THE EFFECT OF THE LEGAL FORM OF BUSINESS ON THE MANAGEMENT CONTROL

SYSTEM Henry Wichmann, Jr., University of Alaska, Fairbanks John

Zublin, University of Alaska, Anchorage

ABSTRACT The management control system is extremely important to both big business and small business. The purpose of this paper is to examine the effect of legal forms of business organization on the management control system. The management control system is often neglected in smaller owner-managed businesses because of the lack of an accounting system to provide information for control. Big businesses can afford elaborate management control systems, while small businesses may often lack money and time for a sophisticated control system. INTRODUCTION Currently, the United States boasts of more than seventeen million businesses. Total business revenues generated exceed $5.8 trillion. We are all direct beneficiaries of this activity through the availability of goods and services as well as employment to pay for the consumed product. An endeavor as large and important as this requires organizations which provide maximum utilization of each firm's resources. United States companies, therefore, have adopted three primary legal forms of business organization: Sole Proprietorship, Partnership, and Corporation. Each of these forms allows, in its own way, effective pursuit of an individual firm's respective goals. Achievement of an enterprises goals are obviously not the automatic by-product of a selected business form. Functionally, the business form provides the platform to perform economic activities. The selection and subsequent application of the legal form of business does, however, impact the information flow needed for control. Hence, another element is introduced: The Management Control System. The purpose of this paper is to examine the effects of legal forms of business

organization on the management control system. Relevant characteristics of the three business forms will be identified and contrasted. The management control system model will be presented and explained. Finally, the impact of the legal form on the control system will be explored. THE LEGAL FORMS OF BUSINESS CHARACTERISTICS Business enterprises in the United States are found primarily in three legal organizational forms: the Sole Proprietorship, Partnership, and Corporation. All other business organizational forms are variations of these three primary formats. Both Partnerships and Corporations have variations to their basic structuring that alters some of their characteristics significantly. These variations will be introduced only when relevant to this discussion. Selection of legal form attributes relevant to the topic results from analytical subjective evaluation. Some advantage, and disadvantages of each business form may be neglected due to lack of relevance or inconsistency of comparison. Characteristics deemed appropriate are: ownership entity life, management control responsibility, litigation capability, liability exposure, financing capability, and taxation responsibility. See Exhibit 1. Sole Proprietorship A sole, or single, proprietorship is defined as "a business owned by one person and operated for his (her) profit." The owner and the business are considered one and the same. Hence, ownership and management responsibility rest on one person. Considering this focus, all other identified characteristic categories center on this individual as well. Therefore, the occurrence of any external event to the sole owner will impact the business equally. The effect, then, is an enterprise literally dependent upon the owner-manager for its existence. Capital funds availability is strictly related to the owner's personal assets and established credit. Concurrently, any liabilities incurred by the business are the responsibility of the owner to the full amount of his assets, both personal and business.

Litigation enacted on behalf of or against the business are directed by or at the single owner. The tax laws are consistent with this owner/operator principle in that Sole Proprietorship profits or losses are attributable to the individual owner's personal income tax return. Partnership Partnership are similar in many regards to the sole proprietorship. Instead of a single owner, it is "an association of two or more persons to carry on as co-owners a business for profit." Ownership is usually held equally by the partners, but may be fragmented via the partnership agreement. However, in the event of ownership fragmentation, enlarged multiple partners, or management control divesture, it is a good idea for all members to understand the rights, limitations and liabilities of their ownership share. Normally, partnership ownership indicates management responsibility. An exception, though, is the Limited Partnership. Here partners exchange their investment for an equity interest without the rights of active management control. Without direct management participation, limited partners usually are not held accountable for any partnership liability in excess of their investment. All partnerships, whether strictly general or limited, must have management control responsibility in the form of active general partners. In a general partnership, responsibility for liabilities extends not only to the general partners' investment, but, as in sole proprietorships, to their personal assets as well. This unlimited liability feature is also true for the general partner of a limited partnership. Individual assets of the partners, particularly general partners, are instrumental to the financing capability of the partnership. Additionally, the personal credit capability of the general partners is an important attribute for debt incurrence. The obvious point is that the greater the number of partners the larger the potential capital base. The quantity of partners affects the litigation possibilities. While the partnership offers a separate legal status and may conduct litigation in its own name, the partners may also

