BAFS Study Notes: Accounting for Limited Company
Hey everyone! Welcome to your study notes for one of the most important topics in BAFS: Accounting for a Limited Company. You've probably heard of big companies like Tencent or MTR – they are all limited companies! Understanding how they work financially is a key skill.
In these notes, we'll break everything down into simple, easy-to-understand steps. We'll cover what a limited company is, how it gets money to operate, and how we prepare its final accounts using the required vertical presentation format. Don't worry if it sounds complicated; we'll go through it together. Let's get started!
Section 1: What Makes a Limited Company Special?
First things first, what's the big deal with a limited company? Why don't all businesses just stay as sole proprietorships or partnerships? It comes down to two super important concepts.
Key Concepts: Separate Legal Entity & Limited Liability
- Separate Legal Entity: Think of a limited company as its own person. It's legally separate from its owners (who are called shareholders). This means the company can own assets, make contracts, and even be sued in its own name, not the owners' names.
- Limited Liability: This is a huge advantage! It means that if the company gets into financial trouble and can't pay its debts, the shareholders are only at risk of losing the money they invested in the company. Their personal belongings (like their house or car) are safe. This is very different from a sole proprietor, who is personally responsible for all business debts.
Analogy: The Pizza Shop
Imagine you and your friends start 'Best Pizza Ltd.'. The company is a 'separate person'. If the company borrows money from a supplier for cheese and can't pay it back, the supplier can only sue 'Best Pizza Ltd.', not you or your friends personally. The most you can lose is the money you put in to start the shop. Your personal savings are safe!
Pros and Cons of a Limited Company
Here’s a quick summary of the good and bad points compared to other business types.
Advantages (Pros):
- Limited Liability: The biggest perk! Owners' personal assets are protected.
- Easier to Raise Capital: Can sell shares to many investors to raise large amounts of money.
- Separate Legal Existence: The company continues to exist even if the owners change (e.g., a shareholder sells their shares or passes away).
Disadvantages (Cons):
- More Complex to Set Up: Requires more legal paperwork and formalities.
- Profits Shared: Profits are shared among all shareholders through dividends.
- More Regulations: Must follow stricter rules and disclose financial information publicly.
Key Takeaway for Section 1
A limited company is a separate legal entity from its owners (shareholders), which provides them with limited liability. This makes it easier to raise funds but also means more complex rules and regulations.
Section 2: The Money Behind the Company (Equity)
A company needs money to grow, and this money is shown in the 'Equity' section of its Statement of Financial Position. For a limited company, this section has some new and interesting parts!
1. Share Capital
This is the money the company raises by selling shares of ownership. There are two main types you need to know.
- Ordinary Shares:
These are the most common type of shares. The owners of these shares are the true owners of the company.
- They have voting rights (e.g., can vote on major company decisions).
- They receive dividends, but the amount is not fixed. They get a share of the profits only after everyone else (like loan providers and preference shareholders) has been paid.
- This is a higher risk, but also offers a potentially higher return!
- Preference Shares:
These shares are a bit like a hybrid between a share and a loan.
- They usually have no voting rights.
- They receive a fixed rate of dividend (e.g., 5% preference shares).
- Their dividends must be paid before any dividends are paid to ordinary shareholders.
- This is a lower risk investment compared to ordinary shares.
Important Note: In the HKDSE syllabus, under the Hong Kong Companies Ordinance, shares have no par value. This means shares do not have a nominal face value printed on them, simplifying our accounting entries!
2. Loan Capital (Debentures)
Sometimes, a company needs to borrow money for the long term without giving away ownership. It does this by issuing debentures.
- A debenture is basically a long-term loan certificate issued by the company.
- The company promises to pay a fixed rate of interest to the debenture holders every year and repay the principal amount at a future date.
- Debenture holders are lenders, NOT owners. They have no voting rights.
Quick Review: Shares vs. Debentures
- Shareholders are OWNERS. They get dividends (a share of profits).
- Debenture holders are LENDERS. They get interest (a business expense in the Income Statement).
3. Reserves and Provisions
- Reserves: This represents profit that the company has decided to keep and reinvest in the business, instead of paying it all out to shareholders. Common types include retained profits and general reserve.
- Provision: This is an amount set aside to cover a likely future obligation. For a limited company, a standard example is the provision for income tax (profits tax).
Key Takeaway for Section 2
A company's equity consists of share capital (money from owners like ordinary and preference shareholders) and reserves (such as retained profits and general reserves). Long-term borrowing is shown under non-current liabilities as debentures or bank loans.
Section 3: Issuing Shares and Debentures
Okay, so how does a company actually get the money from selling shares or debentures? Let's look at the journal entries for shares issued and fully paid on application.
Step-by-Step: Issuing Ordinary Shares
Let's say Trendy T-shirts Ltd. decides to issue 100,000 ordinary shares for \$2 each. People apply and pay for all of them.
Step 1: Receive money from applicants.
The company gets cash from people who want to buy shares.
