Preparation of financial statements - Limited companies (AS)

Preparation of Financial Statements – Limited Companies (AS Level)

Hello future accountants! This chapter is where things get really interesting. We are moving from the small world of Sole Traders and Partnerships into the big league: Limited Companies.

Limited companies (LCs) have special rules because they are legally separate from their owners. This changes how we record share transactions, reserves, and ultimately, how we present the final financial statements. Don't worry, we'll break down the new formats and complex topics like share issues and reserves step-by-step!

1. Features and Financial Structure of Limited Companies

A limited company (LC) is a legal entity distinct from its owners (shareholders). This structure gives rise to several crucial features that affect the accounts:

1.1 Key Characteristics

• Limited Liability: This is the biggest advantage! Shareholders are only liable for the amount they invested (the value of their shares). Their personal assets are protected if the company fails.
  (Analogy: Owning shares is like buying a ticket to a concert. If the concert is cancelled, you only lose the price of the ticket, not your house.)
• Separate Legal Entity: The company can own assets, incur debts, and sue or be sued in its own name.
• Separation of Ownership and Control: Owners are the shareholders. Control is exercised by the directors (who are often not the majority owners).
• Continuity of Existence: The company continues to exist even if shareholders die or sell their shares.

1.2 Sources of Finance Specific to Limited Companies

Limited companies have unique ways of raising large amounts of capital:

1. Ordinary Shares (Share Capital): These represent ownership. Owners have voting rights and receive dividends, but only after preference shareholders (if any) and debenture holders have been paid. They bear the highest risk.
2. Debentures: These are long-term loans taken by the company. Debenture holders are creditors, not owners. They receive fixed interest payments regardless of company profit.
3. Retained Earnings/Reserves: Profits kept within the business for reinvestment (internal source).

Key Takeaway: Limited companies use shares to grant ownership and debentures to take on structured debt. The core feature is limited liability.

2. Share Capital and Reserves

The Equity section of a limited company's Statement of Financial Position is complex because it includes various types of capital and reserves.

2.1 Share Capital (Ordinary Shares)

• Issued Share Capital: The total nominal (par) value of shares actually sold to the public.
• Authorised Share Capital: The maximum number of shares the company is legally allowed to issue (often shown in a note, not on the SFP).
• Par Value (or Nominal Value): The minimum legal value assigned to a share (e.g., $1.00 per share).

2.2 Understanding Reserves (The Crucial Distinction)

\nReserves are profits set aside, but they are categorized based on their source and use.

2.2.1 Capital Reserves (The Locked Pot)

\nThese reserves arise from capital transactions and cannot be used to pay dividends. They are often protected by law.

• Share Premium: The extra amount received when shares are issued for more than their par value.
  (Example: Issuing a $1.00 share for $1.50 results in $1.00 in Share Capital and $0.50 in Share Premium.)
• Revaluation Reserve: Arises when a non-current asset is revalued upwards. (AS syllabus requires understanding, but specific calculations involving its use are limited).

2.2.2 Revenue Reserves (The Usable Pot)

\nThese reserves are generated through normal trading profits and can be used to pay dividends.

• Retained Earnings (or Accumulated Profit): The total profit kept by the company over its lifetime, after deducting dividends. This is the main source for dividend payments.
• General Reserve: An optional portion of Retained Earnings that the directors have decided to set aside for general future use or strengthening the company's financial position.

Memory Trick: Capital Reserves = Can't pay dividends. Revenue Reserves = Ready for dividends.

Key Takeaway: Capital reserves are generally permanent and statutory (e.g., Share Premium); Revenue reserves are flexible and come from accumulated trading profits (e.g., Retained Earnings).

3. Accounting for Share Issues, Debentures, and Dividends

\nWhen a limited company raises finance, specific ledger entries are required.

3.1 Issuing Ordinary Shares

\nShares can be issued at par (at nominal value) or at a premium (above nominal value).

Step-by-Step Journal Entries for Share Issue at a Premium:

1. Debit Cash/Bank (Total cash received).
2. Credit Ordinary Share Capital (Nominal/Par value only).
3. Credit Share Premium (The excess amount above par value).

Example: 10,000 shares (par $1.00) issued for $1.20 each.
Debit Bank $12,000.
Credit Share Capital $10,000.
Credit Share Premium $2,000.

