PRC-5 Introduction to Business PDF

PRC - 5 INTRODUCTION TO BUSINESS THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN i First edition published by The Institute of Chartered Accountants of Pakistan Chartered Accountants Avenue Clifton Karachi – 75600 Pakistan Email: [email protected]....

PRC - 5 INTRODUCTION TO BUSINESS THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN i First edition published by The Institute of Chartered Accountants of Pakistan Chartered Accountants Avenue Clifton Karachi – 75600 Pakistan Email: [email protected] www.icap.org.pk © The Institute of Chartered Accountants of Pakistan, November 2021 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, without the prior permission in writing of the Institute of Chartered Accountants of Pakistan, or as expressly permitted by law, or under the terms agreed with the appropriate reprographics rights organization. You must not circulate this book in any other binding or cover and you must impose the same condition on any acquirer. Notice The Institute of Chartered Accountants of Pakistan has made every effort to ensure that at the time of writing, the contents of this study text are accurate, but neither the Institute of Chartered Accountants of Pakistan nor its directors or employees shall be under any liability whatsoever for any inaccurate or misleading information this work could contain. ii THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN  TABLE OF CONTENTS CHAPTER PAGE Chapter 1 Nature of business 1 Chapter 2 Ownership of business 21 Chapter 3 Organization of business 35 Chapter 4 Sources of business finance 51 Chapter 5 Information systems 71 Chapter 6 Business ethics 97 Chapter 7 Marketing concepts 115 Chapter 8 Human resource strategies 133 Chapter 9 Business operations of a manufacturing organisation 151 Chapter 10 Industries of Pakistan 171 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN iii iv THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN  CHAPTER 1 NATURE OF BUSINESS AT A GLANCE IN THIS CHAPTER Understanding the basic structures, organization, and key forces are important for the survival and success of a business. AT A GLANCE In a fast-changing environment, the change is the only constant. SPOTLIGHT Those businesses which understand the functioning of major AT A GLANCE variables influencing its growth and profitability, will succeed 1 Understanding nature of in long-run. business This chapter will focus on key elements of understanding the nature of business such as: SELF-TEST  Purpose - profit and not-for-profit  Vision, mission, goals and objectives  Factors of productions  Stakeholders – internal and external SPOTLIGHT THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 1  CHAPTER 1: NATURE OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS 1. UNDERSTANDING NATURE OF BUSINESS 1.1. The nature of business A business is an organization that strives for profit by providing goods and services desired by its customers. Businesses meet the needs of consumers by providing household essentials, clothing, medical care, transportation, banking, communication, and countless other goods and services. Goods are tangible items, that can be held, touched, or stored, manufactured or traded by businesses, such as laptops. Services are intangible offerings of businesses that can’t be held, touched, or stored. Physicians, lawyers, hairstylists, car washes, and airlines all provide services. Businesses also sell or serve to other organizations, such as hospitals, retailers, and governments, by providing machinery or goods for resale, computers, and thousands of other items. Thus, businesses create the goods and services that are the basis of our standard of living. The standard of living AT A GLANCE of any country is measured by the output of goods and services people can buy with the money they have. This provides a basis for comparing standard of living among different countries. Businesses play a key role in determining our quality of life by providing jobs and goods and services to society. Quality of life refers to the general level of human happiness based on such things as life expectancy, educational standards, health, sanitation, and leisure time. Building a high quality of life is a combined effort of businesses, government, and not-for-profit organizations (explained later). Different places are ranked and compared based on the quality of life standards. The profitability of a business can be measured through key variables such as revenue, costs, and profit. Revenue is the money a company receives by providing services or selling goods to customers. Costs are expenses for rent, salaries, supplies, transportation, and many other items that a company incurs from creating and selling goods and services. For example, some of the costs incurred by Microsoft in developing its software include expenses for salaries, facilities, and advertising. If Microsoft has money left over after it pays all costs, it has a profit. A company whose costs are greater than revenues incur a loss. There is always a risk that a business may incur a loss by not achieving its goals due to inefficient use of its resources and/or ineffective business strategies to fight against market competition. When a company such as Microsoft uses its resources intelligently, it can often increase sales, hold costs down, and earn a profit. Not all companies earn profits, but that is the risk of being in business. There is a direct SPOTLIGHT relationship between risks and profit: the greater the risks, the greater the potential for profit (or loss). Not-for-Profit Organisations Not all organizations strive to make a profit. A not-for-profit organization is an organization that exists to achieve some goal other than the usual business goal of profit. Charities such as the Edhi Foundation and The Citizens Foundation are not-for-profit organizations, as are most hospitals, educational institutes, social work organizations, non-governmental organisations (NGOs), civic groups, and religious organizations. Like their for-profit counterparts, these groups set goals and require resources to meet those goals. However, their goals are not focused on profits. For example, a not-for-profit organization’s goal might be feeding the poor, preserving the environment or advocating for the rights of some underprivileged community. 1.2. Purpose of a business The primary goal of all businesses is to earn a profit. Businesses have the right to keep and use their profits as they choose—within legal limits—because profit is the reward for the risks business take in providing products (i.e. goods and services). Earning profits contributes to society by providing employment, which in turn provides money that is reinvested in the economy. In addition, profits must be earned in an ethical and socially responsible manner. 2 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN PRC 5: INTRODUCTION TO BUSINESS CHAPTER 1: NATURE OF BUSINESS To earn a profit, a person or organization needs management skills to plan, organize, and control the activities of the business and to find and develop employees so that it can make products consumers will buy. A business also needs marketing expertise to learn what products consumers need and want and to develop, manufacture, price, promote, and distribute those products. Additionally, a business needs financial resources and skills to fund, maintain, and expand its operations. Other challenges for businesspeople include abiding by laws and government regulations; acting in an ethical and socially responsible manner; and adapting to economic, technological, political, and social changes. Even nonprofit organizations engage in management, marketing, and finance activities to help reach their goals. To achieve and maintain profitability, businesses have found that they must produce quality products, operate efficiently, and be socially responsible and ethical in dealing with customers, employees, investors, government regulators, and the community. Because these groups have a stake in the success and outcomes of a business, they are sometimes called stakeholders. Many businesses, for example, are concerned about how the production and distribution of their products affect the environment. As part of a strategic review, management should always re-consider the purpose of the entity that they manage, what it is trying to achieve. In the strategic planning process, goals, objectives and strategies should be decided AT A GLANCE with the aim of fulfilling the entity’s purpose. A business entity should have a hierarchy of aims and plans. A useful way of presenting this is shown below. Future Outlook Vision Overall purpose Mission General overall aims Goals Specific overall aims Objectives Detailed longer-term targets Strategies and Strategic aims Implementation targets and budgets Tactical plans and aims Action plans and targets Operational plans and aims An important aspect of managing business is creating purpose and providing clear messaging to stakeholders. This can be done by the creation of a mission statement and a vision statement. SPOTLIGHT Vision and Vision Statement A vision statement has more to do with the future and really describes what an organization plans or hopes to be in the future. This is more of an inspirational or motivational statement that is meant to drive employees and also clearly demonstrate an organizations’ goals to stakeholders (customers, investors, etc.). A vision statement shouldn't really discuss the present state of the organization but more what the organization wants to be and how it wants to be viewed. To be effective the message should be clear, optimistic, and of course realistic. An