👋 Welcome to Limited Liability Companies: Internal Accounts!

Hello future Accountants! This chapter is incredibly important because it moves us from looking at simple businesses (sole traders) to understanding large organizations: Limited Liability Companies (LLCs).

You already know how to prepare basic financial statements, but LLCs have extra rules—especially regarding tax and distributing profits. This chapter focuses on internal statements, which are like the company's "rough draft" used only by management.

Don't worry if this seems tricky at first; we will break down the essential steps for incorporating things like Corporation Tax and Dividends. Let’s get started!

1. Internal vs. External Financial Statements: The Core Difference

A limited liability company prepares two types of financial statements:

What are Internal Statements?

Internal statements (sometimes called Management Accounts or Draft Accounts) are prepared frequently (monthly or quarterly) and are used only by the directors and management of the company.

  • Purpose: Quick decision-making, monitoring performance against budgets, and identifying immediate problems.
  • Format: Flexible. They don't have to follow strict legal formats, as long as they are useful for the managers.
  • Speed: Prepared very quickly after the period ends.

What are External Statements?

External statements (the published annual reports) are prepared once a year and sent to shareholders, banks, and the government (tax authorities).

  • Purpose: To comply with legal requirements and inform external parties about the company’s performance and position.
  • Format: Must follow strict accounting standards and legal rules.
💡 Analogy Time!

Think of internal statements as the notes you take during a class—they are quick, messy, and only you need to understand them. External statements are the final, polished essay you submit to your teacher—they must be perfect and follow all the rules!

Key Takeaway: Internal statements are informal, fast, and vital for managers to run the business day-to-day.

2. Preparing the Internal Income Statement for an LLC

The Income Statement for an LLC follows the same structure as a sole trader initially (Sales, COGS, Gross Profit, Expenses). The difference lies right at the end: dealing with profits and taxes.

Step 2.1: Calculating Profit Before Tax

This step is straightforward. You calculate the profit exactly as you would for any other business:

  • Gross Profit (Sales less Cost of Goods Sold)
  • Operating Profit (Gross Profit less Operating Expenses like wages, rent, utilities)
  • Profit Before Interest and Tax (PBIT)
  • Profit Before Tax (PBT) (PBIT less Interest Expense)

Step 2.2: Incorporating Corporation Tax

This is the first major adjustment for an LLC. Companies must pay a tax on their profits called Corporation Tax.

The Income Statement must reflect this deduction:

  1. Start with Profit Before Tax (PBT).
  2. Subtract the calculated amount of Corporation Tax (this is often given as a percentage of PBT, e.g., 20%).
  3. The result is the Profit After Tax (or Profit for the Year).

\( \begin{array}{l} \text{Profit Before Tax} \\ \text{Less: Corporation Tax} \\ \hline \mathbf{Profit\ After\ Tax} \\ \end{array} \)

Step 2.3: Dealing with Dividends and Retained Earnings

Once the tax is paid, the remaining profit belongs to the shareholders. The directors decide what portion to pay out as Dividends (payments to shareholders) and what portion to keep in the business as Retained Earnings (savings for future investments).

  • Dividends: These are payments to owners (shareholders). They are NOT an expense of the company, so they are not deducted *before* calculating Profit After Tax. They are paid out *from* the profit after tax.
  • Retained Earnings: This is the final figure. It is the portion of profit kept in the business.

\( \begin{array}{l} \text{Profit After Tax} \\ \text{Less: Proposed Dividends} \\ \hline \mathbf{Retained\ Profit\ for\ the\ Year} \\ \end{array} \)

⚠️ Common Mistake to Avoid!

Students often treat Dividends like an expense (e.g., wages) and deduct them *before* calculating tax. DO NOT DO THIS! Corporation Tax is calculated first; dividends are paid only *after* the tax bill is settled.

Quick Review: LLC Income Statement adds Corporation Tax before getting to Profit After Tax, and then deducts Dividends to find the Retained Profit.

3. Preparing the Internal Statement of Financial Position (SFP)

The SFP for an LLC largely mirrors the SFP for a partnership, but the Equity Section (Capital) is structured differently because shareholders own the company, not partners.

