Welcome to the World of Limited Companies!
In your previous studies, you likely looked at sole traders and partnerships. Now, we are stepping into the big league: Limited Companies. Think of a limited company like a separate "person" in the eyes of the law. It can own property, get into debt, and even go to court, all independently of its owners! This chapter will show you how we track the money in these large organizations and how they report their success to the world.
1. Key Features: What makes a Company "Limited"?
The most important concept to grasp is Limited Liability. In a sole trader or partnership, if the business fails, the owners might have to sell their personal house or car to pay the debts. In a Limited Company, the shareholders only risk the money they have already invested in shares. Their personal assets are safe!
Don't worry if this seems tricky at first: Just remember that the "Limited" part refers to the limit on how much the owners can lose.
Ordinary Shares and Dividends
Companies raise money by selling "pieces" of ownership called Ordinary Shares. - Par Value (or Nominal Value): This is the "face value" printed on the share certificate (e.g., \$1.00). - Dividends: When the company makes a profit, it might share some of that cash with the shareholders. This is called a dividend. - Important Note: Unlike interest on a loan, dividends are not an expense. They are a distribution of profit.
Debentures
Sometimes a company doesn't want more owners; it just wants to borrow money for a long time. It does this by issuing Debentures. - Think of a debenture as a long-term loan certificate. - The company must pay interest on debentures every year, even if they make a loss. - Interest is an expense and goes in the Statement of Profit or Loss.
Quick Review: Shareholders are owners (receive dividends), while debenture holders are lenders (receive interest).
2. The "Piggy Banks": Understanding Reserves
In a company's accounts, we don't just have one "Capital" account. Instead, we split the owners' equity into different "piggy banks" called Reserves. These are divided into two main types:
A. Capital Reserves
These are "locked" reserves. Usually, you cannot use these to pay cash dividends to shareholders. 1. Share Premium: This is created when a company sells shares for more than their par value. \( \text{Share Premium} = (\text{Issue Price} - \text{Par Value}) \times \text{Number of Shares} \) 2. Revaluation Reserve: This is created when the value of a non-current asset (like a building) goes up.
B. Revenue Reserves
These come from the company's trading profits and can be used to pay dividends. 1. Retained Earnings: This is the accumulated profit that has been kept in the business over the years. 2. General Reserve: Profit set aside for general future use (to show shareholders we aren't spending everything at once).
Key Takeaway: Capital Reserves usually come from "accounting adjustments" or share issues, while Revenue Reserves come from hard-earned profit!
3. Changing the Share Capital: Bonus and Rights Issues
Companies often need to change the number of shares they have in issue. There are two ways the syllabus requires you to know:
Rights Issue (Raising New Cash)
The company offers existing shareholders the "right" to buy new shares, usually at a price slightly lower than the current market price. - Advantage: It raises fresh cash for the company. - Accounting: Dr Cash, Cr Ordinary Share Capital (at par), Cr Share Premium (the extra).
Bonus Issue (The "Free" Gift)
The company gives existing shareholders extra shares for free by converting reserves into share capital. No cash changes hands! - Why do it? It makes the company look more "substantial" and brings the share price down to a more affordable level. - Important Rule: You must use Capital Reserves first (like Share Premium) before touching Retained Earnings. - Note: According to your syllabus, the Revaluation Reserve is not to be used for a bonus issue.
Did you know? In a bonus issue, even though you have more share certificates, your percentage of ownership in the company stays exactly the same!
4. Shares vs. Debentures: Making the Choice
Imagine a company needs \$1 million to build a new factory. Should they issue more shares or issue debentures?
Issuing Shares (Equity Finance)
- Pros: No debt to pay back; dividends only paid if there is profit. - Cons: Ownership is diluted (original owners have less control); dividends are not tax-deductible.
Issuing Debentures (Debt Finance)
- Pros: Original owners keep full control; interest is tax-deductible. - Cons: Interest must be paid even if no profit is made; the loan must eventually be repaid.
5. Preparing the Financial Statements
You will be asked to prepare three main documents. Here is a step-by-step guide to what makes them unique for companies:
Statement of Changes in Equity (SOCE)
This is a table that shows how each "piggy bank" (reserve) changed during the year. 1. Start with Opening Balances. 2. Add Profit for the Year (only to Retained Earnings). 3. Deduct Dividends Paid (only from Retained Earnings). 4. Record Issue of Shares (split between Share Capital and Share Premium). 5. Record Bonus Issues (deduct from reserves, add to Share Capital). 6. End with Closing Balances.
Statement of Profit or Loss (SOPL)
Very similar to a sole trader, but watch out for: - Finance Costs: This is where Debenture Interest lives. - Taxation: Companies pay corporate tax on their profits. This is deducted at the very end to find the "Profit for the year."
Statement of Financial Position (SOFP)
The "Capital" section is replaced by Equity. - You must list every reserve separately (Share Capital, Share Premium, General Reserve, Retained Earnings). - Debentures are listed under Non-Current Liabilities.
Summary & Common Mistakes to Avoid
Common Mistakes: - Don't put dividends in the Statement of Profit or Loss. They only appear in the SOCE. - Don't forget that Debenture Interest is an expense, but Dividends are not. - Don't use the Revaluation Reserve for a Bonus Issue in your exam. - Do remember that "Ordinary Share Capital" always stays at the Par Value. Any extra goes to Share Premium.
Key Takeaway: Limited companies use various reserves to manage their equity. The Statement of Changes in Equity (SOCE) is the vital link that explains how the company's value shifted from the start of the year to the end.