unrealistic vision statement, i.e. a corner store owner saying that in six months the company will be bigger than Walmart, won't be motivating or inspirational but end up being comical. A well-written vision statement should be short, simple, specific to the business, leave nothing open to interpretation. THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 3  CHAPTER 1: NATURE OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS  For example: Habib Bank’s vision statement: “Enabling people to advance with confidence and success”. (https://www.hbl.com/about-us/our-brand) Coca Cola’s vision statement:“Our vision serves as the framework for our Roadmap and guides every aspect of our business by describing what we need to accomplish in order to continue achieving sustainable, quality growth. People: Be a great place to work where people are inspired to be the best they can be. Portfolio: Bring to the world a portfolio of quality beverage brands that anticipate and satisfy people's desires and needs. Partners: Nurture a winning network of customers and suppliers, together we create mutual, enduring value. AT A GLANCE Planet: Be a responsible citizen that makes a difference by helping build and support sustainable communities. Profit: Maximize long-term return to shareowners while being mindful of our overall responsibilities. Productivity: Be a highly effective, lean and fast-moving organization.” (https://www.coca-cola.com.sg/our-company/mission-vision-values) Mission: A mission is the purpose of an organization and the reason for its existence. Many entities give a formal expression to their mission in a mission statement. A mission statement defines what an organization is, why it exists, its reason for being. ‘A mission describes the organization’s basic function in society, in terms of the products and services it produces for its customers’ (Mintzberg). A mission statement has a more 'present day' focus and really describes how a company plans on achieving its objectives. This is really a statement to employees, shareholders, and others with an interest in the organization that clearly articulates what an organization is doing, how it's going to do it, and ultimately why it's doing it. For many small businesses this can seem like a trivial item but large organizations spend countless hours, SPOTLIGHT meetings and dollars considering their mission statement and its significance. Changing a company's mission statement can be a major undertaking with numerous consultations and even external advisors being hired. For any growing business this should underline the significance of creating an effective mission statement, particularly when it's not part of the business model (or not possible) for the owner to personally convey the companies’ mission to everyone. A mission statement should be a clear and short statement. The key questions to answer in a mission statement include:  What is our business?  What is our value to the customer?  What will our business be?  What should our business be? Some entities include a statement about the role of their employees in their mission statement, or include a statement on the ethics of the entity. 4 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN PRC 5: INTRODUCTION TO BUSINESS CHAPTER 1: NATURE OF BUSINESS  For example: Habib Bank’s mission statement: “To make our customer prosper, our staff excel and create value for shareholders”. (https://www.hbl.com/about-us/our-brand) Coca Cola’s mission statement: “Our Roadmap starts with our mission, which is enduring. It declares our purpose as a company and serves as the standard against which we weigh our actions and decisions. To refresh the world... To inspire moments of optimism and happiness... To create value and make a difference.” (https://www.coca-cola.com.sg/our-company/mission-vision-values) AT A GLANCE  Example: The World Bank – Mission statement  ‘Our dream is a world free of poverty  To fight poverty with passion and professionalism for lasting results.  To help poor people help themselves and their environment, by providing resources, sharing knowledge, building capacity and forging partnerships in the public and private sectors.  To be an excellent institution able to attract, excite and nurture diverse and committed staff with exceptional skills who know how to listen and learn.’ Commercial entities also often emphasize the ethical aspects of their mission, perhaps as a method of motivating employees. The relevance of the mission statement A mission statement can have several different purposes:  to provide a basis for consistent strategic planning decisions SPOTLIGHT  to assist with translating broad intentions and purposes into corporate objectives  to provide a common purpose for all groups and individuals within the organization  to inspire employees  to establish goals and ethics for the organization  to improve the understanding and support for the organization from external stakeholder groups and the public in general. Mission Statement vs. Vision Statement When considering a mission statement vs. a vision statement the key aspect to remember is the current vs. future context. A mission statement is where you are and why you do it, a vision statement is where you are going to be and how you want to get there. While these may seem like soft topics it can be very important to ensure that the mission and vision of an organization or company's leadership is clearly conveyed to the people who need to know it. Employees, shareholders, and other stakeholders can be provided with quick answers to how an organization views itself and where it plans on being in the future. Conveying this message to them in two well thought out statements can be a very useful communication and governance tool. Ultimately, the mission statement reflects the purpose, value and action. In any business, the goals and objectives should clearly support the organization’s mission statement. THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 5  CHAPTER 1: NATURE OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS For example, Twitter’s mission statement has three parts such as the purpose, value, and action:  Mission: Give everyone the power to create and share ideas and information instantly, without barriers.  Values: We believe in free expression and think every voice has the power to impact the world.  Strategy: Reach the largest daily audience in the world by connecting everyone to their world via our information sharing and distribution platform products and be one of the top revenue generating Internet companies in the world. Accordingly, Twitter combines its mission and values to fulfill its goals and objectives through a well-defined strategy. Goals and objectives There is some confusion about the meaning of goals and objectives, and the terms might be used to mean different things. However, it is useful to think of goals and objectives as follows: AT A GLANCE  Goals are aims for the entity to achieve, expressed in narrative terms. They are broad intentions. For example, an entity might have the goal of maximizing the wealth of its shareholders, or the goal of being the world’s leading business entity in one or more markets.  Objectives are derived from the goals of an entity, and are aims expressed in a form that can be measured, and there should be a specific time by which the objectives should be achieved. The objectives should be SMART:  Specific/stated clearly  Measurable  Agreed  Realistic  Time-bound (clear and specific targets should be set for achievement of objective) A company might have a goal of maximizing the wealth of its shareholders. Its objective might therefore be to double the share price within the next ten years. Objectives might be expressed as a hierarchy of corporate and strategic objectives:  A corporate objective might be to double the share price within the next ten years. This is the overall objective for the entity. SPOTLIGHT In order to achieve the corporate objective, it is necessary to set strategic objectives for key aspects of strategy. Examples of strategic objectives might be:  to increase the annual profit after tax by 125% in the next ten years  to introduce an average of three new products each year for the next ten years  to become the market leader in four market segments within the next ten years, an improvement in each case from the current position of second-largest competitor in each of these market segments. Some strategic objectives are more important than others, and there is a hierarchy of strategic objectives. However, the main strategic objectives might be identified as critical success factors, for which there are key performance indicators. Goals and objectives can therefore be used to convert an entity’s mission into specific strategies with strategic targets for achievement within a strategic planning period. Who decides mission, goals and objectives? When an entity states its mission in a mission statement, the statement is issued by the leaders of the entity. For a company this is the board of directors. Similarly, the formal goals and objectives of an entity are stated by its leaders. 