3.2 Rights Issues vs. Bonus Issues

These are methods used after the initial public offering to change the amount of share capital.

3.2.1 Rights Issue (Raising Cash)

A rights issue offers existing shareholders the right to buy additional shares for cash, usually at a price below the current market price (but often still above par).

• Advantage to Company: Raises significant cash.
• Advantage to Shareholder: Allows them to maintain their percentage of ownership (avoiding dilution).
• Accounting Treatment: The issue is recorded just like a normal share issue (debit Cash, credit Share Capital and Share Premium).

3.2.2 Bonus Issue (Giving away Shares)

A bonus issue (also called a scrip issue or capitalisation issue) gives existing shareholders free shares in proportion to their current holdings. This does not raise new cash.

• Purpose: To convert a reserve balance into permanent share capital, making the company seem less liquid and signaling confidence.
• Accounting Treatment: This involves shifting a reserve balance into Share Capital.
  1. Debit Revenue Reserve (e.g., Retained Earnings or General Reserve).
  2. Credit Ordinary Share Capital (Nominal value of new shares).
• Crucial Note (Syllabus Rule): For your exams, a bonus issue must be financed by Revenue Reserves (Retained Earnings or General Reserve). You must not use the Revaluation Reserve for this purpose.

3.3 Debentures and Dividends

Debentures (Long-Term Loans):

Accounting is straightforward: the issue is recorded as a receipt in the Cash Book (Debit Bank) and a long-term liability (Credit Debentures Account). Interest paid is treated as a finance cost in the Statement of Profit or Loss.

Dividends:

Dividends are the distribution of profits to shareholders.

• Interim Dividend: Paid during the financial year, usually based on expected performance.
• Final Dividend: Paid after the year-end when the final profits are known and officially approved by shareholders.

Dividends are paid out of Retained Earnings (a Revenue Reserve). The payment reduces the equity balance.

Key Takeaway: Rights Issues raise cash; Bonus Issues capitalise reserves by giving free shares. Both change the composition of the Equity section. Dividends reduce Retained Earnings.

4. Preparing Financial Statements for Limited Companies

The structure of the Statement of Profit or Loss (SPL) and Statement of Financial Position (SFP) is generally similar to other entities, but the presentation of the final profit allocation and the equity section is unique.

4.1 Statement of Profit or Loss (SPL)

The top section (Revenue, Cost of Sales, Gross Profit, Operating Expenses) is the same. The limited company format then adds specific finance costs and tax (if applicable) before determining how the profit is distributed.

LC SPL Key Sections:

Profit from Operations (Gross Profit less Operating Expenses)
Less: Finance costs (e.g., Debenture interest)
= Profit Before Tax
Less: Taxation
= Profit for the Year (This is the amount available to shareholders/for reserves)

Common Error to Avoid: Debenture interest is a fixed cost and is always treated as a finance cost in the SPL, not as a dividend payment.

4.2 Statement of Changes in Equity (SoCE)

The SoCE is mandatory for limited companies and shows all movements in the equity accounts during the period. It provides a clear link between the SPL (Profit for the Year) and the SFP (Total Equity).

The SoCE Format must include columns for:

• Ordinary Share Capital
• Share Premium
• General Reserve (if applicable)
• Retained Earnings
• Total Equity

Movements recorded in the SoCE:

1. Balance at start of year (brought forward)
2. Total Comprehensive Income (Profit for the Year from SPL) – This increases Retained Earnings.
3. Issue of shares (affects Share Capital and Share Premium)
4. Bonus issue (affects Share Capital and a Revenue Reserve)
5. Transfers to General Reserve (Reduces Retained Earnings, Increases General Reserve)
6. Dividends Paid/Proposed (Interim and Final) – These reduce Retained Earnings.
7. Balance at end of year (carried forward)

4.3 Statement of Financial Position (SFP)

The SFP for a limited company is distinct in its Equity and Liabilities section.

Equity Section Format:

EQUITY
(A) Share Capital:
    Ordinary Share Capital
(B) Reserves:
    Share Premium
    General Reserve
    Retained Earnings (Total figure taken from the SoCE)
TOTAL EQUITY

Non-current Liabilities:
    Debentures
    Long-term loans