Chapter 8: Debt Finance & Business Accounts Flashcards

Question

The format of a profit and loss account

Answer 1

There are standard formats for presenting the layout of the profit and loss account and all profit and loss accounts for UK businesses follow a similar structure. Please note that you may see the profit and loss account referred to as an 'income statement' in the accounts of businesses prepared according to international accounting standards. You can now consider the example profit and loss account below.

Answer 2

Storage rentals income 388,00 (Column 1) Refrigeration sales income 57,00 (Column 1) Transport charges income 158,00 (Column 1) Total income 553,000 (Column 2) Opening stock 3,000 (Column 1) Purchases 56,000 (Column 1) Total 59,000 (Column 1) Less Closing stock (4,000) Cost of Sales (55,000) (Column 2) Gross Profit 498,000 (Column 2)

Answer 3

Expense: Wages 119,800 (Column 1) · Business Rates 29.100 (Column 1) · Electricity 76,900 (Column 1) · Transport costs 43,300 (Column 1) · Repairs 20,300 (Column 1) · Postage 2,800 (Column 1) · Telephone 10,800 (Column 1) · Stationery 2,000 (Column 1) · Insurance premiums 7,300 (Column 1) · Depreciation: Buildings 2,000 (Column 1) · Plant 17,190 (Column 1) · Motor vehicles 13,900 (Column 1) · Accountants' fees 20,000 (Column 1) · Legal fees 15,000 (Column 1) · Interest on loan 7,600 (Column 1) · Bad and doubtful debts 6,900 (Column 1) · Sundry expenses 9,200 (Column 1) Total expenses (404.090) (Column 2) Net Profit 93,910 (Column 2)

Answer 4

* The profit and loss account essentially records the income of a business throughout an accounting period minus expenses incurred in that period, to arrive at a profit (or a loss) figure for the period. * All income entries from the trial balance are put at the top of the profit and loss account. * The 'cost of sales' figure in the profit and loss account is calculated using figures for 'opening stock' and 'closing stock'. These are both asset accounts, so these two accounts are exceptions to the general rule that a profit and loss account shows only income and expense accounts. * The 'gross profit' calculation represents all the income of the business less the 'cost of sales'. * Towards the end of the profit and loss account, all of the expenses of the business excluding purchases are deducted from the 'gross profit'. * At the end of the profit and loss account is the 'net profit'.

Answer 5

You will recall that the profit and loss account and the balance sheet are the year-end financial statements prepared by a business. On its own, a profit and loss account (covered in a previous element) is an incomplete record of a business’s financial position as it only records two categories of account (income and expenses accounts). For this reason, a balance sheet will record the position of a business in respect of its asset, liability and capital accounts from the trial balance.

Answer 6

The balance sheet of a business differs from a profit and loss account as it is a snapshot relevant on a given date (unlike the profit and loss account which relates to a period, which in most cases is a year). The date at the top of a balance sheet is the last day of the accounting period to which it relates. The heading of a balance sheet always contains the words 'as at' a specified date. For example, it will record the value of the total assets held by the business at that date. That balance could be different the very next day, for example, if an asset were sold and the proceeds used to pay bills.

Answer 7

The balance sheet principally tells the reader two key things: * The net worth or net asset value (NAV) of the particular business (ie the value of the assets it has, less the liabilities it owes). This is recorded in the top half of the balance sheet. * The capital invested in the business to achieve that net worth. This is recorded in the bottom half of the balance sheet.

Answer 8

These two figures (one in each half of the balance sheet) will always be the same, unless something has gone wrong. The two halves of the balance sheet must always balance. This balancing effect is because the top half of the balance sheet demonstrates how the money invested by the owners of the business (shown in the bottom half of the balance sheet) has been used.

Answer 9

As a general rule, asset, liability and capital entries from the trial balance are transferred into the balance sheet. For example, 'debtors/receivables' in a trial balance is an asset entry and this appears in the top half of the balance sheet. However, 'capital at the start of the year' is a capital entry and appears in the bottom half of the balance sheet.

Answer 10

There are standard formats for presenting this information on a balance sheet. The example balance sheet which follows explains the basics of how a balance sheet is put together. You do not need to worry about understanding each individual of a balance sheet, instead, you should focus on the fact that there are three different sections and briefly note what they consist of.

