Accounting (9615) | Accounting for limited companies

Accounting for Limited Companies (Advanced Level)

Hey there! Welcome to the final frontier of business organisations: Limited Companies. If you've mastered Sole Traders and Partnerships, you're ready for this. Limited Companies are the biggest and most complex entities we study, requiring special attention to their unique financing structure and regulatory demands.

This chapter connects directly to the A-Level syllabus (3.2.6), focusing on drafting the complex financial statements (including the Statement of Cash Flow) and understanding the rules (like IAS 1) that govern them. Don't worry if this seems tricky at first; we will break down the statements step-by-step!

1. Understanding the Limited Company Structure

A limited company (Ltd or plc) is a separate legal entity from its owners. This fundamental concept influences all its accounting treatments.

Key Characteristics and Definitions

• Limited Liability: This is the defining feature. The shareholders' personal assets are protected. If the company fails, they only lose the amount they invested in shares, not their house or car.
• Shareholders (Owners): They provide the capital by buying shares.
• Directors (Managers): They are appointed to run the business on a day-to-day basis.
• Public (plc) vs. Private (Ltd): The key difference lies in the ability to sell shares to the general public. We focus generally on the accounting principles applicable to both.

Sources of Finance Recap

Limited companies have unique long-term financing options (3.1.2 recap):

1. Ordinary Shares: The main ownership capital. These shareholders have voting rights and receive dividends (if declared).
2. Debentures: These are long-term loans issued by the company, essentially an IOU to lenders. They are a non-current liability, and holders receive fixed interest payments, regardless of company profit.

Key Takeaway: Limited liability is the core difference. The ownership structure (shares) changes how equity and financing are accounted for.

2. Equity and Share Transactions

Equity in a limited company is more complex than a sole trader’s capital account. It is split into different reserves, primarily Share Capital and Share Premium.

Share Issues and Share Premium

When a company issues shares, they have a Nominal Value (or par value) which is the legal minimum value. This is usually very low (e.g., $1.00 per share). Companies often sell shares for more than this nominal value.

• Share Capital: The total nominal value of shares issued. This figure is fixed and represents the legal capital base.
• Share Premium: The amount received above the nominal value when shares are issued. This is considered a non-distributable reserve (it cannot usually be paid out as dividends).

Example: A company issues 100,000 ordinary shares at a nominal value of $1.00 each, but they are sold to the public for $1.50 each.

Calculation:
* Share Capital: \(100,000 \times \$1.00 = \$100,000\)
* Share Premium: \(100,000 \times (\$1.50 - \$1.00) = \$50,000\)
* Total Cash Received: \(100,000 \times \$1.50 = \$150,000\)

Double Entry:
| Account | Dr (\$) | Cr (\$) | | :--- | :--- | :--- | | Bank/Cash | 150,000 | | | Share Capital | | 100,000 | | Share Premium | | 50,000 |

Dividends Paid

Dividends are the portion of the profit decided by the directors to be distributed to shareholders.

• Dividends are treated as an appropriation of profit, not an expense.
• They reduce the retained earnings balance.
• Double Entry for Payment: Dr Dividends Paid A/C (or Retained Earnings), Cr Bank/Cash.

Did you know? Even if a limited company makes a huge profit, the directors may decide not to pay a dividend if they believe the cash is needed for future expansion (retained earnings).

Key Takeaway: Equity is split into Share Capital (nominal value) and Share Premium (excess cash received). Dividends are deducted from profit.

3. Preparing the Financial Statements (IAS 1 & Company Acts)

Limited companies prepare three mandatory internal financial statements (AS Level requirement 3.1.7). These are governed by International Accounting Standard 1 (IAS 1), which dictates the required presentation.

3.1 The Income Statement

The Income Statement (Profit & Loss) for a limited company is similar to a sole trader's but includes a key addition: Corporate Tax.

The distinction between profit levels is crucial:

1. Profit from Operations (Operating Profit): Gross Profit minus Operating Expenses.
2. Profit for the Year Before Tax: Operating Profit plus any non-operating income (e.g., interest received) minus finance costs (e.g., debenture interest paid).
3. Profit for the Year After Tax: Profit Before Tax minus Corporation Tax expense for the year. This is the amount available for dividends or retention.

Analogy: Think of the government as a business partner who takes their share (tax) before the owners (shareholders) get theirs (dividends).

3.2 Statement of Changes in Equity (SOCIE)

This statement acts as the bridge between the Income Statement and the Statement of Financial Position, showing all movements in equity components (Share Capital, Share Premium, and Retained Earnings/Accumulated Profit) during the year.