6 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN PRC 5: INTRODUCTION TO BUSINESS CHAPTER 1: NATURE OF BUSINESS However, the decisions by a board of directors about the goals and objectives of an entity are influenced by the way in which the company is governed and the expectations of other stakeholders in the company. How to set effective goals Techniques for setting effective goals include:  Participate in the goal-setting process  Ensure that the goals include intrinsically motivating work  Ensure there is a system that can provide feedback on the achievement of goals  Goals must be SMART (see above)  Align personal and commercial goals  When recording goals, state them in a positive statement  Set priorities Problems created by goals AT A GLANCE The most effective and motivating goals are those that are challenging yet remain achievable. The extremes either side are likely to be demotivating whether they are:  unrealistically challenging – result is the employee simply gives up  too easy – resulting in the employee slacking off, feeling under-utilized and lacking inspiration. Other problems that are perceived to be caused by setting goals include:  goals create inflexibility and can lead to a narrow focus. This means that an opportunity that falls outside the scope of recorded and stated goals is potentially overlooked as time spent on the opportunity will not help achieve the previously agreed goals.  goals may generate stress through a constant pressure and reference to needing to constantly perform at the highest levels in order to achieve or exceed stated goals. This can detract from taking enjoyment and interest from the task.  Example The board of OT Limited (OTL) is currently formulating strategy for achieving its business goals during the next four years. The board is of the opinion that the level of business activity in the country would increase significantly and OTL should achieve a fair share of the envisaged growth. SPOTLIGHT The board of OTL should keep the following important matters in perspective while establishing its goals for the next four years: i. The goals should be based on realistic growth parameters and pose reasonable challenges for the employees. Over-ambitious goals or internal/external constraints may frustrate the employees. On the other hand, if the goals are too easy to achieve, the employees may adopt a complacent or laid back attitude and not put in their best efforts. ii. The employees should participate in the goal-setting process because their input and involvement would self-motivate them to make extra efforts to achieve the goals. iii. The commercial goals of OTL should be aligned with the personal goals of the employees. OTL should study the types of rewards and incentives which would motivate the employees to put in their best efforts and design the compensation packages to elicit optimum efforts from the employees. iv. OTL should be able to generate adequate resources to meet the goals and also ensure that the resources are allocated according to the requirements in order to achieve optimum utilization of the available resources. v. The goals should be flexible so that any new opportunities which are not envisaged in the original goal plan are also recognized and targeted. THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 7  CHAPTER 1: NATURE OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS vi. A performance monitoring system should be implemented to ensure that the performance is in line with the goals/ targets and timely corrective measures are taken to rectify any unfavorable variances from the set goals. vii. A system of employees training and development should be implemented to enhance their work skills and ensure that they are fully conversant with the prevailing regulations.  Example Fancy Apparel Company Fancy Apparel Company Limited is a garments’ manufacturing concern; operating in the local market producing apparels for the middle-class segment of the market. The company has ambitious plans to enter in the high-fashion ladies garment business. To achieve effective coordination, the management is of the opinion that various departments should be assigned specific goals of performance for the next two years in order to meet stringent delivery schedules. This is particularly important because a large number of new employees will be recruited who would work in a team environment with the existing work force. AT A GLANCE The new aim of the company will be achieved by introducing and implementing a formal goal setting system. The company will achieve competitive advantage through clear vision of goal achievement. The other advantages for the company are as follows:  All the departmental heads and their subordinates would be fully aware of their responsibilities and duties which they would have to perform during the next two years.   The goal setting system would strengthen the departmental head and subordinate relationship because it would promote an environment of team effort and the manager would not be considered as an arbitrary decision maker.  The goal setting system would have self-correcting characteristics as any slippages in performance would be identified immediately and corrective measures taken.  The goal-setting system would help to identify worker deficiencies and lead to development of training needs in the organization.  All individuals in the organization would know in advance the basis of their performance appraisal.  The goal setting system would help to closely monitor the market trends and adapt to the changes in the market tastes and preferences. SPOTLIGHT  The goal setting system would help to achieve greater departmental coordination and lead to achievement of overall organizational goals. Examples of Goals and Objectives: Variables Goal Objective Growth and Increasing net profit by 15% by  Increasing annual sales by 25% Profitability increasing revenue while limiting  Adding five new customers each month expenses  Reducing the annual utility bills by 5% Customer Care Reducing customer complaints by  Adding two new customer service 30% and improving resolution time employees next 12 months by one day  Reply to customer complaints within two business days Staff Retention Improving staff retention – less than  Training for new employees within first three employees leaving in six months 90 days on the job  Bi-weekly meetings one-on-one basis Efficiency Increasing shipping times from five to  Adding new shipper two days  Improving production time by two hours 8 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN PRC 5: INTRODUCTION TO BUSINESS CHAPTER 1: NATURE OF BUSINESS 1.3. Factors of Production: The Building Blocks of Business To provide goods and services, regardless of whether they operate in the for-profit or not-for-profit sector, organizations require inputs in the form of resources called factors of production. Four traditional factors of production are common to all productive activity: Natural Resources, human resources (labour), capital, and enterprise. Many experts now include knowledge as a fifth factor, acknowledging its key role in business success. By using the factors of production efficiently, a company can produce more goods and services with the same resources. Natural Resources Natural resources include any resources or commodities that can be used in their natural form. They include farmland, forests, mineral and oil deposits, and water. Sometimes natural resources are simply called land, although, as you can see, the term means more than just land. Companies use natural resources in different ways. A paper manufacturing company uses wood pulp to make paper, and a utility distribution company use water, oil, or coal to produce electricity. Land remains the most obvious natural resource that is commonly used by businesses to produce goods and AT A GLANCE services. Agricultural businesses rely on land to grow crops. Other businesses rely on land to establish a site for production of their goods and services. Human Resources (Labor) Human resources are the people who are able to perform work for a business. They may contribute to production by using their physical abilities, such as working in a factory to construct a product. Alternatively, they may contribute by using their mental abilities, such as proposing a change in the existing production process or motivating other workers. Capital The tools, machinery, equipment, and buildings used to produce goods and services and get them to the consumer are known as capital. Sometimes the term capital is also used to mean the money that buys machinery, factories, and other production and distribution facilities. However, because money itself produces nothing, it is not one of the basic inputs. Instead, it is a means of acquiring the inputs. Therefore, in this context, capital does not include money. Physical facilities are typically necessary to produce many goods and services. Especially in recent years, technology has enabled businesses to use their capital more effectively. SPOTLIGHT Entrepreneurship Entrepreneurs are the people who combine the inputs of natural resources, labor, and capital to produce goods or services with the intention of making a profit or accomplishing a not-for-profit goal. These people make the decisions that set the course for their businesses; they create products and production processes or develop services. Entrepreneurship involves the creation of business ideas and the willingness to accept risk. Entrepreneurs attempt to identify business opportunities. When they find one, they invest some of their own resources to create a business with the expectation that they will earn adequate profits as a reward for their efforts. However, they also face the risk that the profits of the business may not be as high as expected. In fact, if expenses exceed revenue, the profits may be negative and the business could fail. In a free market economy, many businesses may be created within an established industry, which results in intense competition. In this situation, a firm that charges too high a price for its product may fail because customers will switch to its competitors. Similarly, a firm that is not well managed may fail because its expenses are too high. This