severally engage and be engaged in legal action. Liability, though, as noted previously, is unlimited for "general partners" but restricted to "limited partner's" investment. Taxation responsibilities of the partnership are similar to the sole proprietorship. Profits or losses are distributed to the partner's individual income tax return. The difference is that the required distribution is in accordance with and income distribution plan set in the articles of partnership. Corporations Owner participation in business management, while the corner stone of sole proprietorships and partnerships, may not be the case in corporations. In fact, an overriding characteristic of a corporation is its ability to separate management and ownership. Legally, the corporation has been identified as an "artificial being"[1], or legal entity, having "the rights, duties and powers of a person" and "does not change its identity with changes in ownership, and one that may have perpetual life."[2] Ownership is established with the incremental exchange of equity in the form of stock. The stockholder may retain or divest the stock at whim, generally without impacting the business management. Aside from the ownership/ management separation aspect, this business form also provides a potentially tremendous capital base not necessarily available to the other forms. Accumulation of wealth to adequately finance new and existing enterprises is a major advantage of the corporation. Generally, the owner/management separation minimizes liability exposure to the assets of the corporation. This is often thought of a protection "under the Corporate veil." Therefore, the business must "stand on its own two feet" in providing debt security. The concept of a separate entity extends to the litigation capability, allowing the firm to sue and be sued without severally impacting the owners. Taxation responsibility is again consistent with the ownership/management separation definition. Profits and losses are usually attributable only to the corporation as a separate entity. Individual owners, or stockholders, are taxed on dividends received and additional

stock value over purchase price at disbursement. An exception to this tax treatment is the "Sub-Chapter S" corporation. "S" corporations are established primarily to minimize owner liability exposure. Tax regulations require the distribution of all profits or losses to the shareholders' personal income tax return. "Sub-Chapter S" corporations are generally small business entities functioning managerially like a sole proprietorships even though legally management and ownership are separate. At this point, a distinction should be made between two categories of corporations: close and open. Historically, corporations owned by family members and corporations converted from Sole Proprietorship and Partnerships are examples of close corporations. Usually, the stockholders are part of management, thereby denying the ownership/management separation. Stock shares are not available to the public but are closely held by a few individuals. It can be expected that management decision processes of closely held corporations are also similar, if not identical, to sole proprietorships or partnerships. An open corporation is one having stock available for purchase by the general public. Corporations with stock traded on any of the public markets are examples. The term "Public Corporation" is often used synonymously and more frequently than an "Open Corporation." THE LEGAL FORMS OF BUSINESS IN THE UNITED STATES ECONOMY Comparison of Business Forms - Revenue Distribution Analysis of the previously noted seventeen million businesses in the United States indicates that of the distribution of all business forms sole proprietorships comprise approximately 76%, partnerships about 8%, and corporations nearly 16%. See Exhibit II. Ranking by revenues received provide a distribution almost a mirror image of the business form distribution yielding approximately 88% to corporations and 4% and 8% to partnerships and sole proprietorships, respectively. Corporations, though they account for only a minority portion of entities, possess the lion's share of business revenues. This would seem to indicate that corporations represent "big" business while partnerships and

sole proprietorships are primarily related to small business. Comparison of Small and Big Business Forms - Revenue Distribution However, as previously mentioned, "S" and close corporations are generally small operations functioning somewhat like proprietorships and partnerships. Grouping business forms into two categories based on maximum revenues received, greater than $1.0 million and less than or equal to $1.0 million, will provide a rough adjustment for this problem. The combined total of all proprietorships, partnerships, and corporations with less than or equal to $1.0 million revenue per entity show that 97% of all businesses provide 20% of total revenues. See Exhibit III. This data seems to lend credence to the concept that proprietorships, partnerships and "S" and closely held (close) corporations are predominately affiliated with small business. Further, such small businesses can be expected to utilize decision-making elements similar to each other. Conversely, "C" corporations (defined as corporations other than closely held ones) can predominately be expected to provide differing management control processes due to their large, or "big", business posturing. THE MANAGEMENT CONTROL SYSTEM MODEL A management control system is a series of processes allowing businesses to effectively coordinate activities to the achievement of stated goals. Perhaps more succinctly, it is "concerned with the attainment of goals through the implementation of strategies."[2] The management control model identifies the process phases as programming, budgeting, operating and measurement, and reporting and analysis. See Exhibit IV. Information is displayed as constantly being provided to each process. Information needed to control a business is provided by the accounting system, with the chief accountant called the controller. However, the management control system is defined as being broader than the accounting system. The starting point is the selection of goals and their subsequent strategies. Goal and Strategy Selection