Answer 11

* Asset, liability and capital entries from the trial balance are transferred into the balance sheet. The balance sheet is a snapshot relevant only on the given date. * The net asset value (NAV) of the business is recorded in the top part of the balance sheet. * Assets are categorised as either fixed assets or current assets on the balance sheet. * The net book value takes into account the depreciation of fixed/non current assets over time.

Answer 12

* The liabilities of the business are categorised as either current or long term/non-current. * The net current assets of a business = current assets - current liabilities. * Fixed assets (net book value) + net current assets – long term/non current liabilities = NAV. * The amount of capital invested in the business is recorded in the bottom part of the balance sheet. * The NAV and total capital figures must always be the same in order for the balance sheet to effectively balance and demonstrate how the capital invested in the business has been used.

Answer 13

Year-end adjustments are transactions or modifications to the account entries on the trial balance. They are needed in order to apply the accruals/matching concept to the preparation of financial statements. This concept requires that: * all income and expenditure must be 'matched' to the relevant accounting period; and * all current obligations must be anticipated as liabilities and all asset values must be assessed to make sure they can be recovered through future profits in conditions of uncertainty.

Answer 14

There are five year-end adjustments: - Depreciation -Accruals -Prepayments -Bad debts -Doubtful debts. In this element you will consider DEPRECIATION.

Answer 15

A fixed asset (which for a company may be referred to as a 'non-current asset') may have a useful life of several years, after which it may be of little or no value.

Answer 16

Depreciation is a mechanism used in the accounts to deal with this decline in value and to spread the cost of the asset over its useful life.

Answer 17

If depreciation were not used, the accounts would not give a true reflection of the position of the business. The assets would be stated at their cost value, which may, over time, be well above their actual value. Depreciation must be carried out in a systematic (ie regular) way but the method used should mirror as closely as possible how the asset loses value over the relevant accounting periods

Answer 18

There are two methods of depreciation: the straight-line method, and the reducing balance method. The method that is chosen will depend not only on how the asset loses value but how it produces revenue for the business on an ongoing basis. An asset such as shelving will use the straight-line method because the asset is being used up consistently over its lifespan and is generating a consistent amount of income.

Answer 19

An asset such as a van, however, will produce much more revenue for the business in its earlier years of use and will tend to lose a larger part of its value at this time and hence the reducing balance method will be more relevant. This amount is known as the 'charge to depreciation' or 'depreciation charge'. The straight-line method the most common and straightforward method, so we will focus on it.

Answer 20

* spreads the depreciation charge evenly over the life of the asset; and * gives rise to the same charge for depreciation each year. This is the most common and straightforward method. The straight-line method is used where the service provided by the asset continues throughout its useful economic life on a consistent basis (eg the shelving unit mentioned earlier). If plotted on a graph, the depreciation of the asset would form a straight line.

Answer 21

* The depreciation charge each year is expressed as a percentage (x %) of the reducing balance (ie the net book value of the asset at the start of the relevant accounting period). * More depreciation is thus charged in earlier years than in later years since the net book value of the asset reduces year on year. This method is less common and slightly more complicated. The reducing balance would be used where an asset is likely to lose a large part of its value in the first few years of ownership eg motor vehicles. If plotted on a graph the depreciation of the asset would form a curved line.

Answer 22

Marleys Department Store buys some shelving for its warehouse, costing £6,000. The shelving is expected to last for 5 years. The cost will be spread evenly over the five-year period. A depreciation charge of £1,200 (ie £6,000 ¸ 5) will be made each year. This annual depreciation charge will 'accumulate' over the years. In year one, the accumulated charge will be £1,200, year two £2,400, year three £3,600 etc.

Answer 23

The charge each year (ie £1,200 in the Marleys example) will be included in a depreciation account as the loss in value of the shelving constitutes a ‘cost’ to the business and will be shown on the Profit and Loss Account as an expense. The accumulated depreciation will be included in an accumulated depreciation account (liability account) thereby reducing the net book value of the asset and will be shown on the Balance Sheet. In the Marleys example, the accumulated depreciation after Year 3 will be £3,600.