risk of failure can reduce the motive to create a business. Entrepreneurs should realize that if they overestimate the potential profitability of a business or manage the business poorly, they will lose the money. THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 9  CHAPTER 1: NATURE OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS 1.4. Key Stakeholders in a Business Every business involves transactions with people. Those people are affected by the business and therefore have a stake in it. They are referred to as stakeholders, or people who have an interest (or stake) in the business. In business, a stakeholder is any individual, group, or community that has an interest in an organization and the outcomes of its operation. Common examples of stakeholders include employees, customers, shareholders, suppliers, communities, and governments. Different stakeholders have different interests, and companies often face trade-offs in trying to please all of them. Therefore, businesses would set priorities while playing a balancing act in serving all of its stakeholders, e.g. in a highly regulated business environment the top priority of the business would be to operate within all boundaries set by the government and ensuring that no laws are being compromised. Another example would be of a service related business where customers are an important stakeholder and the business would include satisfaction of its customers in its vital strategy. A stakeholder in an organisation is a person who has an interest (or ‘stake’) in what the organisation does, and who might therefore try to influence the decisions and actions of the organisation. Stakeholders are individuals and other organisations, but they may often have a common interest. It is therefore AT A GLANCE possible to categorise some stakeholders into groups of people with a similar interest. Stakeholders can be either: a) people or groups within the organisation (internal stakeholders), or b) people, groups or other entities that are external to the organisation (external stakeholders). A ‘power-interest matrix’ can be used to categorise stakeholders based on their power or influence and interest in a project or entity. This should begin with a list of all possible stakeholders involved in a project. Relevant stakeholders can be identified by reviewing corporate documentation, holding workshops, and discussions with management. 1.4.1 Internal stakeholders Within a business organisation, internal stakeholders can be categorised into groups as follows: a) shareholders/owners b) executive directors and senior managers c) other managers and employees It might be appropriate to divide management and employees into sub-categories, where there are groups with SPOTLIGHT differing interests and concerns. Owners Every business begins as a result of ideas about a product or service by one or more entrepreneurs. As explained earlier, entrepreneurship is the act of creating, organizing, and managing a business. Today, a lot of businesses are a result of initiatives by individuals who take the risk of becoming entrepreneurs. Entrepreneurs are critical to the development of new business because they create new products (or improve existing products) desired by consumers. People will be willing to create a business only if they expect to be rewarded for their efforts. The rewards of owning a business come in various forms. Some people are motivated by the chance to earn a large income. Others desire to be their own boss rather than work for someone else. Many people enjoy the challenge or the prestige associated with owning a business. Most business owners would agree that all of these characteristics motivated them to start their own business. Many firms have grown by issuing shares or stock to other investors; that is, they essentially sell a portion of the ownership to these investors. The stock received by investors is a certificate representing ownership of the specific business. The investors who purchase stock are called stockholders (or shareholders) of those firms. The funds received by a firm that issues stock can be used to expand the business. Large firms such as Unilever, Lucky Group of Companies and General Tyres now have millions of stockholders, but when they were created, they were small businesses. 10 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN PRC 5: INTRODUCTION TO BUSINESS CHAPTER 1: NATURE OF BUSINESS Stakeholder vs Shareholder This is an important distinction to make. A stakeholder is anyone who has any type of stake (interest) in a business, while a shareholder is someone who owns shares (stock) in a business and thereby has an equity interest. In large companies, the main shareholders are not usually involved in the day-to-day management (although there are some exceptions). Shareholders in a large company are usually investors, seeking to earn a return on their investment in the form of dividends and a higher share price. Shareholders leave the management of their company to the board of directors and executive management team. However, they might become more closely involved in the company, and try to influence the decisions of the directors, when they feel that their interests are threatened. For example, shareholders might express their concerns about any of the following: a) Falling profits and a falling share price b) Lower dividend payments c) A proposal to invest in a major project where the business risk is high AT A GLANCE d) A proposed takeover bid for another company or from another company. When shareholders feel that their interests are threatened, they might try to become more actively involved in the company. Major shareholders can discuss their concerns with the company chairman and other senior directors. A company might have a majority shareholder, who owns enough shares in the company that the shareholder is able to control the composition of the board and the decisions that the company’s directors make. When there is a majority shareholder, the interests of this shareholder might differ from those of the minority shareholders owning the remainder of the shares. (In other words, the majority shareholder and the minority shareholders might be different stakeholder groups.) Employees Employees have a direct stake in the company in that they earn an income to support themselves, along with other benefits (both monetary and non-monetary). Depending on the nature of the business, employees may also have a health and safety interest (for example, in the industries of transportation, mining, oil and gas, construction, etc.) Firms hire employees to conduct their business operations. Some firms have only a few employees; others, such SPOTLIGHT as General Motors and IBM, may have more than 200,000 employees spread across the globe running their operations in different regions. Employees or human resource is one of the most important stakeholders of the business and can significantly affect the performance of the business. Companies invest a great deal of time and commitment on the process of hiring good quality of human resource and then retain them by offering competitive benefits as incentive. Employees also make the decision to work for a company after careful thought as they are directly affected by the business, its policies and its success or failure. Executive directors and senior managers A board of directors might consist of executive directors and non-executive directors. Executive directors are usually full-time employees of the company (whereas non-executives are not). As executives and full-time employees, executive directors are involved in the management of the company. Their interests are therefore often similar to the interests of other senior executives, who do not have a position on the board of directors. The interests of executive directors and senior managers are affected by matters such as: a) their remuneration, which consists of basic salary, pension rights, cash bonuses and share incentive schemes THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 11  CHAPTER 1: NATURE OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS b) power and status c) career prospects d) job security. Executive directors and other senior managers often want their company to grow in size, because in a larger company, they expect larger remuneration, more power and status and better career prospects. However, growing the company is not necessarily in the best interests of shareholders, who are more concerned about profitability, dividends and the share price. Other managers and employees Managers in the middle and junior ranks of a management hierarchy might have ambitions to become senior managers. However, their interests and concerns are different. Often, junior managers and other employees share common interests, such as: a) pay b) working conditions AT A GLANCE c) job security d) job satisfaction e) quality of life. 1.5. External stakeholders Business organisations, particularly large organisations, have a large number of external stakeholders. These include: a) lenders b) suppliers c) government d) customers e) local communities f) the general public, including special interest groups and pressure groups g) non-executive directors. SPOTLIGHT Lenders and Creditors Firms typically require financial support beyond the capital injected by the owners or their personal assets being used in the business. When a firm is initially created, it incurs expenses before it starts selling a single product or service. For example, it may have to acquire machinery and equipment, purchase or rent a facility or premises, and hire workers before it can generate any revenue. In the first several months, its costs incurred may exceed its revenue. Therefore, the firm cannot solely rely on money made from sales to cover its expenses. The owners of a new business may initially have to rely on borrowed funds or credit. Many firms that need funds borrow from financial institutions or individuals called creditors, who provide loans. Creditors may include friends and family at first and banks which may be willing to provide money when a business is been running for some time with a stable financial history and market conditions. The amount taken from these creditors represents the debt or liability of a business which the business will return on agreed terms with the lender. Creditors will lend funds to a firm only if they believe the firm will perform well enough to pay the interest on the loans and the principal (amount borrowed) in the future. The firm must convince the creditors that the business will be able to generate sufficient profits to make the interest and principal payments of the loan. Lenders to a company include banks and bondholders. (Companies might issue bonds or debentures in order to raise finance. Interest is paid on the bonds, which represent a debt that the company must eventually repay.) The main concerns of lenders are that the borrower should be able to repay the debt, with interest, on schedule. 