Limited Companies (Copy)

Chapter 21: An Introduction to Limited Company Accounts

Introduction to Limited Companies

• A limited company is a business entity separate from its owners (shareholders).
• It offers limited liability, meaning shareholders are not personally liable for company debts beyond their investment.
• Companies can raise capital by issuing shares and can be either private limited companies (Ltd) or public limited companies (PLC).
• Governed by company laws such as the UK Companies Act 2006 and International Accounting Standards (IAS 1).

21.1 Characteristics of Limited Companies

1. Separate Legal Entity

• The company exists independently from its owners.
• It can own assets, enter contracts, and sue/be sued in its name.

2. Limited Liability

• Shareholders’ financial risk is limited to the amount invested in shares.
• If a company fails, personal assets of shareholders are protected.

3. Share Capital and Shareholders

• Companies issue ordinary shares (equity ownership) and preference shares (fixed dividends).
• Shareholders elect directors to manage the company.

4. Taxation

• Companies pay corporation tax on profits instead of income tax.
• Shareholders pay tax on dividends received.

5. Raising Capital

• Private companies raise funds from shareholders.
• Public companies can issue shares on the stock exchange.

21.2 Formation of Limited Companies

Documents Required for Company Formation

1. Memorandum of Association – Defines the company’s purpose and scope.
2. Articles of Association – Sets internal regulations for management and governance.
3. Certificate of Incorporation – Issued by the Registrar of Companies, confirming legal existence.
4. Prospectus (for PLCs only) – Invitation for public investment.

Public vs. Private Companies

• Private Limited Companies (Ltd):
  • Cannot sell shares to the public.
  • Fewer regulatory requirements.
• Public Limited Companies (PLC):
  • Can sell shares to the public via the stock exchange.
  • Must have a minimum share capital.
  • Subject to stricter regulations and reporting.

21.3 The Role of Shareholders and Directors

• Shareholders own the company but do not manage day-to-day affairs.
• Directors are appointed to make decisions and act as stewards of shareholder investment.
• Annual General Meetings (AGMs) allow shareholders to:
  • Approve financial statements.
  • Vote on dividends.
  • Elect or remove directors.

21.4 Share Capital and Reserves

Types of Shares:

• Ordinary Shares:
  • Holders are entitled to dividends based on company profits.
  • Have voting rights in company decisions.
• Preference Shares:
  • Fixed dividend payments before ordinary shareholders.
  • Usually no voting rights.

Reserves in Company Accounts:

• Share Premium Reserve: Created when shares are issued at a price above their nominal value.
• Revaluation Reserve: Arises from an increase in the value of non-current assets.
• Retained Earnings: Accumulated profits not distributed as dividends.

21.5 Debentures and Other Borrowing Methods

• Debentures: Long-term loans secured by company assets.
  • Fixed interest payments to debenture holders.
  • Unlike shares, debentures do not dilute ownership.
• Bank Loans: Fixed-term borrowing, often with interest.
• Leasing: Acquiring assets without upfront purchase.

21.6 Statement of Profit or Loss (Income Statement) for Limited Companies

• Companies must prepare financial statements in accordance with IAS 1.
• The format of a Statement of Profit or Loss includes:

  Revenue
  - Cost of Sales
  ----------------
  Gross Profit
  - Operating Expenses (Administration & Distribution Costs)
  ----------------
  Operating Profit
  - Finance Costs (e.g., loan interest)
  ----------------
  Profit Before Tax
  - Taxation (Corporation Tax)
  ----------------
  Net Profit (Profit for the Year)
  - Dividends Paid
  ----------------
  Retained Earnings
  

• Example Calculation:
  • Revenue = $500,000
  • Cost of Sales = $250,000
  • Operating Expenses = $80,000
  • Finance Costs = $20,000
  • Tax = $30,000
  • Net Profit:

    500,000 - 250,000 - 80,000 - 20,000 - 30,000 = $120,000
    

21.7 Statement of Financial Position (Balance Sheet)

• Summarizes company assets, liabilities, and equity at year-end.
• Format:

  ASSETS:
    Non-current Assets (Property, Equipment, Intangibles)
    Current Assets (Inventory, Receivables, Cash)
  LIABILITIES:
    Current Liabilities (Payables, Short-term Loans)
    Non-current Liabilities (Debentures, Long-term Loans)
  EQUITY:
    Share Capital
    Reserves (Share Premium, Revaluation, Retained Earnings)
  

• Example Figures:
  • Assets = $800,000 (Non-current: $600,000, Current: $200,000)
  • Liabilities = $300,000 (Current: $100,000, Non-current: $200,000)
  • Equity Calculation:

    800,000 - 300,000 = $500,000 (Share Capital + Reserves)
    

21.8 Differences Between Partnerships and Limited Companies

21.9 Regulatory and Compliance Requirements

• Companies must comply with IAS 1 for financial reporting.
• Large companies require external audits.
• Companies Act 2006 (UK) governs corporate structure and reporting.