Journal Entry:
Dr Bank \( (100,000 \times \$2) = \$200,000 \)
Cr Application - Ordinary Shares (A temporary account) \( \$200,000 \)
(To record receipt of application money)
Step 2: Allot (officially issue) the shares.
Now, the company officially makes these applicants the owners. We close the temporary 'Application' account and move the money to the real 'Ordinary Share Capital' account.
Journal Entry:
Dr Application - Ordinary Shares \( \$200,000 \)
Cr Ordinary Share Capital \( \$200,000 \)
(To record allotment of shares)
What if TOO MANY people apply? (Oversubscription)
This is common for popular companies! Let's say Trendy T-shirts Ltd. only wanted to issue 100,000 shares, but they received applications for 120,000 shares.
Step 1: Receive ALL the application money.
The company first collects the money for all 120,000 applications.
Dr Bank \( (120,000 \times \$2) = \$240,000 \)
Cr Application - Ordinary Shares \( \$240,000 \)
Step 2: Allot the shares you planned to issue.
The company only issues 100,000 shares. So, only that amount becomes share capital.
Dr Application - Ordinary Shares \( (100,000 \times \$2) = \$200,000 \)
Cr Ordinary Share Capital \( \$200,000 \)
Step 3: Refund the money to the unsuccessful applicants.
The company must return the money for the extra 20,000 shares it couldn't issue.
Dr Application - Ordinary Shares \( (20,000 \times \$2) = \$40,000 \)
Cr Bank \( \$40,000 \)
Did you know? The accounting entries for issuing debentures are almost identical! Just replace 'Application - Ordinary Shares' with 'Application - Debentures' and 'Ordinary Share Capital' with 'Debentures'.
Common Mistakes to Avoid
- Forgetting to create the temporary 'Application' account. Don't credit 'Share Capital' straight away!
- In oversubscription, debiting Bank for the refund. Remember, when you give money back, your Bank account must be credited (it is decreasing).
- Mixing up the amounts. The 'Ordinary Share Capital' account should only show the value of the shares that were actually issued, not the total applications received.
Key Takeaway for Section 3
Issuing shares is a two-step process: (1) receive cash and credit a temporary 'Application' account, then (2) debit the 'Application' account and credit 'Share Capital'. For oversubscription, a third step is added: refunding the extra cash.
Section 4: The Final Accounts of a Limited Company
In HKDSE BAFS, final accounts of limited companies must be presented in the vertical format.
Part A: Income Statement & Statement of Retained Earnings
The Income Statement calculates 'Net Profit before Tax' and then deducts Profits Tax to arrive at Net Profit after Tax.
How profits are retained or distributed is shown in the Statement of Retained Earnings.
Crucial Accounting Rule on Dividends (HKAS 10)
Under HKAS 10, proposed final dividends declared after the reporting date are NOT a liability at the year-end and are NOT deducted in the financial statements for that year (they are only disclosed in the notes). Only dividends declared/paid during the year (such as interim dividends or dividends approved before year-end) are deducted.
Format of the Statement of Retained Earnings
Retained Profits brought forward (from last year)
Add: Net Profit after Tax for the year
Less: Interim / Paid Dividends
- Preference Dividend paid
- Interim Ordinary Dividend paid
Less: Transfer to General Reserve
Retained Profits carried forward (to the Statement of Financial Position)
Example Walkthrough
Gamer Gear Ltd. made a Net Profit before Tax of \$500,000 for the year.
- Profits tax for the year is \$80,000.
- An interim ordinary dividend of \$100,000 was paid during the year.
- Transfer to General Reserve is \$50,000.
- Retained profits brought forward from the start of the year were \$250,000.
Statement of Retained Earnings for Gamer Gear Ltd. for the year ended...
Retained profits brought forward........................\$250,000
Add: Net Profit after Tax (\$500,000 - \$80,000)....\$420,000
Less: Interim ordinary dividend paid..................(\$100,000)
Less: Transfer to General Reserve.......................(\$50,000)
Retained Profits carried forward..................\$520,000
This final figure, \$520,000, is what appears under Equity in the Statement of Financial Position!
Part B: The Statement of Financial Position
The assets are presented vertically as Non-current Assets and Current Assets. The Equity and Liabilities section clearly separates owners' equity from liabilities.
Format of the 'Equity and Liabilities' Section
Equity
Ordinary Share Capital
Preference Share Capital
General Reserve
Retained Profits
Non-current Liabilities
Debentures
Bank Loan
Current Liabilities
Trade Payables
Accrued Expenses
Tax Payable
Total Equity and Liabilities
Key Takeaway for Section 4
For a limited company, vertical presentation is required. The Statement of Retained Earnings reconciles beginning and ending retained profits by adding net profit after tax and deducting paid/interim dividends and transfers to reserves. Under HKAS 10, proposed final dividends are never deducted in that year's financial statements.
Congratulations!
You've made it through the key concepts of accounting for a limited company. Keep practicing the journal entries for share issues and the vertical format of the financial statements, and you'll master this topic in no time. Good luck with your studies!