12 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN PRC 5: INTRODUCTION TO BUSINESS CHAPTER 1: NATURE OF BUSINESS Lenders might therefore be concerned about heavy borrowing by a business organisation, because when a borrower gets into heavy debt, the risks increase that it will not be able to meet all the claims for interest and debt repayment, especially if profitability falls. Suppliers Businesses commonly use materials to produce their goods and services. For example, automobile manufacturers use steel to make automobiles, while home builders need cement, wood siding, and many other materials. Firms cannot complete the production process if they cannot obtain the materials. Therefore, their performance is partially dependent on the ability of their suppliers to deliver the materials on schedule. Business organisations also buy goods and services from their suppliers. Suppliers will usually agree to allow their customers some credit (time to pay) but their main interests are that: a) a customer will pay what is owed and will not become a bad debt b) customers will continue to buy from them c) customers will treat them fairly, and deal with them in an ethical way. AT A GLANCE Government Governments can also be considered a major stakeholder in a business, as they collect taxes from the company (corporate income taxes), as well as from all the people it employs (payroll taxes) and from other spending the company incurs (sales taxes). Governments benefit from the overall Gross Domestic Product (GDP) that companies contribute to. Governments of free-market economies recognize the advantages of allowing businesses to be set up. Not only do businesses serve consumers, but by creating work for the business owners and employees, they also reduce the country’s unemployment which is an important goal of the government. Firms rely on entrepreneurs (owners) to create business ideas and possibly to provide some financial support. They rely on other owners and creditors to provide additional financial support. They rely on employees (including managers) to produce and sell their products or services. They rely on suppliers to provide the materials needed for production. They rely on customers to purchase the products or services they produce. The government has an interest in all business organisations, but especially large organisations, for a wide range of reasons. a) Businesses pay tax on profits, so government has an interest in company profitability. SPOTLIGHT b) The government want to create and maintain a strong economy. This depends partly (or largely) on new investments by businesses. Government might therefore want to encourage business investments. c) The government want to achieve low levels of unemployment. Businesses are major employers. d) The government regulates many different aspects of business activity: employment law, environmental law, health and safety regulations and company law are just a few examples. The government might be a significant external stakeholder in a business because of its power to introduce new laws and regulations, or amend existing laws. Customers Customers have a stake in a business organisation because they expect to obtain value from the goods or services that they buy. A business cannot survive without customers. To attract customers, a firm must provide a desired product or service at a reasonable price. It must also ensure that the products or services produced are of adequate quality so that customers are satisfied. If a firm cannot provide a product or service at the quality and price that customers desire, customers will switch to the firm’s competitors. Apple and Samsung’s cell phone manufacturing divisions attribute most of their recent success to recognizing the types of products and features that consumers want. These firms also are committed to a certain standard of quality and price their products in a manner that matches the expectations of their customers. THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 13  CHAPTER 1: NATURE OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS Local communities In some cases, local communities might be stakeholders in a business organisation, especially when the organisation is a major employer in the area and the local economy depends on the work and business activity that the organisation brings to the area. The concerns of a local community might be very strong when a business organisation proposes to close down operations in the area, and make its employees redundant. Business shut down by a major employer in an area has a knock-on effect for other businesses, which will lose trade and income. The general public The general public might consider that it has a stake or interest in major companies, because the actions of these companies can affect society as a whole. Public concerns might be expressed by action groups or pressure groups. Areas of public concern might include: a) public health, especially in the case of food manufacturers and manufacturers of drugs and medicines b) protection of the environment, reducing pollution, and creating ‘sustainable businesses’ AT A GLANCE c) corruption in business practices (such as bribery) d) the exploitation of the consumer through mis-selling and misleading descriptions of goods e) the monopolisation of a market by one or a small number of companies. (In the UK for example there is public concern about the dominance of supermarket chains in the retail market, and the shift of retailing from town centres to out-of-town locations.) Non-executive directors Oddly, perhaps, non-executive directors are external stakeholders in a company. Although they are members of the board of directors, they are not full-time employees, and they are usually appointed to a company’s board because: a) they bring experience and knowledge to the board that they have gained outside the company, and which executive directors often do not have b) their interests are different from those of executive directors and senior executives: they are not affected by concerns about remuneration (bonuses and performance incentives), power and status or job security. Appointing independent non-executive directors to the board of directors of a company is good corporate SPOTLIGHT governance practice, because independent NEDs can help to prevent a company from being dominated by the personal interests of the executive directors. The main stakeholders The main stakeholders in a business organisation, internal or external, are those who exercise the greatest influence. The most influential stakeholders in a company are usually the board of directors, and possibly also senior executives below board level. These are the individuals with the power to make most of the decisions for the company. The directors will often be influenced by the opinions of their shareholders, especially their largest shareholders, because shareholders can take some action against the directors if they are dissatisfied. For example, shareholders can vote against the re-election of directors (and in extreme cases can vote to have a director removed from office). Connected stakeholders Other stakeholder groups, other than the directors, senior management and the shareholders, might influence the decisions that directors and senior management make. The term ‘connected stakeholder’ means a stakeholder who: 14 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN PRC 5: INTRODUCTION TO BUSINESS CHAPTER 1: NATURE OF BUSINESS a) is not a decision-maker, or b) is not a part of the permanent (full-time) infrastructure of the organisation, but c) is nevertheless very influential in shaping the future of the organisation and the decisions of its leaders. The main connected stakeholders in a company are usually: a) non-executive directors b) employees c) key suppliers d) key customers The main connected stakeholders in a business organisation must have some power that they are able to use to influence decisions. Some sources of power, and the stakeholders who might have them, are listed below: Source of power: External Example Legal rights Shareholders have some legal voting rights under company law. AT A GLANCE Lenders have legal rights under the terms of their lending agreements: for example a lender has a right to take action in the event of default by a borrower. Publicity, and ability to influence Pressure groups and protest groups