Accounting (9706) | Preparation of financial statements - Limited companies

Preparation of Financial Statements – Limited Companies

Welcome to the A Level content! This chapter is where you transition from understanding smaller entities (sole traders, partnerships) to the big players: the Limited Company (Ltd or Plc).

Why is this important? Limited companies are complex because ownership (shareholders) is separate from management (directors). This separation means their financial statements must be highly structured and transparent, adhering to international standards (like IAS 1, which you learn about later). Understanding this structure is essential for preparing accurate accounts and achieving top marks in Paper 3.

Let’s break down the unique elements of limited company accounting!

1. Understanding Company Capital and Financing

The way limited companies raise money is fundamentally different from a sole trader using their personal savings.

1.1 Share Capital: The Owners' Contribution

Share capital represents the permanent funds contributed by the owners (shareholders).

• Ordinary Shares (Equity): These are the core ownership units. Holders have voting rights and are entitled to dividends, but only after all other obligations (like debenture interest) are paid. They take the highest risk but get the highest potential reward.
• Note: The syllabus specifically states that questions will not be set on preference shares. Focus purely on ordinary shares.

1.2 Debt Financing: Debentures

A debenture is essentially a long-term loan certificate issued by the company.

• Key Distinction: Debenture holders are creditors (lenders), not owners. They receive fixed interest payments regardless of company profit.
• They are a non-current liability on the Statement of Financial Position.

Quick Tip: Remember 'D' for Debenture means 'Debt'. Remember 'S' for Share means 'Stake' (ownership).

1.3 Issuing Shares (At Par or At a Premium)

Shares have a nominal value (or par value), which is the minimum legal price they can be issued for (e.g., $1 per share).

When shares are issued, the proceeds can be:

1. At Par: The issue price equals the nominal value (e.g., a $1 share sold for $1).
2. At a Premium: The issue price is higher than the nominal value (e.g., a $1 share sold for $1.50).

The extra $0.50 received is recorded in a special account called the Share Premium account.

Why issue at a premium? Usually because the company is performing well and investors are willing to pay more than the minimum face value.

1.4 Rights Issues vs. Bonus Issues

These are methods used by companies to change their capital structure. Don't worry if this seems tricky at first; the key is remembering the flow of cash and reserves!

Rights Issue of Shares

• Definition: New shares offered for sale to existing shareholders, usually at a discounted price, in proportion to their current holdings.
• Effect: It brings new cash into the company.
• Advantages: Good source of finance for the company; existing shareholders maintain their percentage of ownership.
• Disadvantages: If shareholders cannot afford the new shares, their proportionate ownership is diluted.

Bonus Issue of Shares

• Definition: Issuing free additional shares to existing shareholders, using reserves to increase the paid-up share capital.
• Effect: No cash flow into the company. It's an internal transfer (capitalisation of reserves).
• Analogy: Imagine you have a $10 pizza cut into 4 slices (4 shares). A bonus issue doesn't change the pizza's value ($10), but cuts it into 8 slices (8 shares). Each slice is now worth less, but you have more slices!
• Advantages: Makes shares more affordable and liquid (easier to trade); signals financial strength.
• Disadvantages: Doesn't raise new cash; total value of shareholders' investment remains the same immediately after the issue.
• Syllabus Note: For a bonus issue, you must transfer funds from revenue reserves (Retained Earnings or General Reserve) or the Share Premium account. The revaluation reserve is not to be used.

2. Reserves and Dividends

2.1 The Two Types of Reserves

Reserves are part of the shareholders' equity and represent past profits retained or premiums received. The key division is their legal usability, particularly regarding dividends.

A. Capital Reserves

These reserves are not available for distribution as cash dividends to shareholders (i.e., they are 'locked up'). They generally arise from capital transactions.

• Share Premium: The excess received above the nominal value when shares were issued.
• Revaluation Reserve: Arises when non-current assets are revalued upwards (as per IAS 16).

Did you know? Share premium can be used for things like paying expenses related to issuing new shares, or, crucially, funding a bonus issue.

B. Revenue Reserves (Distributable Reserves)

These reserves are derived from accumulated trading profits and are available for paying dividends.

• Retained Earnings (or Accumulated Profit): The cumulative profit earned by the company less any dividends paid out. This is the main reserve used to pay future dividends.
• General Reserve: An amount of profit voluntarily set aside by the directors for general business purposes (e.g., future expansion). Since it comes from profit, it is still a revenue reserve.