Answer 24

First Response Plumbers buys a van for £12,000 for use in the business. The van will be depreciated at a rate of 20% of the reducing balance each year. At the end of Year 1, a depreciation charge of £2,400 (i.e. 20% of £12,000) will be made. This will be shown as an expense on the Profit and Loss Account for that year. It will also appear as a liability on the Balance Sheet, set off against the purchase (or cost) value of the van.

Answer 25

At the end of Year 2, the depreciation charge will be calculated as follows: the accumulated depreciation for the previous year (£2,400) is deducted from the cost of the asset in the trial balance.In this case the calculation will be £12,000 - £2,400 = £9,600.This figure of £9,600 is the reduced balance. The depreciation charge for Year 2 is calculated by applying the depreciation rate (20%) to the reduced balance (£9,600). This gives a depreciation charge for Year 2 of £1,920. This will be shown as an expense on the Profit and Loss Account for the second year. The accumulated charge at the end of Year 2 is £4,320 (£2,400 + £1,920) and this appears on the Balance Sheet as a liability

Answer 26

At the end of Year 3, a depreciation charge of £1,536 (i.e. 20% of (£12,000 - £4,320) will be made. This will be shown as an expense on the Profit and Loss Account for Year 3. The Balance Sheet as at the end of Year 3 will show accumulated depreciation of £5,856.

Answer 27

As you have seen, the fixed (or non-current) assets are recorded at the top of the Balance Sheet. The original cost of the asset is shown, as is the accumulated depreciation relating to that asset. A calculation is then performed to show the current value of the asset after taking into account its loss of value due to depreciation.

Answer 28

COST – ACCUMULATED DEPRECIATION = NET BOOK VALUE

Answer 29

* Year-end adjustments are transactions or modifications to the account entries on the trial balance. * They are needed in order to apply the accruals concept to the preparation of financial statements. * Depreciation is a year end adjustment and can be calculated using two methods: * Straight line, or * Reducing balance * Depreciation is a mechanism used in the accounts to deal with this decline in value and to spread the cost of the asset over its useful life. * The depreciation charge for the year will appear in the profit & loss account as an expense. * The depreciation charge for the year will be added to the (accumulated) provision for depreciation (liability) account, which will appear in the balance sheet.

Answer 30

An accrual arises when an expense has been incurred and should be charged against profit in the current year but for some reason - for example, the business has not received an invoice for the item - by the time the accounts are drawn up, that expense has not been included in the trial balance. An accrual occurs when a business has had the benefit of something in one accounting period but will not pay for it until the next. Making an adjustment in this way complies with the accruals/matching concept referred to above.

Answer 31

If an adjustment is not made for an accrual in these circumstances, then the accounts will not be giving a true reflection of the position of the business for that year. The business will have had the benefit of something but not yet paid for it. Therefore, the profit of the business will be shown as artificially high unless the adjustment is made, and the expense is taken into account in that accounting period.

Answer 32

Panache Beauty Salon ('Panache') has called on the services of its solicitors several times during the year just ended. The preliminary trial balance includes a balance of £27,000 in the Legal Fees account. At the year end, Panache has not yet received a bill of costs for some work done by the solicitors a month ago. The bill is expected to be for £5,000. The trial balance shows that Panache has used £27,000 of legal advice in the accounting year when really it has used £32,000 (ie £27,000 + £5,000) of legal advice. As a result of the adjustment: · The figure of £32,000 (including the £5,000 which Panache has not yet paid for) must be included in the Legal Feesexpense account and shown in the Profit and Loss Account. · The £5,000 which Panache owes must be included as an Accrual current liability account and shown on the Balance Sheet.

Answer 33

A prepayment arises when an expense is paid for in the current year but all or part of the cost should be charged as an expense next year. It occurs when a business has paid for something in advance during one accounting period but does not get the benefit of all or some of what it has paid for until the next. It is, in effect, the opposite of an accrual.

Answer 34

If an adjustment is not made for the prepayment then the accounts will not be giving a true reflection of the position of the business. If the business has paid for something but not yet received the benefit, then the profit of the business will be artificially low. Again, this is an example of the accruals concept trying to match the expenditure incurred to the relevant accounting period.