might be influential. These include customers or legislators environmental protection groups, human rights protection groups, and animal welfare activists. Control over key resources A major supplier could exert influence by controlling the supply of a key resource to the organisation. This results in a ‘supplier or vendor risk’ for a business. Buying power Customers can exert influence collectively through their buying power. If they do not like what a business organisation is doing, they can switch to buying from competitors. This results in a ‘customer concentration risk’ for a business. Source of power: Internal Example Position power Individual employees might be in a position of power within the organisation, perhaps because of special expertise that they possess. Top SPOTLIGHT consultants and investment bankers are examples. This results in a ‘key person risk’ for a business. Claim on resources Power might arise from a claim or control that exists over particular resources of the business. For example the power of employees or trade union representatives might come from their ability to withhold labour in the event of a dispute with management. Personal charisma or influence Some individuals might exercise considerable influence through their personal qualities and charisma. Power Interest Matrix Power-interest matrix is used to categorise relevant stakeholders based on their power or influence and level of interest in a project or an entity. Based on the above categorisation, strategies can be developed to manage all stakeholders effectively and to develop a communication plan accordingly for their consultation and engagement. This may further result in applying RASCI (Responsible, Accountable, Supporting, Consulted, and Informed) based strategy to identify the roles and responsibilities of each relevant stakeholder. THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 15  CHAPTER 1: NATURE OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS Once the stakeholders are identified, they are plotted on a grid in relation to the power and interest as follows: Grid Strategy  High power / High interest Managed closely with regular engagement  High power / Low interest Keep satisfied with active consultation  Low power / High interest Keep informed  Low power / Low interest Monitor only AT A GLANCE SPOTLIGHT 16 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN PRC 5: INTRODUCTION TO BUSINESS CHAPTER 1: NATURE OF BUSINESS SELF-TEST For the following questions select the best answer. 1. A business is an organization that strives for ____________ by providing goods and services desired by its customers. Which of the following completes the statement:? a. Profit b. Satisfaction c. Efficiency d. All of the above 2. The Board of Directors are the most powerful decision makers of a business. If this is true, what factor can influence the decision of the Board of directors. Choose the best answer from the following: AT A GLANCE a. Opinion of customers b. Knowledge of the business c. Employee feedback d. Opinion of shareholders 3. Which of the following are not considered as External Stakeholders of a company: a. lenders b. non-executive directors c. local communities and pressure groups d. competitors 4. TRUE OR FALSE: The general public has a stake or interest in major companies, because the actions of these companies can affect society as a whole. a. TRUE SPOTLIGHT b. FALSE 5. Which of the following is a reason why the government has an interest in all business organisations, a. Businesses pay tax on profits, so government has an interest in company profitability. b. Government wants to encourage business investments. c. The government is interested in regulating business activity d. All of the above 6. Business organisations buy goods and services from suppliers. Suppliers will usually agree to allow their customers some credit only if: a. a customer will pay what is owed and will not become a bad debt b. supplier has customer’s personal information c. The government allows sales on credit. d. The government gives a guarantee that it will provide subsidy on credit sales THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 17  CHAPTER 1: NATURE OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS 7. Firms typically require financial support beyond the capital injected by the owners or their personal assets being used in the business. Which stakeholder could be a source of funding for a new business? a. Lenders and creditors b. Suppliers c. Customers d. Government 8. Which of the following are the advantages that a government of a free-market economy would recognize and allow businesses to be set up? a. businesses serve consumers b. businesses create work for the business owners and employees c. businesses reduce the country’s unemployment AT A GLANCE d. All of the above 9. Which of the following is a goal of the government fulfilled by encouraging new businesses to set up? a. Earning profit b. businesses reduce the country’s unemployment c. Paying salaries of government employees d. Investment in country’s infrastructure 10. TRUE or FALSE: A stakeholder is anyone who has any type of stake in a business, while a shareholder is someone who owns shares (stock) in a business and thereby has an equity interest. a. TRUE b. FALSE c. More information is needed to answer d. None of the above SPOTLIGHT 11. Which of the following are the main concerns of shareholders in a business? a. Falling profits and a falling share price b. A proposal to invest in a major project where the business risk is high c. A proposed takeover bid for another company or from another company d. All of the above 12. Managers in the middle and junior ranks of a management hierarchy might have ambitions to become senior managers. However, their interests and concerns are different. Which of the following may be the interests of junior managers and other employees? a. pay and working conditions b. job security and satisfaction c. quality of life. d. A, B and C 18 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN PRC 5: INTRODUCTION TO BUSINESS CHAPTER 1: NATURE OF BUSINESS 13. Within a business organisation, internal stakeholders can be categorised into groups. Which of the following are NOT internal stakeholders? a. Mr. Masood who owns 20% shares of the company b. executive directors and senior managers c. finance managers d. M/s AM Tech – supplier of machinery 14. By using the ________________efficiently, a company can produce more goods and services with the same resources. Fill in the blank to complete the sentence. a. Machinery b. Human resources c. Factory space d. Factors of production AT A GLANCE 15. TRUE OR FALSE: A mission describes the organization’s basic function in society, in terms of the products and services it produces for its customers. a. TRUE b. FALSE 16. TRUE OR FALSE: A vision statement has more to do with the future and really describes what an organization plans or hopes to be in the future. a. TRUE b. FALSE 17. What is the key question to answer when developing a mission statement? a. What is our business? b. What is our value to the customer? c. What will our business be? SPOTLIGHT d. All of the above 18. ______________ are the people who combine the inputs of natural resources, labor, and capital to produce goods or services with the intention of making a profit or accomplishing a not-for-profit goal. Fill in the blank to complete the statement. a. Factory labour b. Employees c. Directors d. Entrepreneurs 19. What is the single element that sets a mission statement apart from a vision statement? a. When considering a mission statement vs. a vision statement the key aspect to remember is the current vs. future context b. Mission statement is longer than a vision statement c. Mission statement is shorter than a vision statement d. Vision statements are considered to be more important than mission statements THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 19  CHAPTER 1: NATURE OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS ANSWERS TO SELF-TEST 1 A 2 D 3 B 4 A 5 D 6 A AT A GLANCE 7 A 8 D 9 B 10 A 11 D 12 D 13 D 14 D 15 A SPOTLIGHT 16 A 17 D 18 D 19 A 20 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN  CHAPTER 2 OWNERSHIP OF BUSINESS AT A GLANCE IN THIS CHAPTER: To achieve the goals and objectives of a business in an effective AT A GLANCE and efficient manner, the first step of owner(s) is to decide on the type of business organization which means the form of SPOTLIGHT business ownership such as sole proprietorship, partnership, or a limited liability company. AT A GLANCE 1. Organization of business 2. Types of business organizations 3. Laws governing business organisations SELF-TEST SPOTLIGHT THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 21  CHAPTER 2: OWNERSHIP OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS 1. ORGANIZATION OF BUSINESS Definition of Organization In general, an Organization is a tool to arrange individual or combined resources for a particular purpose in an efficient and effective manner. Working independently may not allow to achieve the required purpose. A business organization is an entity formed for the purpose of carrying on required activities to achieve its goals and objectives. It can be seen as the process of dividing up activities in an efficient and effective manner to enable a system of co-operative activities of two or more persons. These activities would collectively lead to the completion of common goals and objectives of an entity operated by an individual or group of people. Since people from different backgrounds come to work together, organizations are strongly influenced by the people that form them. Their