2.2 Dividends

A dividend is a distribution of profits to shareholders. Dividends are decided by the directors and approved by shareholders.

• Interim Dividend: Paid during the financial year, usually based on expected profits.
• Final Dividend: Paid after the Statement of Profit or Loss is finalised for the year.
• Accounting Treatment: Dividends are deducted from the Retained Earnings (Revenue Reserve) in the Statement of Changes in Equity.

3. Preparation of Limited Company Financial Statements (3.1.5)

Limited companies must prepare a complete set of financial statements that comply with relevant International Accounting Standards (IAS).

3.1 Statement of Profit or Loss (SOPL)

The SOPL for a limited company looks very similar to a sole trader's, but the bottom section—the Appropriation section—is unique.

The SOPL ends with Profit for the year (or Profit after interest and tax). This figure is then transferred to the Statement of Changes in Equity (SOCIE) as an increase to Retained Earnings.

Structure Focus:

• Revenue
• Less: Cost of Sales
• = Gross Profit
• Less: Operating Expenses
• = Profit from Operations (Crucial figure for ROCE calculation!)
• Less: Debenture Interest (Finance Costs)
• = Profit before Tax
• Less: Tax Expense
• = Profit for the year

3.2 Statement of Financial Position (SOFP)

The SOFP structure follows the standard format (Assets = Equity + Liabilities), but the Equity section must show the detailed breakdown of capital and reserves.

The Equity Section Must Include:

• Share Capital (Nominal value of issued shares)
• Reserves (Share Premium, General Reserve, Retained Earnings)

This section clearly shows the legal distinction between the funds provided by owners (Share Capital and Reserves) and the funds provided by external lenders (Non-Current Liabilities like Debentures).

3.3 Statement of Changes in Equity (SOCIE)

The SOCIE is essential for limited companies. It acts as a bridge, linking the SOPL (Profit for the year) to the SOFP (closing balances of Share Capital and Reserves).

It shows every movement in the equity accounts during the year, including:

• Opening balances
• Profit for the year (from SOPL)
• Bonus Issues (transfer from reserves to share capital)
• Rights Issues (new cash received increases share capital/premium)
• Dividends paid (deducted from Retained Earnings)
• Closing balances (transferred to SOFP)

3.4 Statement of Cash Flows (SOCF) and Schedule of Non-Current Assets

You are required to understand that a complete set of limited company financial statements also includes:

• Statement of Cash Flows (SOCF): Shows the movement of cash under three headings (Operating, Investing, Financing activities). (Linked to IAS 7)
• Schedule of Non-Current Assets: Provides detailed movements (cost, accumulated depreciation, net book value) for non-current assets during the period, especially for additions, disposals, and revaluations. (Linked to IAS 16)

4. Accounting Treatment: Ledger Entries

The tricky part is often the double entry needed to record share issues and related transactions.

4.1 Issuing Shares at a Premium

A company issues 100,000 ordinary shares (nominal value $1.00) for $1.50 each.

Step 1: Cash received (100,000 x $1.50 = $150,000)

Debit Bank Account $150,000

Step 2: Record the nominal value (100,000 x $1.00 = $100,000)

Credit Ordinary Share Capital Account $100,000

Step 3: Record the premium (100,000 x $0.50 = $50,000)

Credit Share Premium Account $50,000

4.2 Bonus Issue of Shares (Using Reserves)

A company decides to make a 1 for 4 bonus issue (i.e., for every 4 shares held, 1 free share is issued). The shares have a nominal value of $1.00. The company needs to issue 50,000 shares, totalling $50,000. It will use the Share Premium account first.

Step 1: Capitalise the required amount from a suitable reserve.

Debit Share Premium Account $50,000

Step 2: Increase the share capital.

Credit Ordinary Share Capital Account $50,000

(Remember: If the Share Premium account wasn't large enough, you would take the remainder from Retained Earnings or General Reserve.)

4.3 Recording Dividends

The company proposes a final dividend of $25,000.

When declared:

Debit Retained Earnings $25,000

Credit Payable/Accrued Dividends $25,000 (A current liability)

When paid:

Debit Payable/Accrued Dividends $25,000

Credit Bank Account $25,000