David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

6.2 A firm's accounts
A sole trader gets the revenue of the business and is responsible for any losses it makes.
If he cannot meet these losses, he becomes personally bankrupt. His remaining
assets, such as his house, are sold and the money shared out among the creditors.
If the business prospers, a sole trader may need money to expand. One way is to
bring in new partners, who inject money in exchange for a share of the subsequent
profits. Partnerships usually have unlimited liability. Like sole traders, partners
are personally liable for the firm's losses, however large. Firms where trust is
A sole trader is o business
owned by o single individual.
A partnership is o business
jointly owned by two or more
people, sharing the profits and
jointly responsible for any losses.
involved - solicitors or accountants - are often partnerships. Customers see that the people running the
business are willing to put their own wealth behind the firm's obligations.
Any business needs money to start it up and finance its growth. Firms of lawyers, doctors or accountants,
businesses relying on human expertise, need relatively little money for such purposes. The necessary funds
can be raised from the partners and, possibly, by a bank loan. Businesses requiring large initial expenditure
on machinery need much larger initial funds. It is too complicated to have a huge number of partners.
Instead, it makes sense to form a company.
Unlike a partnership, a company has a legal existence distinct from that of its
owners. Ownership is divided among shareholders. The original shareholders may
now have sold shares of the profits to outsiders. By selling entitlements to share in
the profits, the business can raise new funds.
Shareholders earn a return in two ways. First, the company makes regular dividend
payments, paying out to shareholders that part of the profits that the firm does not
wish to reinvest in the business. Second, the shareholders may make capital gains
(or losses). If you buy Microsoft shares for a value of £1000 but then people decide
A company is an
organization legally allowed to
produce and trade.
Shareholders of a company
have limited liability. The
most they can lose is the money
they spent buying shares.
Microsoft profits and dividends will be unexpectedly high, the Microsoft shares will increase their market
value and you may be able to resell the shares for £1200 for example, making a capital gain of £200. Unlike
sole traders and partners, shareholders cannot be forced to sell their personal possessions if the business
goes bust - they have limited liability. At worst, the shares become worthless.
Companies are run by boards of directors who submit an annual report to the shareholders, who can vote
to sack the directors if it seems that other directors could do better. Companies are the main form of
organization of big businesses.
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A firm's accounts
_ _ _ _ _
Firms report two sets of accounts, one for stocks and one for flows.
The water flowing out of a tap is different per second and per minute. The measure
needs a time interval to make sense of it. The stock of water in the basin at any
instant is a number of litres, with no time dimension. A firm reports profit-andloss
accounts per year (flow accounts) and a balance sheet showing assets and
Stocks are measured at a
given point in time; flows ore
corresponding measures
during a period of time.
liabilities at a point in time (stock accounts). The two are related, as they are for the basin of water. The
inflow from the tap changes the stock of water over time, even though the stock is in litres at each point in
time. We begin with flow accounts.
Flow accounts
These ideas are simple, but the calculation of revenue, cost and profit for a large firm
is tricky. Otherwise we would not need so many accountants. Here is a simple example.
Rent-a-Person (R-a-P) is a firm that hires people whom it then rents out to other
firms that need temporary workers. R-a-P charges £10 an hour per worker but
Revenue is what the firm
earns from selling goods or
services in a given period, cost
is the expense incurred in
production in that period and
profit is revenue minus cost.
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