personalities, attitudes, perceptions, behaviors, and expectations significantly affect the functioning of an organization. AT A GLANCE SPOTLIGHT 22 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN PRC 5: INTRODUCTION TO BUSINESS CHAPTER 2: OWNERSHIP OF BUSINESS 2. TYPES OF BUSINESS ORGANIZATIONS When entrepreneurs establish a business, they must decide on the form of business ownership. There are three basic forms of business ownership: (i) sole proprietorship, (ii) partnership, and (iii) corporation or the limited liability company. The form that is chosen can affect the growth, profitability, risk, and value of the firm. The basic design features of an organization depend on the type of organization, the environment it operates in and its nature of business. For example, there are certain regulatory requirements to follow to form a bank or an insurance company. Each type of organization has features that distinguish one from the other. a) Purpose. They have different purposes. Business organizations exist to make a profit. Public sector organizations exist to provide a benefit to the public, such as good government or key services such as health, education, a police force, national defense, and so on. b) Ownership. They have different types of owners. Companies are owned by their shareholders, whereas public sector organizations are owned by the government (as the representative of the general public). Co-operatives are owned by the members. c) Funding. Business organizations obtain the funds they need to operate from a variety of sources. A stock AT A GLANCE market company, for example, obtains its long-term funds from a mixture of reinvesting profits in the business, issuing new shares and borrowing from the lenders. Charities rely on a mixture of government grants and private donations for the funds they need. Public sector organizations obtain their funds from the government, which in turn raises through the taxation. d) Accountability. The management of an organization is accountable to its owners for the goals and objectives of the organization. The directors of a company, for example, are accountable to the shareholders for the financial performance of the company. This is the main reason why companies produce their annual report and accounts. Broadly speaking, organizations can be classified in two broad categories:  Business organizations, and  Not-for-profit organizations 2.1 Business organizations: This type of organization engages in commercial activities, with the purpose of making a profit. The main types of business organization are: SPOTLIGHT 2.1.1 Sole Proprietorships A sole proprietor is an individual who owns and operates his or her own business, but might employ a small number of people. There are no legal formalities needed to set up as a sole proprietor. Any profit made after tax belongs to the owner. The owner is in complete control and is free to make decisions. The independence is one of the key attractions of running a business as a sole proprietor. Typical examples of sole proprietorships include a local restaurant, a local construction firm, a barber shop, a laundry service, and a local clothing store. Sole proprietors must be willing to accept full responsibility for the business’s performance. The pressure of this responsibility can be much greater than any employee’s responsibility. Sole proprietors must also be willing to work flexible hours. They are on call at all times and may even have to substitute for a sick employee. Their responsibility for the success of the business encourages them to continually monitor business operations. They must exhibit strong leadership skills, be well organized, and communicate well with employees. Many successful sole proprietors had previous work experience in the market in which they are competing, perhaps as an employee in a competitor’s firm. For example, restaurant managers commonly establish their own restaurants. Prior experience is critical to understanding the competition and the behavior of customers in a particular market. THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 23  CHAPTER 2: OWNERSHIP OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS Advantages of Sole Proprietorships Ease and Low Cost of Formation. Forming a sole proprietorship is relatively easy and inexpensive. In some cases, creating a sole proprietorship involves merely announcing the new business in the local newspaper. The legal requirements are minimal. A sole proprietorship need not establish a separate legal entity. The owner may also need to apply for an occupational license to conduct a particular type of business. The specific license requirements vary with the province and even the city where the business is located. Secrecy. Sole proprietorships make possible the greatest degree of secrecy. The proprietor, unlike the owners of a partnership or corporation, does not have to discuss his or her operating plans with other partners or public, minimizing the possibility that competitors can obtain trade secrets. Financial reports need not be disclosed, as do the financial reports of publicly owned corporations. Distribution and Use of Profits. All profits from a sole proprietorship belong exclusively to the owner. He or she does not have to share them with any partners or stockholders. The owner decides how to use the funds— for expansion of the business, or salary increases, for travel to purchase additional inventory, or to find new customers. AT A GLANCE Greater Flexibility and Direct Control. The sole proprietor has complete control over the business and can make decisions on the spot without anyone else’s approval. This control allows the owner to respond quickly to competitive business conditions or to changes in the economy. The ability to quickly change prices or products can provide a competitive advantage for the business. Ease of Government Regulations. Sole proprietorships have the most freedom from government regulation. Many government regulations – federal or provincial- apply only to businesses that have a certain number of employees, and securities laws apply only to corporations that issue stock. Nonetheless, sole proprietors must ensure that they follow all laws that do apply to their business. For example, sole proprietorships must be careful to obey labour laws and food safety regulation in case of food related businesses. Lower Taxation. Profits from sole proprietorships are considered personal income and are taxed at individual tax rates than imposed on some other forms of business ownership. The owner, therefore, pays one income tax that includes the business and individual income. Sole proprietorships do not pay special franchise or corporate taxes. Profits are taxed as personal income as reported on the owner’s individual tax return. Ease of dissolution. A sole proprietorship can be dissolved easily. No approval of co-owners or partners is necessary. The only legal condition is that all financial obligations must be paid or resolved. Disadvantages of Sole Proprietorships SPOTLIGHT Along with its advantages, the sole proprietorship has the following disadvantages: Unlimited Liability. The sole proprietor has unlimited liability in meeting the debts of the business. In other words, if the business cannot pay its creditors, the owner may be forced to use personal, nonbusiness holdings such as a car or a home to pay off the debts under the bankruptcy laws. The more wealth an individual has, the greater is the disadvantage of unlimited liability. Difficulty in raising funds. Among the relatively few sources of money available to the sole proprietorship are banks, friends and family, or his or her own funds. The owner’s personal financial condition determines his or her credit standing. Additionally, sole proprietorships may have to pay higher interest rates on funds borrowed from banks than do large corporations because they are considered greater risk of default. Often, the only way a sole proprietor can borrow for business purposes is to pledge a car, house, other real estate, or other personal assets to guarantee the loan. If the business fails, the owner may lose the personal assets as well as the business. Publicly owned corporations, in contrast, can not only obtain funds from commercial banks but can sell stocks and bonds to the public to raise money. If a public company goes out of business, the owners do not lose personal assets as their liability is limited to their shareholding. Limited skills. The sole proprietor must be able to perform many functions and possess skills in diverse fields such as management, marketing, finance, accounting, bookkeeping, and personnel management. Specialized professionals, such as accountants or attorneys, can be hired by businesses for help or advice. Sometimes, sole proprietors need assistance with certain business functions. 24 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN PRC 5: INTRODUCTION TO BUSINESS CHAPTER 2: OWNERSHIP OF BUSINESS Lack of Continuity. The life expectancy of a sole proprietorship is directly linked to that of the owner and his or her ability to work. The serious illness of the owner could result in failure of the business if competent help cannot be found. It is difficult to arrange for the sale of a proprietorship and at the same time assure customers that the business will continue to meet their needs. This results in ‘key person’ risk. Difficulty in finding qualified Employees. It is usually difficult for a small sole proprietorship to match the wages and benefits offered by a large competing corporation because the proprietorship’s profits may not be as high. In addition, there is little room for advancement within a sole proprietorship, so the owner may have difficulty attracting and retaining qualified employees. Taxation. Although we listed taxation as an advantage for sole proprietorships, it can also be a disadvantage, depending on the proprietor’s income and the marginal tax rate of corporations. However, sole proprietorships avoid the double taxation that occurs with corporations. The tax effect often determines whether a sole proprietor chooses to incorporate his or her business. 