A business stated goals are specific end products sought by an organization quite often without a finite time period. A typical example in many firms is the goal of maximizing profit or investment return. Strategies are a derivation of selected goals designed "to provide a pathway to success in attaining (these) goals."[3] Goals, then, identify the war and strategies the battles to be fought in winning the war. The selection of profit maximization as a goal is fairly common among profit oriented businesses. However, the actual pursuit of maximum profitability may not be representative of companies' behavior. According to Robert Anthony and others, there is little evidence to support the conclusion that business leaders actually behave in the way that the profit maximization model assumes...," and, in fact, "organizations pursue many goals, of which profit is one."[4] The suggestion is that goal selection can be multifarious, reflecting the multi-faceted requirements of an organization. The result, instead of maximization of profit or any other goal, is the selection of goals leading to a satisfactory return as demanded by the diverse requirements. Program Selection Programming is the necessary selection of activities in order to the satisfy the identified goals and their resultant strategies. Simply: the equipment (resources) to be used in the war. It follows that the quantity of goals and strategies selected can severely impact the programming phase. A firm seeking a single goal of profit maximization may select activities, or programs, being either small in quantity or singular. Businesses responding to multiple and/or diverse goals may be expected to implement programs having a mutual, or satisfactory, goal realization. Budgeting Allocations of resources to the selected programs occurs in the budgeting phase. This may be viewed as a business' commitment to the goals selected. Some understanding of total available resources is ,implicit in the prior process phases. Budgeting, therefore, should become a resource distribution commitment. Assuming acknowledgement of a known fixed total resource level, the budget will reflect the firm's negotiated resource

distribution aimed at a satisfactory goal achievement yield. Budgeting often is a simple allocation of monetary funds. However, it quite possibly can lead to the more efficient and effective allocation of all of a business' resources. Aside from the obvious increases and/or decreases of personnel and/or existing equipment due to expected matching of revenues with expenses, the budget may also set the stage for providing additional funds through, among other things, a fresh look at capital structuring. The budgeting process may force the organization to reevaluate its asset utilization so as to provide debt or equity based funding for the accomplishment of selected goals via identified activities. Operating and Management This is the activity process; the point at which all programming plans and budgeting commitments are enacted. The firm's management is expected to closely observe the activities, recording outputs produced and resources consumed. Assuming properly selected programs and adequate resource allocation, the operations process will provide achievement of the required goals. Reporting and Analysis Certainty of goal achievement only comes through accurate reporting of actual operating results. Variations of these results from expectations require systematic analysis, providing management direction to effect changes to an appropriate process. Actually, some variations in actual operating results and expectations can lead to alterations in goals and/or strategies, as well. Goals selected and strategies implemented which are unrealistic compared to the business' available resources may turn up as wide discrepancies in this phase. This, of course, could be more the result of over-zealous of irrational management than caused by system failure. The Information Link Although information is not identified as a process phase, it is probably the most critical thing affecting the management control system. Information provides the link between and among the various processes to allow "fine tuning" of the system. Process phases of the system are not static in nature, each being performed as a specific pre-determined

event without recourse to the preceding process. In fact, each process is dynamic, constantly receiving and sending stimulus among and between the other processes. Continuous communicating of information as resultant feedback to the appropriate process should allow a business to effectively recognize goals through constant efficient and effective utilization resources. The accounting system reports and analyzes much of the information in a business. THE LEGAL FORMS OF BUSINESS - THE EFFECT ON CONTROL Obviously, not all of the identified characteristics of business forms will significantly influence the management control system. As well, evaluation from the strictly defined categorical standpoint is likely to minimize some of the impact on management control associated with business form selection. Drawing from the business form redistribution by revenues in Exhibit III, an assumption is made that all businesses with revenues less than or equal to $1 million exhibit generally similar "functional attributes" when employing a management control system regardless of their legal form. Therefore, all sole proprietorships, partnerships, and corporations in this revenue classification will impact the control processes in a nearly identical fashion. The same assumption is made for businesses with revenues greater than $1 million. Four businesses characteristics seem to provide the greatest effect on the management control model: Ownership, management control responsibility, financing capability, and taxation responsibility. These characteristics are compared to specific impacted control system areas. Ownership/Management Control Responsibility Effect on Goal, Strategy, and Program Selection Ownership and management control characteristics taken as a single impacting topic is a slight extension of the "functional attributes" assumption. Small businesses are expected to be managed by their primary owner. Large businesses are expected to provide ownership/management separation. The impact of these differences is significant to the quantity, type and diversity of goal, strategy and program selection.