Core Structure (Simplified):

• Opening Balances (Equity at start of year)
• Add: New Share Issues (increasing Share Capital and Share Premium)
• Add: Profit for the Year (increasing Retained Earnings)
• Less: Dividends Paid (decreasing Retained Earnings)
• Closing Balances (Equity at end of year)

3.3 Statement of Financial Position (SOFP)

The SOFP lists the assets, liabilities, and equity at a specific date. The standard subheadings required are (3.1.7):

1. Non-Current Assets (e.g., Property, Plant, Equipment)
2. Current Assets (e.g., Inventory, Receivables, Cash)
3. Equity (Share Capital, Share Premium, Retained Earnings)
4. Non-Current Liabilities (e.g., Debentures, Long-term loans)
5. Current Liabilities (e.g., Trade Payables, Accrued Expenses, Corporation Tax Payable, Proposed Dividends)

Key Takeaway: The Income Statement adds tax, and the SOCIE tracks all movements in Share Capital, Share Premium, and Retained Earnings.

4. Advanced A-Level Statements (3.2.6)

At A-Level, we expand the reporting to include detailed non-current asset management and, crucially, the Statement of Cash Flow.

4.1 Schedule of Non-Current Assets

This is an appendix or note accompanying the SOFP, providing a detailed breakdown of non-current asset movements (3.2.6). It includes calculations for cost, accumulated depreciation, and Net Book Value (NBV).

The schedule typically tracks movements like:

• Opening Cost / Accumulated Depreciation
• Additions (New purchases)
• Disposals (Assets sold)
• Depreciation Charge for the year
• Closing Cost / Accumulated Depreciation

(Remember: You must know how to calculate depreciation using both the Straight Line and Reducing Balance methods, as covered in 3.1.6.)

4.2 Statement of Cash Flow (IAS 7 - The Indirect Method)

The Statement of Cash Flow (SCF) is governed by International Accounting Standard 7 (IAS 7). It shows how the business generated and used cash during the year, categorized into three activities.

Analogy: The Income Statement tells you if the company is profitable, but the SCF tells you if the company has enough physical cash to survive.

The specification requires the use of the Indirect Method. This method starts with the Profit Before Tax and adjusts it for all non-cash items and changes in working capital to arrive at the net cash flow.

The Three Activities:

1. Cash Flow from Operating Activities: Cash generated from the normal day-to-day running of the business (e.g., selling goods, paying suppliers). This is the complex section using the indirect method.
   Step 1: Start with Profit Before Tax.
   Step 2: Adjust for non-cash items (e.g., ADD back Depreciation, ADD back loss on disposal, DEDUCT gain on disposal).
   Step 3: Adjust for changes in working capital (Inventory, Receivables, Payables).
2. Cash Flow from Investing Activities: Cash movements related to long-term assets (Non-Current Assets).
   (e.g., Cash paid for purchasing new NCA, Cash received from selling old NCA.)
3. Cash Flow from Financing Activities: Cash movements related to long-term liabilities and equity capital.
   (e.g., Cash received from issuing shares/debentures, Cash paid for dividends, Cash paid for loan repayments.)

The Final Step: Reconciliation

The final calculation takes the Net increase/decrease in cash and cash equivalents, adds the opening cash balance, and must equal the closing cash balance shown on the SOFP.

Key Takeaway: The SCF (Indirect Method) adjusts profit for non-cash items (like depreciation) and changes in current assets/liabilities to find the true cash generated from operations, which is then combined with investing and financing activities.

5. Regulatory Framework and Stakeholders (3.2.6)

Limited companies are required to publish their accounts, making regulation and consistent reporting essential.

The Requirement to Publish Accounts

Companies Acts (laws) require LCs to publish their accounts. This information is vital for many groups of people (stakeholders).

• Lenders (Banks/Debenture Holders): They need to assess if the company can repay its loans (liquidity and profitability).
• Potential Investors: They assess the return and risk before buying shares.
• Government/Tax Authorities: They calculate corporate tax owed.
• General Public/Suppliers: They assess the stability of a major customer or employer.

The Role and Importance of IAS

International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS) provide a global framework for reporting.

• Purpose: They ensure comparability, consistency, and reliability across different countries and industries.
• IAS 1 (Presentation): Governs the format and presentation of the main financial statements (Income Statement, SOFP, SOCIE).
• IAS 7 (Cash Flow): Governs the structure and preparation of the Statement of Cash Flow.

Quick Review: The IAS framework provides the *rules* so that a financial statement prepared in London looks similar to one prepared in Hong Kong, making global investment decisions much easier!

Key Takeaway: Publishing accounts is mandatory under Companies Acts. IAS 1 and IAS 7 ensure the accounts are presented consistently, benefiting all stakeholders.