A brief on business, tax, and financial environments

The four basic forms of business organization are the sole proprietorship, the partnership, the corporation, and the limited liability company (LLC).

The corporation has emerged as the most important organizational form due to certain advantages that it has over the other organizational forms. These advantages include limited liability, easy transfer of ownership, unlimited life, and an ability to raise large sums of capital.

Most firms with taxable income prefer to use an accelerated depreciation method for tax reporting purposes in order to lower their taxes. A firm that is profitable for financial reporting purposes may, in fact, show losses for tax purposes.

Interest paid by corporations is considered a tax deductible expense; however, dividends paid are not tax deductible.

Financial assets (securities) exist in an economy because an economic unit’s investment in real assets (such as buildings and equipment) frequently differs from its savings. In the economy savings surplus units meaning those whose savings exceed their investment in real assets provide funds to savings deficit units that is those whose investments in real assets exceed their savings. This exchange of funds is evidenced by investment instruments, or securities, representing financial assets to the holders and financial liabilities to the issuers.

The purpose of financial markets in an economy is to allocate savings efficiently to ultimate users. Financial intermediaries help the financial markets more efficient. Intermediaries come between ultimate borrowers and lenders by transforming direct claims into indirect claims. Financial intermediaries purchase direct or primary securities and, in turn, issue their own indirect or secondary securities to the public.

Financial brokers, such as investment bankers and mortgage bankers, bring together parties who need funds with those who have savings. These brokers are not performing a direct lending function but rather are acting as matchmakers or middlemen.

Financial markets can be broken into two classes — the money market and the capital market. The money market is concerned with the buying and selling of short-term government and corporate debt securities. The capital market deals relati0vely long-term debt and equity instruments.

Within the money and capital markets there exist both primary and secondary markets. A primary market is a “new issues” market, and a secondary market is a “used issues” market. The secondary market for long-term securities, comprised of the organized exchanges and the OTC market, increases the liquidity (marketability) of financial assets and, therefore, enhances the primary market for long-term securities.

The allocation of savings in an economy occurs primarily on the basis of expected return and risk. Differences in default risk, marketability, maturity, taxability, and option features affect the yield of one security relative to another at a point in time. Fluctuations in supply and demand pressures in financial markets, as well as changing inflation expectations, help explain variability in yields over time.

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