Goal selection reflects the road an organization's management mandates the business to travel. Little, if any, separation between management's and owner's desired goals would be expected in a small business. It would be quite unusual for goal selection to be less than homogeneous. Large businesses, however, are quite different. Management may or may not be part of the owner body. If it is, it is likely not to represent a large enough portion to accurately reflect the overwhelming desires of the remaining owners. The reality is that large business ownership bodies have diverse and heterogeneous desires. The conflict by a large, heterogeneous ownership impacts goal selection due to the effect on management in attempting to achieve a satisfactory return on those goals. The more diverse and numerous the demands by big business for goals, strategies, and programs the greater the spread between management control responsibility and ownership. Minimal spread should exist in small business, lending itself to congruent ownership and management goal, strategy and program selection derived from its somewhat homogenous nature. One further note: The existence of ownership/management separation very often allows management to consider owner's desires to be secondary to management desires. Obviously, when ownership and management are the same, owner's/management's desires are the same by definition often the case in small business. Financing Capability Effect on Program Selection and Budgeting The capability of a business to provide capital resources can be restricted by its legal form, as previously explained. The corporation may be capable of accumulating large amounts of wealth through stock issues, while the sole proprietorship may be limited to the owner's wealth. Fund limitations can sharply curtail the quantity of programs selected. Lack of understanding of accurate financial capabilities during goal or strategy selection may induce a business to select an overly ambitious of programs in an effort to

implement the strategy. Additionally, should the overly large program quantity not be revised, the program quality may be significantly diminished due to the wide distribution of finite funds during the budgeting process. Small businesses with a limited ownership base must be cautious not to over-commit to programs consuming limited resources. The small business ownership form may result in diversification limitations created by the lack of available funds. Additionally, the inability to increase either the program quantity or quality without jeopardy to the small business may be expected to provide a strong barrier to growth. One of the primary advantages to the corporate form of business is the ability to sustain growth by trading increases in net worth for capital through stock sale. Programs may then be selected and budgeted with intermediate capital from, as an example, debt funding. The expectation is that the additional programs will provide higher equity value for the business, raising the cash level available from the stock sale. The dynamic nature of equity and debt financing for a corporation provides more flexibility in programming and budgeting to this legal form than found under either a proprietorship or partnership organization. The flexibility of alternative financing possibilities obviously opens the door for the various segments of the large firm's management to promote a wide variety of programs. Negotiation for the quantity of programs may be extensive. Once agreed upon, program quality level may be negotiated equally as extensively in an effort to achieve as large an allocation of the resource pie as possible. Negotiation for programs and budgeted resources in small businesses should be relatively straight forward in that both ownership diversity and financing capabilities are limited. Taxation Responsibility Effect on Goal and Strategy Selection Diversity of the ownership body, as noted, may have a major impact on the goal and strategy selection. Taken as a separate characteristic, the responsibility for taxation may

be nearly as influential. Small firm owner-managers are generally taxed by passing profits or losses through to their personal tax return. Separation of the business and taxation responsibility does not exist. Therefore, less incentive exists to retain profits within the business. Goals and strategies are selected mostly for the benefit of the ownermanagers. Corporations, though, are taxed as separate entities. Income is taxed for the corporate entity, with net income being retained in the business. Owner-shareholders are "double taxed" on the distribution of excess retained earnings as dividends and any gain over the purchase price of stock. Management has no incentive, from a tax standpoint, to consider the ownership's distributions. Selected goals and strategies may be determined by their benefit to the business (and management) without consideration of the impact on the ownership. Ownership Effect on the Information Link Small businesses with direct owner-management ties are quite able to effectively communicate their demands into the management control processes. Equally as important, the reverse is true. Information transmitted from the management control process can very quickly be received by management if proper records are kept. Consequently, data distortion should be minimal in a small business. Larger businesses naturally will be transmitting and receiving information from a greater quantity of programs. Additionally, the management-ownership separation may delay needed problem remedy until the manager responsible for the corrective action can be notified. Considering the dynamic nature of businesses and their management control processes, correction adjustments left unattended for a long period of time may bring disastrous results to the firm. A pragmatic point worth noting is the difference in the availability of information between small owner-managed businesses and large corporations. Due to their inherent generally unweildly nature, large corporations usually have management information

