Accounting (0452) | Limited companies

Welcome to Limited Companies!

Hello future Accountants! You've successfully mastered sole traders and partnerships. Now, we move on to the biggest type of business: the Limited Company (sometimes called a Corporation).

This chapter is about understanding what makes these companies different and how their financial statements (especially the Owners' Equity section) are structured. Don't worry, the core accounting principles you learned (like calculating profit) still apply!

1. Understanding Limited Companies

1.1 What is a Limited Company?

A limited company is a large business organization recognized by law as being a separate legal entity from its owners (the shareholders).

Think of it this way: The business wears its own mask and coat; it can sue, be sued, own assets, and owe debts in its own name.

1.2 The Power of Limited Liability (A Key Concept)

This is perhaps the most important difference between a limited company and a sole trader or partnership.

Definition: Limited Liability means that the maximum amount a shareholder can lose if the company goes bankrupt is the amount they invested (or promised to invest) in buying the shares. Their personal assets (like their house or car) are safe.

Analogy: Limited liability is like a safety shield. If the company debt collectors come knocking, the shield protects the personal wealth of the owners. For sole traders, there is no shield.

Key Term: The owners of a limited company are called shareholders.

1.3 Advantages and Disadvantages

Limited companies are popular because they offer significant benefits, but they also come with drawbacks.

Advantages of a Limited Company

• Limited Liability: Protects the personal assets of the shareholders (owners). This makes it easier to convince people to invest.
• Easier to Raise Capital: Companies can sell more shares to the public or private investors, allowing them to raise huge amounts of money.
• Continuity of Existence: The company continues to exist even if shareholders die or change hands.
• Expert Management: Owners (shareholders) can hire professional managers to run the business.

Disadvantages of a Limited Company

• Legal Formalities: They are expensive and time-consuming to set up, requiring lots of paperwork and legal compliance.
• Public Disclosure: The law often requires them to publish their financial statements, meaning competitors and the public can see their performance (less privacy).
• Taxation: They are usually subject to company tax (corporate tax), which can be complex.
• Separation of Ownership and Control: Conflicts can arise between the shareholders (owners) and the hired managers (control).

2. The Financial Structure: Equity and Capital

In a sole trader business, the owner's investment is simply called Capital. In a limited company, the structure is more detailed and is referred to as Equity.

2.1 Understanding Equity

Definition: Equity (also called Shareholders' Equity) is the total residual interest of the owners in the assets of the company after deducting all its liabilities. It represents the claim of the shareholders on the business.

2.2 Components of the Capital Structure

The syllabus requires you to understand the specific components that make up the equity of a limited company. These fall into two main categories: Share Capital and Reserves.

(A) Share Capital (Money originally invested)

This is the amount of money raised by issuing shares to the public. There are two types you need to know:

• Ordinary Share Capital: These shares represent the true ownership of the company. Ordinary shareholders have voting rights and receive dividends (a share of the profits) that fluctuate depending on how well the company performs.
• Preference Share Capital: These shareholders usually do not have voting rights, but they receive a fixed dividend rate *before* ordinary shareholders are paid. They have a "preference" in receiving their payout.

(B) Reserves (Profits kept by the company)

These are profits that the company has earned over time and decided to keep within the business instead of paying out as dividends.

• Retained Earnings: This is the accumulated profit that has been kept and reinvested in the business over its lifetime, after dividends have been paid out. This often changes every year based on the current year's profit.
• General Reserve: This is an amount transferred from Retained Earnings, set aside for general future use, such as expanding the business or covering unexpected losses. This transfer is a decision made by the directors.

Analogy: If Retained Earnings is your checking account (where the recent profit lands), the General Reserve is your savings account (set aside for big goals).

2.3 Distinguishing Share Capital and Loan Capital

It is vital to distinguish between money provided by owners (equity) and money provided by lenders (liabilities).

• Share Capital: Represents ownership (Equity). Shareholders own a piece of the company.
• Loan Capital (Debentures): Represents a non-current liability (debt). A debenture is essentially a long-term loan certificate issued by the company. Debenture holders are creditors (lenders), not owners. They receive fixed interest payments, regardless of company profit.

