who invest money in the business. These ownership shares are documented by stock certificates, which state the name of the owner and how many shares are owned. the corporation has to keep a register, or list, of how many shares everyone owns. Owners of a corporation are called stockholders because they own shares of stock issued by the corporation. One share of stock is one unit of ownership; how much one share is worth depends on the total number of shares that the business issues. the more shares a business issues, the smaller the percentage of total owners' equity each share represents.

Stock shares come in different classes of stock. Preferred stockholders are promised a certain amount of cash dividends each year. Common stockholders have the most risk. If a corporation ends up in financial trouble, it's required to pay off its liabilities first. If any money is left over, then that money goes first to the preferred stockholders. If anything is left over after that, then that money is distributed to the common stockholders.

What is financial window dressing?

Financial managers can do certain things to increase or decrease net income that's recorded in the year. This is called profit smoothing, income smoothing or just plain old window dressing. This isn't the same as fraud, or cooking the books.

Most profit smoothing involves pushing some amount of revenue and/or expenses into other years than they would normally be recorded. A common technique for profit smoothing is to delay normal maintenance and repairs. This is referred to as deferred maintenance. Many routine and recurring maintenance costs required for autos, trucks, machines, equipment and buildings can be delayed, or deferred until later.

A business that spends a significant amount of money for employee training and development may delay these programs until the next year so the expense in the current year is lower.

A company can cut back on its current year's outlays for market research and product development.

A business can ease up on its rules regarding when slow-paying customers are written off to expense as bad debts or uncollectible accounts receivable. The business can put off recording some of its bad debts expense until the next reporting year.

A fixed asset that is not being actively used may have very little current or future value to a business. Instead of writing off the un-depreciated cost of the impaired asset as a loss in the current year, the business might delay the write-off until the next year.

You can see how manipulating the timing of certain expenses can make an impact on net income. This isn't illegal although companies can go too far in massaging the numbers so that its financial statements are misleading. For the most part though, profit smoothing isn't much more than robbing Peter to pay Paul. Accountants refer to these as compensatory effects. The effects next year offset and cancel out the effects in the current year. Less expense this year is balanced by more expense the next year.

Disclosure

Financial statements are the backbone of a complete financial report. In fact, a financial report is not complete if the three primary financial statements are not included. but a financial report is much more than just those statements. A financial report requires disclosures. This term refers to additional information provided in a financial report. Therefore, any comprehensive and ethical financial report must include not only the primary financial statements, but disclosures as well.

The chief executive of a business (usually the CEO in a publicly held corporation) has the primary responsibility to make sure that the financial statements have been prepared according to generally accepted accounting principles (GAAP) and the financial report provides adequate disclosures. He or she works with the chief financial officer or controller of the business to make sure that the financial report meets the standard of adequate disclosures.

Some common methods of disclosures include:

• Footnotes that provide information about the basic figures. Nearly all financial statements require footnotes to provide additional information for several of the account balances in the financial statements.
• Supplementary financial schedules and tables that provide more details than can be included in the body of the financial statements.Other information may be required if the business is a public corporation subject to federal regulations regarding financial reporting to its stockholders. Other information is voluntary and not strictly required legally or according to GAAP.
  

Some disclosures are required by various governing boards and agencies. These include:

• The financial Accounting Standards Board (FASB) has designated many standards. Its dictate regarding disclosure of the effects of stock options is one such standard.
• The Securities and Exchange Commission (SEC) mandates disclosure of a broad range of information for publicly held companies.
• International businesses have to abide by disclosure standards adopted by the International Accounting Standards Board.
  

What happened in corporate accounting scandals?

When a corporation deliberately conceals or skews information to appear healthy and successful to its shareholders, it has committed corporate or shareholder fraud. Corporate fraud may involve a few individuals or many, depending on the extent to which employees are informed of their company's financial practices. Directors of corporations may fudge financial records or disguise inappropriate spending. Fraud committed by corporations can be devastating, not only for outside investors who have made share purchases based on false information, but for employees who, through 401ks, have invested their retirement savings in company stock.

Some recent corporate accounting scandals have consumed the news media and ruined hundreds of thousands of lives of the employees who had their retirement invested in the companies that defrauded them and other investors. The nuts and bolts of some of these accounting scandals are as follows:

WorldCom admitted to adjusting accounting records to cover its operation costs and present a successful front to shareholders. Nine billion dollars in discrepancies were discovered before the telecom corporation went bankrupt in July of 2002. One of the hidden expenses was $408 million given to Bernard Ebbers (WorldCom's CEO) in undisclosed personal loans.

At Tyco, shareholders were not informed of the $170 million in loans that were taken by Tyco's CEO, CFO, and chief legal officer. The loans, many of which were taken interest free and later written off as benefits, were not approved by Tyco's compensation committee. Kozlowski (former CEO), Swartz (former CFO), and Belnick (former chief legal officer) face continuing investigations by the SEC and the Tyco Corporation, which is now operating under Edward Breen and a new board of directors.

At Enron, investigations against uncovered multiple acts of fraudulent behavior. Enron used illegal loans and partnerships with other companies to cover its multi-billion dollar debt. It presented erroneous accounting records to investors, and Arthur Anderson, its accounting firm, began shredding incriminating documentation weeks before the SEC could begin investigations. Money laundering, wire fraud, mail fraud, and securities fraud are just some of the indictments directors of Enron have faced and will continue to face as the investigation continues.

What happened at Enron?

Everyone knows at least a little about the Enron story and the devastation it created in the lives of is employees. It's a story that belongs in any discussion of ethical accounting processes and what happens when accounting standards and ethics are discarded for personal greed.

Enron began in 1985 selling natural gas to gas companies and businesses. In 1996, energy markets were changed so that the price of energy could now be decided by competition among energy companies instead of being fixed by government regulations. With this change, Enron began to function more as a middleman than a traditional energy supplier, trading in energy contracts instead of buying and selling natural gas. Enron's rapid growth created excitement among investors and drove the stock price up. As Enron grew, it expanded into other industries such as Internet services, and its financial contracts became more complicated.

In order to keep growing at this rate, Enron began to borrow money to invest in new projects. However, because this debt would make their earnings look less impressive, Enron began to create partnerships that would allow it to keep debt off of its books. One partnership created by Enron, Chewco Investments (named after the Star Wars character Chewbacca) allowed Enron to keep $600 million in debt off of the books it showed to the government and to people who own Enron stock. When this debt did not show up in Enron's reports, it made Enron seem much more successful than it actually was. In December 2000, Enron claimed to have tripled its profits in two years.

In August 2001, Enron vice president Sherron Watkins sent an anonymous letter to the CEO of Enron, Kenneth Lay, describing accounting methods that she felt could lead Enron to "implode in a wave of accounting scandals." Also in August, CEO Kenneth Lay sent e-mails to his employees saying that he expected Enron stock prices to go up. Meanwhile, he sold off his own stock in Enron.

On October 22nd, the Securities and Exchange Commission (SEC) announced that Enron was under investigation. On November 8th, Enron said that it has overstated earnings for the past four years by $586 million and that it owed over $6 billion in debt by next year.
With these announcements, Enron's stock price took a dive. This drop triggered certain agreements with investors that made it necessary for Enron to repay their money immediately. When Enron could not come up with the cash to repay its creditors, it declared for Chapter 11 bankruptcy.