Accounting | Limited companies

Welcome to the World of Limited Companies!

Hello future accountants! This chapter takes us away from sole traders and partnerships and introduces the powerful structure of the Limited Company. This is the foundation of Corporate Accounting, and understanding how companies raise money and structure their capital is absolutely crucial for the Statement of Financial Position (SFP).

Don’t worry if the terminology seems heavy; we’ll break down concepts like 'Share Premium' and 'Authorized Capital' step-by-step using simple language and helpful analogies. By the end, you will be able to confidently account for share issues and present the Equity section of a company’s SFP.

1. What is a Limited Company? (The Basics)

The Concept of Separate Legal Personality

Unlike a sole trader, a limited company is treated as a person in the eyes of the law. This is called Separate Legal Entity (or Personality).

• It can own assets, owe money, sue, and be sued, all in its own name, separate from its owners (shareholders).

Limited Liability – The Safety Shield

The most important feature is Limited Liability.

• If the company incurs massive debts, the personal assets of the owners (shareholders) are protected.
• The shareholders are only liable for the amount they initially invested in purchasing shares. They cannot lose more than that amount.

Analogy: Think of limited liability as a safety shield. If the company car crashes (gets into financial trouble), the shield protects the driver (shareholder) from having to use their personal house or savings to pay the damages (company debts).

Types of Limited Companies (A Quick Look)

Limited companies are broadly divided into two types:

a) Private Limited Company (Ltd)

Their shares are not offered to the general public. They are usually smaller or family-run businesses. They must include 'Ltd' after their name.

b) Public Limited Company (PLC)

Their shares can be bought and sold by the general public on the Stock Exchange. They are usually much larger and must include 'PLC' after their name.

2. Share Capital: The Building Blocks

A limited company raises its initial capital by issuing Shares. Share Capital is therefore the ownership interest in the company.

Definitions of Capital Amounts (Jargon Buster!)

These terms describe the total value of shares the company deals with:

a) Authorized Share Capital (Nominal Capital)

This is the maximum number of shares the company is legally allowed to issue, as stated in its foundational documents.

Did you know? A company does not have to issue all its authorised capital at once.

b) Issued Share Capital

This is the portion of the Authorized Capital that has actually been sold to and paid for by the shareholders. This is the figure that appears in the SFP.

c) Unissued Share Capital

The difference between Authorized Capital and Issued Capital (shares available but not yet sold).

The golden rule for the SFP: We only record the value of the Issued Share Capital.

Types of Shares

a) Ordinary Shares (Equity Shares)

These are the most common.

• Voting Rights: Usually carry voting rights, giving shareholders control.
• Dividend Risk: Dividends (share of profit) are variable and only paid if the company makes enough profit. They are paid after preference shareholders.
• Risk/Reward: They carry the highest risk but potentially the highest reward.

b) Preference Shares

These offer some priority, usually regarding dividends.

• Fixed Dividend: They usually receive a fixed percentage dividend payout every year, regardless of how high the profits are.
• Priority: If the company is liquidated, they receive their money back before ordinary shareholders.
• Voting: Often do not carry voting rights.

Memory Aid: Think of Preference shares as having Priority for receiving dividends.

3. Share Premium Reserve (A Special Reserve)

Issuing Shares at a Premium

The Nominal Value (or par value) is the minimum legal price assigned to a share (e.g., $1 per share). If a company is successful and its shares are in high demand, it can sell them for more than their nominal value.

When a share is sold for a price higher than its nominal value, the extra amount is called the Share Premium.

Example: A company issues 1 share with a nominal value of $1.00, but sells it for $1.50.
Total cash received: $1.50
Nominal Value: $1.00 (This goes to Share Capital account)
Share Premium: $0.50 (This goes to the Share Premium Reserve account)

Nature of the Share Premium Reserve

The Share Premium is not considered normal trading profit. It is a Capital Reserve.

• It is used to boost the company’s capital base.
• Crucial Point: It is generally not distributable, meaning it cannot be used to pay dividends to shareholders.

4. Accounting for Share Issues (The Journal Entries)

When shares are issued, the process involves the movement of cash and recording the capital structure change.

Step-by-Step Accounting Process

Let’s assume a company issues 10,000 Ordinary Shares (Nominal Value $1.00) at a price of $1.20 each.

Total Cash received: 10,000 shares * $1.20 = $12,000

Step 1: Record the Receipt of Cash (Application/Allotment Money)

The company receives the cash from the applicants.

\( \begin{array}{lcc} \text{DR Bank} & & 12,000 \\ \text{CR Share Application/Allotment Account} & & 12,000 \\ \end{array} \)

(To record cash received for the share issue)

Step 2: Allotment and Transfer to Capital and Premium Accounts

We now close the temporary Application account and allocate the funds to the permanent capital accounts. Remember, the $1.20 must be split: $1.00 to Capital, $0.20 to Premium.

\( \begin{array}{lcc} \text{DR Share Application/Allotment Account} & 12,000 & \\ \text{CR Ordinary Share Capital (10,000 \times \$1.00)} & & 10,000 \\ \text{CR Share Premium Reserve (10,000 \times \$0.20)} & & 2,000 \\ \end{array} \)

(To record the allotment of shares and premium)

5. Dividends (Sharing the Profit)

Dividends are payments made by a company to its shareholders out of its accumulated profits (Retained Earnings).

Types of Dividends

a) Interim Dividends

Paid during the financial year, usually based on an estimate of profit for the first half of the year.

b) Final Dividends

Declared and paid after the financial year-end when the actual profit for the year is known and approved by the shareholders.

Accounting for Dividends

The process involves two main stages: declaration (when the liability is created) and payment (when the cash leaves the bank).

Step 1: Declaration (Creating the Liability)

When the directors declare the dividend, the Retained Earnings (Profit and Loss account) decrease, and a liability (Payable account) is created.

\( \begin{array}{lcc} \text{DR Retained Earnings (or P&L Appropriation)} & \text{X} & \\ \text{CR Dividend Payable} & & \text{X} \\ \end{array} \)

(To record the declaration of dividends)

Step 2: Payment (Settling the Liability)

When the company pays the shareholders, the liability is cancelled, and cash decreases.

\( \begin{array}{lcc} \text{DR Dividend Payable} & \text{X} & \\ \text{CR Bank} & & \text{X} \\ \end{array} \)

(To record the payment of dividends)

6. Presentation in the Statement of Financial Position (SFP)

The Equity and Reserves section of the SFP for a limited company is structured differently from a partnership or sole trader, reflecting the different sources of capital.

The Equity Section Structure

The total Equity is the sum of Share Capital and all Reserves. This section is usually presented just before Liabilities in the SFP.

1. Share Capital: This is the total value of shares issued (recorded at nominal value).

2. Reserves: These represent accumulated funds.

Remember, the SFP must clearly detail the different classes of shares (ordinary, preference) and their nominal values.

Encouraging thought: Understanding the breakdown of Share Capital and Reserves is often considered the trickiest part of corporate accounting. If you've grasped the difference between nominal value and premium, you've done brilliantly! Keep practicing those ledger entries.