Mnemonic Trick: Shares = Shareholders = Owners. Debentures = Debt = Creditors.

3. Detailed Understanding of Share Issuance

When a company decides to sell shares, the process involves several stages which lead to different terms for the share capital amount.

Don't worry if this seems tricky at first—just focus on who has agreed to pay what.

A company's share capital is often stated in terms of value (e.g., $1 shares). We focus on the amount of capital actually generated.

• Issued Share Capital: This is the total value of shares the company has offered and sold to shareholders. This is the amount that legally constitutes the share capital shown in the Statement of Financial Position.
• Called-up Share Capital: This is the portion of the issued share capital that the company has formally requested (called upon) the shareholders to pay. (Sometimes companies don't demand full payment right away).
• Paid-up Share Capital: This is the amount that the shareholders have *actually paid* to the company. This may be less than the Called-up capital if some shareholders haven't paid their dues yet.

Example: A company issues 100,000 shares at $1 each (Issued Capital = $100,000). They decide to ask shareholders only for $0.80 per share now (Called-up Capital = $80,000). But one shareholder skips payment on 1,000 shares ($800). The Paid-up Capital is $79,200.

For IGCSE purposes, the total amount you use in the Statement of Financial Position Equity section is usually the Issued Share Capital, assuming it has been called and paid up. If a question specifies the amounts are different, you must use the Paid-up Capital as the true investment.

4. Preparing Financial Statements for Limited Companies

The goal of preparing financial statements is the same as for sole traders: determine profit and show the financial position. However, the presentation of the final profit allocation and the equity section changes drastically.

4.1 The Income Statement

The top half of the Income Statement (calculating Gross Profit and Profit from Operations) is identical to a sole trader.

The key difference comes after calculating the Profit for the Year:

• A limited company must first deduct debenture interest (if applicable) and corporate tax (though complex tax calculations are usually excluded at IGCSE level, you must know that interest is paid before owners receive dividends).
• The remaining profit is then dealt with in the Statement of Changes in Equity (see below).

Remember: All standard adjustments (depreciation, accruals, irrecoverable debts, etc., as learned in 5.1) are still necessary before calculating the final profit figure.

4.2 Statement of Changes in Equity

Since a company has multiple parts to its equity (Ordinary Shares, Preference Shares, General Reserve, Retained Earnings), we need a statement to track how these amounts change during the year. This statement replaces the "Appropriation Account" structure used for partnerships.

This statement tracks the allocation of the Profit for the Year.

How the Profit is Distributed:

1. Start with Profit for the Year.
2. Add: Opening balance of Retained Earnings.
3. Deduct: Transfer to General Reserve (A decision to save for future).
4. Deduct: Proposed/Paid Dividends (The payments to shareholders).
   • First, deduct preference dividends (must be paid).
   • Second, deduct ordinary dividends.
5. The remaining balance is the Closing Retained Earnings, which is carried forward to the Statement of Financial Position.

In summary, the Statement of Changes in Equity shows:

\( \text{Opening Retained Earnings} + \text{Profit for the Year} - \text{Dividends} - \text{Transfer to Reserves} = \text{Closing Retained Earnings} \)

4.3 Statement of Financial Position (SFP)

The structure of the SFP remains mostly the same (Non-Current Assets, Current Assets, Current Liabilities, etc.).

The crucial difference is in the Non-Current Liabilities and Equity sections.

Equity Section Layout (Simplified)

The total equity now looks like this:

• Share Capital:
  • Ordinary Share Capital (Issued and Paid-up)
  • Preference Share Capital (Issued and Paid-up)
• Reserves:
  • General Reserve (The total accumulated set-aside fund)
  • Retained Earnings (The closing balance from the Statement of Changes in Equity)

Non-Current Liabilities Section

This is where Loan Capital (Debentures) will appear, as it is a long-term debt owed to external creditors, not an ownership stake.

Remember: The fundamental accounting equation still holds:
\( \text{Assets} = \text{Equity} + \text{Liabilities} \)