2.1.2 Partnerships A partnership exists when the ownership of a business is shared by at least two people. In most cases, the AT A GLANCE maximum number of partners is 20, although there are some exceptions, e.g. accountants and solicitors. A business that is co-owned by two or more people is referred to as a partnership. The co-owners of the business are called partners and they collectively form the ‘firm’. The parties agree, either orally or ideally in writing, to share in the profits and losses of a joint enterprise. A written partnership agreement, spelling out the terms and conditions of the partnership, is recommended to prevent later conflicts between the partners. Such agreements typically include the name of the partnership, its purpose, and the contributions of each partner (financial, asset, skill/talent, etc.). It also outlines the responsibilities and duties of each partner and their compensation structure (salary, profit and loss sharing, etc.). It should contain provisions for the addition of new partners, the sale of partnership interests, and procedures for resolving conflicts, dissolving the business, and distributing the assets. There are two basic types of partnership: general partnership and limited partnership. A general partnership involves a complete sharing in the management of a business. In a general partnership, each partner has unlimited liability for the debts of the business. Professionals such as lawyers, accountants, and architects often join together in general partnerships. A limited partnership has at least one general partner, who assumes unlimited liability, and at least one limited partner, whose liability is limited to his or her investment in the business. Limited partnerships exist for risky investment projects where the chance of loss is great. The general partners accept the risk of loss; the limited SPOTLIGHT partners’ losses are limited to their initial investment. Limited partners do not participate in the management of the business but share in the profits in accordance with the terms of a partnership agreement. Usually the general partner receives a larger share of the profits after the limited partners have received their initial investment back. Popular examples are oil-drilling partnerships and real estate partnerships. There are also limited liability partnerships (LLP), which are similar to a general partnership except that partners are not held responsible for the business debt and liabilities. Advantages of Partnerships Ease of formation. Like sole proprietorships, partnerships are easy to form. The partners agree to do business together and draw up a partnership agreement. For most partnerships, applicable laws are not complex. Higher availability to raise funds. Partnerships have the benefit of a combination of talents and skills and pooled financial resources. Therefore, partnerships can raise funds more easily for operating expenses and business expansion. The partners’ combined financial strength also increases the firm’s ability to raise funds from outside sources due to enhanced credibility. THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 25  CHAPTER 2: OWNERSHIP OF BUSINESS PRC 5: INTRODUCTION TO BUSINESS Combined Knowledge and Skills. Partners share the responsibilities of managing and operating the business. Combining partners skills to set goals, manage the overall direction of the firm, and solve problems increases the chances for the partnership’s success. The diversity of skills in a partnership makes it possible for the business to be run by a management team of specialists instead of by a generalist sole proprietor. With their respective specializations, a wide variety of customers can be served. For example, an accounting firm may have one partner who specializes in personal taxes for individuals and another who specializes in corporate taxes for firms. A medical practice partnership may have doctors with various types of expertise. Flexibility of decision making. Partnerships can react more quickly to changes in the business environment than can large corporations. Such fast reactions are possible because the partners are involved in day-to-day operations and can make quick decisions after consultation. Less Regulatory Control. Like a sole proprietorship, a partnership has fewer regulatory controls affecting its activities than does a corporation. A partnership does not have to file public financial statements with government agencies or send out quarterly financial statements to several thousand owners, as the corporations do such as Unilever and Pakistan State Oil. A partnership does, however, have to abide by all laws relevant to the industry or profession in which it operates as well as provincial and federal laws relating to labour, safety, AT A GLANCE environment, and so on, just as the sole proprietorship does. Disadvantages of Partnerships Unlimited Liability. All general partners have unlimited liability for the debts of the business. In fact, any one partner can be held personally liable for all partnership debts and legal judgments (such as malpractice)— regardless of who caused them. As with sole proprietorships, business failure can lead to a loss of the general partners’ personal assets. To overcome this problem, many countries now allow the formation of limited liability partnerships (LLPs), which protect each individual partner from responsibility for the acts of other partners and limit their liability to harm resulting from their own actions. Sharing of profits. Any profits that the partnership generates must be shared among all partners. As a result, higher the number of total partners, smaller the share of each individual partner. Sharing the profits is relatively easy if all partners contribute equal amounts of time, expertise, and capital. But if one partner puts in more money and others more time, it might be more difficult to arrive at a fair profit-sharing formula. Difference of opinion. In contrast of combined knowledge and skills, diversity of partners may result in serious disagreements for key business decisions such as how to run their business, which employees to hire, how to allocate responsibilities, and when to expand. Such diversity in personalities and work styles can cause clashes or breakdowns in communication, sometimes requiring outside intervention to save the business. SPOTLIGHT Dissolution of partnerships. As a rule, partnerships are easier to form than to leave. When one partner wants to leave, the value of their share must be calculated. It is always difficult to decide who is going to acquire the shares of a leaving partner, and if that person is acceptable to other partners. If a partner who owns more than 50 percent of the entity withdraws, dies, or becomes disabled, the partnership must reorganize or end. To avoid these problems, most partnership agreements include specific guidelines for transferring partnership interests and buy–sell agreements that make provision for surviving partners to buy a deceased partner’s interest. 2.1.3 Limited Companies or corporations The main feature of a limited company is that it has a separate legal identity from that of its owners. All owners of a company have limited liability. If the company collapses, they cannot be forced to use personal funds to pay off business debts. They only lose the amount that they originally invested in the company. A company, also known as a corporation, is a legal entity, created under the government regulations, whose assets and liabilities are separate from its owners. As a legal entity, a corporation has many of the rights, duties, and powers of a person, such as the right to receive, own, and transfer property. Corporations can enter into contracts with individuals or with other legal entities, and they can sue and be sued in court of law. As a limited company has a separate legal identity, all owners have limited liability. If the company collapses, they cannot be forced to use personal funds to pay off business debts. They only lose the amount that they originally invested in the company. 26 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN PRC 5: INTRODUCTION TO BUSINESS CHAPTER 2: OWNERSHIP OF BUSINESS People become owners of a company by purchasing shares of stock. Many small companies are privately held, meaning that ownership is restricted to a small group of investors, and are called private limited companies. Most large corporations are publicly held, meaning that shares can be easily purchased or sold by investors. These companies are called public limited companies. Stockholders of publicly held companies can sell their shares of stock when they need money, are disappointed with the performance of the company, or simply expect that the stock price will not rise in the future. Their stock can be sold to some other investor who wants to invest in that company. A private limited company that needs more money to expand or to take advantage of opportunities may have to obtain financing by “going public” through an initial public offering (IPO), that is, becoming a public limited company by selling stock so that it can be traded in public markets. Publicly held companies can obtain additional funds by issuing new common stock. This mea