Answer 35

Flitwick Carpentry ('Flitwick') has paid £30,000 rent for its business premises. The rent was paid on 1 October (when the business moved in) for 12 months in advance. Flitwick has an accounting year end of 31 December. The trial balance will show that Flitwick has paid £30,000 of rent in the accounting year. However, Flitwick should only be paying rent in the present accounting period for the three months of October, November and December (ie £7,500, ((£30,000 ¸ 12 months) x 3 months)). The rest of the £30,000 (£22,500) should be accounted for in the next accounting period. The figure of £22,500 is the amount that Flitwick has prepaid in respect of rent.

Answer 36

As a result of the adjustment: · The correct figure of £7,500 must be shown in the Rent expense account on the Profit and Loss Account) instead of £30,000). · The £22,500 (ie the amount of the prepayment) will be shown in a Prepayment current asset account that will be created on the Balance Sheet since the business has yet to enjoy the benefit of the rent already paid for

Answer 37

· Year-end adjustments are transactions or modifications to the account entries on the trial balance. · They are needed in order to apply the accruals/matching concept to the preparation of financial statements. · Accruals occur when a business has had the benefit of something in one accounting period but will not pay for it until the next. · Accruals will appear on the Profit and Loss account as an expense in the appropriate account (eg legal expenses) and it will appear on the balance sheet as a current liability.

Answer 38

· Prepayments occur when a business has paid for something in advance during one accounting period but does not get the benefit of all or some of what it has paid for until the next. · Prepayments will appear in the Profit and Loss account as a reduction in the appropriate expense account (eg rent) and it will appear on the balance sheet as a current asset.

Answer 39

The Receivables or 'debtors' figure shows the amount of money owed to the business and the total of these amounts is shown in the 'Receivables' account. The 'Receivables' entry in the accounts of partnerships and companies is made up of all those who owe money to the company, each of whom are a 'debtor' of the company. This is an asset account because it represents money which the business can look forward to receiving from the people who owe it money hence its title 'Receivables'.

Answer 40

An unfortunate fact of business is that not all debts are paid. This should be taken into account when preparing financial statements. A debt is a 'bad debt' when a business knows with certainty that it is never going to receive it. It might be that the debtor has gone into an insolvency procedure. When this happens, the bad debt or debts are 'written off'. The owner of the business gives up any prospect of collecting the debt and the debt is therefore removed from the 'Receivables' entry in the accounts as it will not be paid.

Answer 41

Bad debts may be written off during the accounting year. If this is the case, there will already be a bad debts expense account in the trial balance. (If no bad debts are written off in a given accounting year, there will be no such account). The business may also need to carry out a further year-end adjustment as other debts may be written off at the end of the accounting year when a review is made of the debts then owed to the business. If it is decided that a further debt needs writing off as a bad debt, but the year-end adjustment is not performed, the accounts will not give a true reflection of the position of the business. Instead, it will seem that the business is expecting more money to be paid to it than is actually the case therefore distorting the financial position.

Answer 42

At the end of its accounting period Woburn Hardware Store ('Woburn') has a balance on its receivables account of £7,000. At year end it is discovered that one of its trade customers has been declared bankrupt. The bankrupt customer owes the store £360. The trial balance will show that £7,000 is owing to Woburn but the store knows that £360 of that will never be paid. The receivables asset account must be reduced to £6,640 (ie £7,000 - £360). The bad debt itself will be shown as part of a 'bad and doubtful debts' expense account. Note: In company accounts this expense account is referred to as 'Impairments'.

Answer 43

A doubtful debt occurs when a business is providing for the possibility that a debt or debts may not be paid. A doubtful debt differs from a bad debt in that the business is not writing off the debt completely. It is just making sure that the accounts accurately reflect the fact that the business may not receive all of the money owed to it. There are two ways of 'being doubtful' about debts:

Answer 44

A business may know that a particular debtor is in trouble financially or is disputing its liability to pay the debt. The debtor may not have entered into an insolvency process or the dispute may be settled on favourable terms and therefore, the owner of the business has not given up hope (so the debt is not a bad one) but the business wants to show that it may not receive the amount owed.

Answer 45

* General doubtful debts: A business may not have any information on a specific debtor but knows that the market generally is not doing well and wants to make a general provision for a certain percentage of its debtors not to pay, e.g. across a sector it is estimated that 5% of its receivables may not be paid.