3.1 The Capital/Equity Section

The equity section (what the owners have invested or earned) has two main parts:

  1. Share Capital: The money shareholders originally paid to the company to buy shares. This amount usually stays the same unless new shares are issued.
  2. Reserves: This includes Retained Earnings (also called Revenue Reserves).

3.2 Linking the Income Statement to the SFP (The Retained Earnings Calculation)

This is the most critical link between the two internal statements. The amount retained from this year’s profit is added to the total retained earnings saved from previous years.

Retained Earnings Calculation:

\( \text{Opening Retained Earnings} \\ + \text{Profit for the Year (after tax)} \\ - \text{Dividends Paid/Proposed} \\ \hline \mathbf{Closing\ Retained\ Earnings} \\ \)

⭐ Memory Trick: S.P.D.E.

Start + Profit - Dividends = Ending (Retained Earnings)

3.3 The Final SFP Structure

In the SFP, the final figures are shown under the Capital and Reserves heading:

  • Share Capital
  • Retained Earnings (Closing Balance)
  • (Note: Any dividends formally proposed but not yet paid are shown as a Current Liability on the SFP.)

Key Takeaway: The SFP shows the final balance of Retained Earnings, which is the cumulative (total) profit the company has saved since it began trading.

4. Commenting on the Internal Statements (Analysis)

Preparation is only half the battle. Directors need to comment on the internal statements to understand what happened and decide what to do next. We focus on two main areas: Performance and Position.

4.1 Performance Analysis (Profitability)

Internal statements allow management to track profitability quickly, often comparing current results to budgets or prior periods.

What to Look For:
  • Trend: Is Gross Profit or Net Profit improving or declining compared to the budget? (e.g., "The Gross Profit Margin fell from 30% to 25%, suggesting cost of purchasing goods is too high.")
  • Tax Impact: How does the Corporation Tax rate affect the final profit available for shareholders?
  • Dividend Policy: Are the dividends paid sustainable? Is the company paying out too much profit, leaving too little for retained earnings and future growth?
Did You Know?

Management often uses monthly internal statements to adjust pricing or reduce specific variable costs *before* the year ends, allowing them to fix problems rapidly.

4.2 Position Analysis (Liquidity and Capital Structure)

The SFP tells us about the company’s financial health—especially its ability to pay short-term debts (liquidity) and its long-term borrowing strategy (capital structure).

Liquidity Check (Short-Term Health):

We look at the Current Ratio and the Acid Test Ratio (covered in detail in other chapters, but essential for commentary).

  • Comment Example: "The Current Ratio is 0.8:1, which is below the safe standard of 1.5:1. This suggests the company may struggle to pay its current liabilities (like creditors) on time."
  • Recommendation: "We should negotiate longer payment terms with suppliers or try to convert inventory to sales faster."
Capital Structure Check (Shareholders vs. Borrowing):

The SFP clearly shows the split between equity (share capital + retained earnings) and non-current liabilities (long-term loans). This helps assess Gearing (how much the company relies on borrowing).

  • High Retained Earnings: Means the company is funding its growth internally, which reduces risk.
  • High Non-Current Liabilities: Means high reliance on borrowing, which increases risk, especially if interest rates rise.

4.3 Summarizing and Making Recommendations

A good commentary must conclude with actionable steps. Directors aren't just summarizing; they are planning.

Your commentary should always link the performance figures to the future position:

"Although Net Profit Margin improved slightly, the substantial amount paid in dividends means that Retained Earnings only grew by 5%. This lack of internal funding suggests we will need to seek a loan (increasing Non-Current Liabilities) if we proceed with the planned purchase of new machinery."

Key Takeaway: Commenting involves comparing, identifying weaknesses (e.g., low liquidity, low profitability), and recommending specific corrective actions based on the figures.

🎉 You've Mastered the Draft!

Understanding how internal statements work, especially the impact of Corporation Tax and Dividends, is crucial for your examination success. Keep practising the Retained Earnings calculation!