Conclusion

• Limited companies provide limited liability and easier access to capital.
• Financial reporting is standardized under IAS 1.
• Shareholders invest for dividends and capital appreciation.
• The Statement of Profit or Loss and Statement of Financial Position are key financial documents.
• Compliance with company laws and accounting standards ensures transparency and accountability.

Chapter 22: Limited Companies – Further Considerations

Introduction to Further Considerations in Limited Companies

• This chapter expands on limited companies’ financial concepts, particularly share issues, reserves, debentures, and dividend policies.
• Limited companies raise capital through shares, maintain reserves, and manage long-term liabilities like debentures.
• Companies must comply with International Accounting Standards (IAS 1, IAS 37) to ensure accurate financial reporting.

22.1 Bonus and Rights Issues of Shares

Bonus Issue

• Also known as a capitalization issue.
• New shares are issued free of charge to existing shareholders, using reserves.
• Purpose:
  • Increases total share capital without raising cash.
  • Enhances market perception without affecting shareholding percentages.
• Example:
  • A company with 1,000,000 shares issues a 1-for-5 bonus issue.
  • New shares issued:

    1,000,000 / 5 = 200,000 shares
    

  • Total shares after issue:

    1,000,000 + 200,000 = 1,200,000 shares
    

• Journal Entry:

  Debit: Retained Earnings (or Share Premium) 200,000
  Credit: Share Capital 200,000
  

Rights Issue

• Existing shareholders can buy additional shares at a discount.
• Purpose:
  • Raises cash for expansion.
  • Maintains shareholder ownership ratios.
• Example:
  • A company offers a 1-for-4 rights issue at $5 per share.
  • Shareholder owns 800 shares; they can buy 200 new shares at $5 each.
• Journal Entry:

  Debit: Bank (Cash Received) 1,000
  Credit: Share Capital 1,000
  

22.2 Share Premium and Reserves

• Share Premium: Arises when shares are issued above par value.
• Revaluation Reserve: Records gains when assets appreciate in value.
• Retained Earnings: Accumulated profits available for reinvestment or dividends.
• Journal Entry for Share Premium:

  Debit: Bank 10,000
  Credit: Share Capital (at Par) 5,000
  Credit: Share Premium 5,000
  

22.3 Debentures and Loan Capital

• Debentures: Long-term loans secured against company assets.
• Types:
  • Redeemable Debentures: Repaid on a fixed date.
  • Irredeemable Debentures: No fixed repayment date.
  • Convertible Debentures: Can be converted into shares.
• Journal Entry for Issuing Debentures:

  Debit: Bank 50,000
  Credit: Debentures Payable 50,000
  

• Interest on Debentures: Treated as a finance cost in the Statement of Profit or Loss.

  Debit: Interest Expense 4,000
  Credit: Bank 4,000
  

22.4 Dividend Policies

• Interim Dividends: Paid before finalizing annual accounts.
• Final Dividends: Declared at the end of the financial year.
• Example Calculation:
  • If a company declares a dividend of $0.30 per share for 1,500,000 shares:

    1,500,000 × 0.30 = $450,000
    

• Journal Entry for Declaring Dividend:

  Debit: Retained Earnings 450,000
  Credit: Dividends Payable 450,000
  

• Journal Entry for Paying Dividend:

  Debit: Dividends Payable 450,000
  Credit: Bank 450,000
  

22.5 Provisions and Liabilities

• Liabilities: Amounts a company must pay, including trade payables and loans.
• Provisions: Amounts set aside for future obligations (e.g., bad debts, warranties).
• IAS 37 Guidelines:
  • Recognize provisions when:
    1. A legal or constructive obligation exists.
    2. A probable outflow of resources is required.
    3. The amount can be estimated reliably.
• Example of Warranty Provision:
  • Expected warranty claims: $15,000
  • Journal Entry:

    Debit: Warranty Expense 15,000
    Credit: Provision for Warranty 15,000
    

22.6 Statement of Changes in Equity

• Shows movements in share capital, reserves, and retained earnings.
• Format:

  Share Capital | Share Premium | Retained Earnings | Revaluation Reserve | Total Equity
  ---------------------------------------------------------------------------------
  Opening Balance  500,000  50,000  200,000  20,000  770,000
  Bonus Issue       50,000 (50,000) - - -
  Net Profit            - - 100,000 - 100,000
  Dividend Paid       - - (40,000) - (40,000)
  Closing Balance  550,000  0  260,000  20,000  830,000
  

22.7 Other Sources of Finance for Limited Companies

• Bank Loans: Fixed-term borrowing, usually with interest.
• Leasing: Renting assets instead of buying.
• Trade Payables: Short-term credit from suppliers.

22.8 Financial Reporting Standards and Compliance

• IAS 1: Guidelines on presenting financial statements.
• IAS 37: Rules for recognizing provisions and liabilities.
• Company Law Compliance: Ensures transparency in reporting.

Conclusion

• Limited companies must carefully manage shares, reserves, liabilities, and financing.
• Bonus and rights issues impact share capital and ownership structure.
• Debentures provide long-term financing but increase financial obligations.
• Dividend policies affect cash flow and shareholder satisfaction.
• Adhering to accounting standards ensures accurate financial reporting and compliance with regulations.