Question 1: What form of partnership allows some of the investors to limit their liability? Explain by giving examples.
Question 2: When does insider trading occur? What government agency is responsible for protecting against the unethical practice of insider trading? Explain by giving examples.
Question 3: Explain how the tax code allows depreciation to contribute to cash flow.
Question 4: Explain why inflation may restrict the usefulness of the balance sheet as normally presented.
Answer 1:
The form of partnership that allows some of the investors to limit their liability is a limited partnership. In a limited partnership, there are two types of partners: general partners and limited partners. General partners have unlimited liability and are responsible for the day-to-day management of the business. Limited partners, on the other hand, have limited liability and are not involved in the management of the business.
Limited partnerships are common in industries such as real estate, where investors may want to limit their liability while still benefiting from the investment. For example, if a real estate developer creates a limited partnership to finance a new development, the developer may serve as the general partner and contribute their expertise to the project, while the limited partners contribute capital but are not responsible for any losses beyond their investment.
Answer 2:
Insider trading occurs when someone uses non-public information to buy or sell stocks, giving them an unfair advantage over other investors. For example, if an executive of a company knows that the company is about to release a positive earnings report, they may buy shares of the company before the report is released, allowing them to profit from the increase in the stock price.
The government agency responsible for protecting against insider trading is the Securities and Exchange Commission (SEC) in the United States. The SEC has the authority to investigate and prosecute individuals who engage in insider trading. For example, in 2020, the SEC charged a former executive of a pharmaceutical company with insider trading, alleging that he used non-public information to sell his stock in the company before the stock price dropped.
Answer 3:
Depreciation is a tax deduction that allows businesses to recover the cost of assets over time. This deduction reduces taxable income, which in turn reduces the amount of taxes a business must pay. The tax savings generated by depreciation can contribute to a business’s cash flow, as the savings can be used for other purposes such as investing in new projects or paying off debt.
For example, if a company buys a new piece of equipment for $10,000 and the equipment has a useful life of 5 years, the company may be able to deduct $2,000 per year in depreciation. This deduction would reduce the company’s taxable income by $2,000 per year, which would result in tax savings. These tax savings can be used to support the business’s cash flow.
Answer 4:
Inflation can restrict the usefulness of the balance sheet as normally presented because it does not take into account the changing value of money over time. The balance sheet presents financial information at a particular point in time, and the values of assets and liabilities are recorded based on their historical cost. However, inflation can erode the value of assets and liabilities over time, which can lead to misleading information on the balance sheet.
For example, if a company purchased a building for $1 million 10 years ago and recorded it on their balance sheet at that cost, the building’s value may have increased due to inflation. However, if the balance sheet does not reflect this increase in value, the company’s assets may be undervalued. Similarly, if the company has long-term liabilities such as bonds or mortgages, inflation may increase the value of these liabilities over time, which could lead to an overstatement of the company’s debt on the balance sheet.
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