systems available to aid in communication of process results. The information may be easily obtained and detailed for big corporations; thus, aiding in accurate problem correction. Small businesses on the other hand, quite often rely on sporadic information or poor information systems due to limited funds. Untimely recognition may result. Problem correction may be swift, but due to the lack of necessary detail the answer may not be sufficient. CONCLUSION This comparison and evaluation of business form characteristics and their impact on the management control system model has ultimately focused on the ownership trait as the most influential. A business ownership form may determine how the other characteristics will interplay. Most significantly, the management control responsibility is determined by the firm's ownership. Proprietorships, Partnerships, "S", and Close Corporations, coming under the defined small business banner provide ownership and management control within the same individual or group. The impact on the management process, as noted, is seen as more direct and having straight forward control, with the owner-manager's desires at the forefront. The trade-off is found in the lacking flexibility for future growth. Large corporations, offering separation between management and ownership, have the flexibility to pursue goals and programs more extensively due to their larger debt and equity capital base. The heterogeneous nature of the large bodies may create a management need to select diverse goals appealing to both management and ownership. Big businesses must have sophisticated management control systems to fulfill programs and goals. In summary, a strong management control system is extremely important to both big business and small business. The management control system is often neglected in smaller businesses because of the lack of an accounting system to provide information for control. Sole proprietorships have owner-managers who often lack accounting ability and may be unable to hire accounting expertise, while large corporations have the wealth to

hire a large accounting staff and controller. As a result, small business owner-managers must either acquire accounting ability or hire an accountant to compete in the market place. (References provided on request.)

EXHIBIT I – CHARACTERISTIC OF THE PRIMARY LEGAL FORMS OF BUSINESS

SOLE

PROPRIETORSHIP PARTNERSHIP CORPORATION _______________________________________________________________ Ownership 1 Person 2 or More People Stockholders (1 or

More People in AK)

Entity Life Discretion of Owner Subject to Partnership Indefinite

Agreement Management Owner Owners (Excluding Board of Directors Control Any Limited Partners) Responsibility Litigation Owner Severally Partners and Corporation Responsibility Responsible Individuals Responsible Responsible

(Excluding Limited (800 and Officers Partners) may be responsible

for negligence

Liability Owner's Company Owner's Company and Limited to Company Exposure & Personal Assets Personal Assets Assets

(Limited to Company Assets of Limited Partners)

Financing Owner's Personal Owner's Personal Funds Stock, Debt, Bonds, CapabilityFunds Private Private & Conventional Debenture, Warrants,

and Conventional Debt Sale Options Debt of Partnership Shares to

Limited Partners Taxation Owner's Personal Partner's Percent of Profits/Losses to Responsibility Income Ownership to Personal Corporation only

Income Shareholder's Taxed

on Dividends & Gain/Losses of Stock Value at

Sale

EXHIBIT II – COMPARISON OF BUSINESS FORM AND REVENUE DISTRIBUTION

Quantity of Businesses Revenue

SOLE PROPRIETORSHIPS 76% 8% PARTNERSHIPS 8% 4% CORPORATIONS 16% 88%

EXHIBIT III – COMPARISON OF SMALL AND LARGE BUSINESS FORMS

AND REVENUEDISTRIBUTION

Quantity of Businesses Revenue

SOLE PROPRIETORSHIP, PARTNERSHIP, AND CORPORATION: 97% 20% $1.0 Mil. and less CORPORATIONS: 3% 80% $1.0 Mil. plus (+) [EXHIBIT 4 OMITTED: PHASES OF THE MANAGEMENT CONTROL SYSTEM]