Answer 46

A business may choose to make a specific or general provision, or a combination of both, to quantify its doubts and express them as an actual figure. This figure will be shown as the balance on an account called 'Provision for Doubtful Debts'. The amount allocated to the provision for doubtful debts account is set afresh at each year-end. It might increase, reduce or stay the same compared with the previous year’s provision. A provision account provides some cushioning for the business. Such an account can be viewed as a mechanism by which the business 'ring-fences' a certain amount of its net asset value, just in case it transpires that the doubtful debts need to be written off.

Answer 47

Its nature, and effect on the Balance Sheet, is most similar to that of a liability account and it is treated as such, because the amount of assets available to the business is reduced by the amount of the provision. Remember that we are discussing accounting procedures: a business will not literally set aside cash in order to make a provision for doubtful debts.

Answer 48

A doubtful debt may, in future, be written off as a bad debt and become a real cost to the business. For this reason, doubtful debts are accounted for in the same expense account in the Profit and Loss Account as bad debts, a 'Bad and Doubtful Debts' expense account. You have seen why the 'bad debts' element of this account should be categorised as an expense. Bad debts represent a cost to the business. Doubtful debts, on the other hand, represent potential costs which the business may (or may not) incur. Therefore, it would be incorrect to show the whole amount of a business' provision for doubtful debts as an expense. Instead, only the increase (if any) in the provision for doubtful debts over the amount of the previous year’s provision is treated as an expense.

Answer 49

Nightingales Fashion Wholesale ('Nightingales') is a new business. In this example, references to 'Years' are to accounting periods of the business. Nightingales' first accounting period is 'Year 1'.

Answer 50

Year 1: At the end of Year 1, Nightingale’s receivables amount to £101,000. Nightingales believes that one of its debtors, Contact Retail Ltd ('Contact'), is on the brink of insolvency. It is unlikely that Contact will pay its outstanding invoice of £1,000. Nightingales makes a specific provision for doubtful debts for this £1,000. In addition, Nightingales decides that, taking into account the general economic conditions in the market, it is likely that 1.5% of the remaining receivables may never be paid. Nightingales therefore wishes to create a general provision of £1,500 for doubtful debts (£100,000 x 1.5% = £1,500). The total Provision for Doubtful Debts at the end of Year 1 is £2,500.

Answer 51

Year 1 Profit and Loss Account: Nightingales is a new business, so the provision for doubtful debts at the start of Year 1 was £0. Therefore, at the end of Year 1 there has been an increase in the provision from £0 to £2,500. The whole of this £2,500 increase is treated as an expense and must be included in the balance of the Bad and Doubtful Debts account in the Profit and Loss Account.

Answer 52

Year 2: When preparing the financial statements for Year 2, Nightingales decides that the total Provision for Doubtful Debts should be £3,000. This represents an increase of £500 from Year 1 (£3,000 - £2,500= £500). Year 2 Profit and Loss Account: It is the increase of £500 that is an expense. By increasing its provision, Nightingales is in effect £500 ‘worse off’ than it was last year. Therefore, £500 is added to the Bad and Doubtful Debts Expense in the Profit and Loss Account.

Answer 53

Year 3: At the end of Year 3, Nightingales decides that trading conditions have improved and therefore the total Provision for Doubtful Debts is to be reduced to £2,000. Year 3 Profit and Loss Account: A decrease in the Provision for Doubtful Debts reduces expenses. It ‘frees up” £1,000 for other purposes. Therefore, when preparing the Profit and Loss Account for Year 3, the Bad and Doubtful Debts expense is reduced by £1,000 (£3,000 - £2,000).

