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. 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, we only deal with shares that have no par value. This just means the share doesn't have a face value printed on it. It simplifies 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).
3. Reserves and Provisions
- Reserves: This is basically profit that the company has decided to keep and reinvest in the business, instead of paying it all out to shareholders. The most common type you will see is retained profits.
- Provision: This is an amount set aside to cover a likely future expense. For a limited company, the most common one is the provision for income tax.
Key Takeaway for Section 2
A company's equity consists of share capital (money from owners like ordinary and preference shareholders), while its long-term financing can also include loan capital (money from lenders, i.e., debenture holders). Profits kept in the business are called reserves.
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. The good news is, for your syllabus, we only need to know the simplest case: where shares/debentures are issued at par and are 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 (Asset increases) $$ (100,000 \times \$2) = \$200,000 $$
Cr Application - Ordinary Shares (A temporary liability 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 'Share Capital' account.
Journal Entry:
Dr Application - Ordinary Shares (Close the temporary account) $$ \$200,000 $$
Cr Ordinary Share Capital (Equity increases) $$ \$200,000 $$
(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 (Asset decreases) $$ \$40,000 $$
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's decreasing).
- Mixing up the amounts. The '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 the 'Share Capital' account. For oversubscription, a third step is added: refunding the extra cash.
Section 4: The Final Accounts of a Limited Company
Preparing the final accounts for a limited company is very similar to what you've learned for partnerships, with a few key differences, especially in how profit is shown and how the equity section is structured.
Remember: The syllabus does NOT require you to prepare 'published accounts'. We just need to know the internal format.
Part A: The Income Statement & Appropriation Account
The first part of the Income Statement (calculating gross profit and profit from operations) is exactly the same! The change happens after we calculate the 'Net Profit before Tax'.
We add a new section called the Appropriation Account. Its job is to show how the company's profit is 'appropriated' or distributed.
Format of the Appropriation Account
This section is added right at the end of the Income Statement.
Net Profit before Tax
Less: Income Tax
Net Profit after Tax
Less: Dividends
- Preference Dividend (Paid or Proposed)
- Ordinary Dividend (Paid or Proposed)
Retained Profit for the year
Add: Retained Profits brought forward (from last year)
Retained Profits carried forward (to the Statement of Financial Position)
Example Walkthrough
Gamer Gear Ltd. made a Net Profit before Tax of $500,000.
- The company's tax for the year is $80,000.
- It paid an ordinary dividend of $100,000.
- The retained profits from the start of the year were $250,000.
Appropriation Account for Gamer Gear Ltd. for the year ended...
Net Profit before Tax........................................$500,000
Less: Income Tax.............................................($80,000)
Net Profit after Tax...........................................$420,000
Less: Ordinary Dividend....................................($100,000)
Retained Profit for the year..............................$320,000
Add: Retained Profits brought forward...........$250,000
Retained Profits carried forward..................$570,000
This final figure, $570,000, is what will appear in the Statement of Financial Position!
Part B: The Statement of Financial Position
The 'Assets' part is exactly the same. The big change is in the 'Equity and Liabilities' section. It's now much more detailed to show the different types of capital and reserves.
Format of the 'Equity and Liabilities' Section
Equity
Ordinary Share Capital
Preference Share Capital
Retained Profits (This is the final figure from our Appropriation Account!)
Non-current Liabilities
Debentures
Bank Loan
Current Liabilities
Trade Payables
Accrued Expenses
Tax Payable
Total Equity and Liabilities
See how it's structured? It clearly separates the money from owners (Equity) from money owed to others (Liabilities). It's much more informative for investors and lenders.
Key Takeaway for Section 4
For a limited company, we add an Appropriation Account after the Income Statement to show how profits are used (tax, dividends, and retained profits). The final 'Retained Profits' balance is then carried to the Equity section of the Statement of Financial Position, which also clearly shows Share Capital and Reserves.
Congratulations!
You've made it through the key concepts of accounting for a limited company. We've seen that while some terms are new, the basic accounting logic is the same. The key is to understand the structure and the new accounts like Share Capital, Debentures, and the Appropriation Account.
Keep practicing the journal entries and the format of the final accounts, and you'll master this topic in no time. Good luck with your studies!