Understanding Business Accounting For Dummies, 2nd Edition (81 page)

Retained earnings (also referred to as Reserves):
Represents the profit earned by a business over the years that has not been distributed to its owners. If all profit has been distributed every year, retained earnings will have a zero balance. (If a business has never made a profit, its accumulated loss will cause retained earnings to have a negative balance, called a
deficit
.) If none of the annual profits of a business have been
distributed to its owners, the balance in retained earnings will be the cumulative profit earned by the business since it opened its doors.

The account title
retained earnings
for the profit that a business earns and does not distribute to its owners is appropriate for any type of business entity. Business companies - one of the most common types of business entities - use this title. The other types of business entities discussed in this chapter may use this title, but they may collapse both sources of owners' equity into just one account for each owner. Companies are legally required to distinguish between the two sources of owners' equity: invested capital versus retained earnings. The other types of business entities may not be.

Whether to retain some or all of annual net income is one of the most important decisions that a business makes; distributions from profit have to be decided at the highest level of a business. A growing business needs additional capital for expanding its assets, and increasing the debt load of the business usually cannot supply all the additional capital. So, the business
ploughs back
some of its profit for the year - it keeps some (perhaps all) of the profit, rather than giving it out to the owners. In the long run this may be the best course of action, a step back before a leap forward.

Banks are one major source of loans to businesses. Of course, banks charge interest on the loans; a business and its bank negotiate an interest rate acceptable to both. Also, many other terms and conditions are negotiated, such as the term (time period) of the loan, whether collateral is required to secure the loan, and so on. The loan contract between a business and its lender may prohibit the business from distributing profit to owners during the period of the loan. Or, the loan agreement may require that the business maintain a minimum cash balance - which could mean that money the business would like to distribute to owners from profit has to stay in its cash account instead.

The chairman or other appropriate officer of the business signs the lending agreement with the bank. In addition, the bank may ask the major investors in the business to sign the agreement
as individuals
, in their personal capacities - and perhaps ask their spouses to sign the agreement as well. You should definitely understand your personal obligations if you are considering signing a lending agreement for a business. You take the risk that you may have to pay some part - or perhaps all - of the loan out of your personal assets.

Now, who are the owners and how do they organise themselves? A business may have just one owner, or two or more owners. A one-owner business may choose to operate as a
sole trader or proprietorship
;
a multi-owner business must choose to be a
partnership
,
a limited partnership
,
or a
limited liability company
.
The most ordinary type of business is a sole trader - there are 1.5 million of them in the UK. Around a million limited companies are in operation at present, too.

No ownership structure is inherently better than another; which one is right for a particular business is something that the business's managers and owners need to decide (or should consult a tax adviser about, as discussed later in this chapter). The following discussion focuses on how ownership structure affects profit distribution to owners. Later, this chapter explains how the ownership structure determines the tax paid by the business and its owners - which is always an important consideration.

Companies

The law views a
company
as a real, live person. Like an adult, a company is treated as a distinct and independent individual who has rights and responsibilities. A company's ‘birth certificate' is the legal form that is filed with the Department for Business Enterprise and Regulatory Reform if the company is domiciled in the UK. A company must have a legal name, of course, like an individual. Just as a child is separate from his or her parents, a company is separate from its owners. The company is responsible for its own debts, just like a person is. The bank can't come after you if your neighbour defaults on his or her loan, and the bank can't come after you if the company you have invested money in goes belly up. If a company doesn't pay its debts, its creditors can seize only the company's assets, not the assets of the company's owners.

This important legal distinction between the obligations of the business entity and its individual owners is known as
limited liability
- that is, the limited liability of the owners. Even if the owners are excessively wealthy they have no legal liability for the unpaid debts of the company (unless they've used the corporate shell to defraud creditors, or are trading in some fraudulent or illegal manner). So, when you invest money in a company as an owner, you know that the most you can lose is the same amount you put in. You may lose every pound you put in, but that's the most you can lose. The company's creditors cannot reach through the corporate entity to grab your assets to pay off the liabilities of the business.

Stock shares

A company issues ownership shares 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 company has to keep a
register
(list) of how many shares everyone owns, of course. (An owner can be another company, or any other legal entity.) The owners of a company are called its
shareholders
because they own
shares
issued by the company.
The shares are fully
negotiable
, which means the owner can sell them at any time to anyone willing to buy them without having to get the approval of the company or the other shareholders to sell the shares.
Publicly-owned companies
are those whose shares are traded in public markets, most notably the London Stock Exchange, the New York Stock Exchange, and NASDAQ (National Association of Securities Dealers Automated Quotation).

One share is one unit of ownership; how much one share is worth with respect to the value of the whole business depends on the total number of shares that the business issues. If a business has issued 400,000 shares and you own 40,000 of them, you own 1⁄10 of the business. But suppose that the business issues an additional 40,000 shares; you now have 40,000 of 440,000, giving you a 1⁄11 interest in the business. The more shares a business issues, the smaller the percentage of total owners' equity each share represents. Issuing additional shares may dilute, or decrease the value of each share of stock. A good example is when a publicly-owned company doubles the number of its shares by issuing a two-for-one stock split. Each shareholder gets one new share for each share presently owned, without investing any additional money in the business. As you would expect, the market value of the stock drops in half - which is exactly the purpose of the split, because the lower stock price is better for stock market trading (according to conventional wisdom).