Answer 54

The Provision for Doubtful Debts is treated as a liability on the Balance Sheet. As a matter of presentation, it is shown in a different way from other liabilities and is 'matched' to the asset it most directly affects, the receivables asset account (see example below). This is because the business will wish to show its affairs accurately. It is appropriate to show the actual value of the receivables account but the business will also wish to demonstrate that it is prudently providing for the possibility that some debts may not be paid and allow a reader to see what the figures are. Example, the relevant extract of Nightingales' Balance Sheet for Year 1 would show the Provision for Doubtful Debts as below. [Note: the 'Provision for Doubtful Debts' in the Balance Sheet of a company is referred to as 'Impairments']. £ £ Receivables 101,000 Less Provision for Doubtful Debts (2,500) 98,500

Answer 55

* A bad debt is a debt which a business knows with certainty that it is never going to receive. * Bad debts can be written off during the financial year or at the end of the financial year. * A provision for doubtful debts occurs when a business is providing for the possibility that a debt or debts may not be paid. * A provision for doubtful debts can be specific or general. * Bad debts will appear on the balance sheet by a reduction in the Receivables account and in the P&L account as an expense. * The increase/decrease in the provision for doubtful debts will be shown in the P&L account and they will appear on the balance sheet as a liability (matched to the asset that they reduce ie the receivables).

Answer 56

In general, the accounts of a partnership are very similar to those of a sole trader. The year-end adjustments are the same. The accounts of LLPs and limited partnerships are prepared in a similar way to those of 'ordinary' partnerships. The main differences are in the bottom half of the Balance Sheet (denoting capital). This is because, in a partnership, the business will be owned by at least two different people. To show the capital of a partnership correctly on the Balance Sheet, it is necessary to take an additional, intermediate step, which is to prepare a profit appropriation statement. This records how the profits of the business for the relevant accounting period are divided between the partners.

Answer 57

'Drawings' are withdrawals of profits by the partners during the year, to pay themselves (in the same way as sole traders). They are usually based on an estimate of the partner’s share of expected profits for the year. If they draw too much, they could be liable to contribute a balancing payment back to the partnership depending on the terms of the partnership agreement.

Answer 58

Within a partnership, each partner will have their own account. Commonly there are two accounts for each partner: * Capital account, for long-term capital. This represents the partner's original investment in the partnership (along with any subsequent investments). This capital cannot be withdrawn in normal circumstances. * Current account, for capital that can be withdrawn at the partner's discretion. This account records the partner's share of the ongoing business profits. It will also show any drawings that the partner has taken out over the year.

Answer 59

After the profit for the business as a whole has been calculated, ie after the Profit and Loss Account has been drawn up, the profit which the partnership has made needs to be divided amongst the partners. This is done as follows: firstly, sums are allocated to individual partners corresponding to any 'interest' on their capital or 'salaries' due to each of them under the partnership agreement. Then the remaining profit will be distributed to the partners according to an agreed profit share ratio.

Answer 60

This is a payment representing interest on the capital in the partner's long-term capital account. The rate of interest would be specified in the partnership agreement. Although it is labelled 'interest', this should not be treated as an expense item in the Profit and Loss Account. It is notional interest, ie it is really an appropriation of profit under a different name.

Answer 61

One or more partners might receive a notional salary. Again, the amount of such salary (if any) will be specified in the partnership agreement and it is really an appropriation of profits. Generally, for partners, any salary paid to them: a) must be treated as an appropriation of profit, not an expense in the Profit and Loss Account (which is how the salaries of employees are represented), and b) will be treated as drawings.

Answer 62

The residual profits are the profits remaining after each partner has appropriated the amount(s), if any, to which they are entitled under the partnership agreement as notional interest and/or as notional salary. The residual profits are divided amongst the partners according to an agreed ratio.

Answer 63

* Within a partnership, each partner will have their own accounts – commonly both a capital account and a current account. * These are capital accounts. * Partners in a partnership will take 'drawings' – ie a share of the profits of the partnership. * Surplus profits are distributed to partners in the following order: * 'interest' on their capital * 'salaries' * remaining profit will be distributed according to an agreed profit share ratio. * The Profit Appropriation Statement must be completed before the Balance Sheet can be drawn up. * The top half of a partnership Balance Sheet is similar to that of a sole trader. The bottom half, which shows capital, follows a different format.

Answer 64

Companies prepare accounts because they are obliged to do so by statute. The accounts also have to take on a particular appearance and format and must also present a true and fair view of the profits, assets and liabilities of the company. This is because the accounts need to provide the reader, be that a shareholder, potential investor or an individual investigating an allegation of fraud, with certain key information. Unless that information is presented in a particular way, and in the same way each year, then the story that the accounts tell may not be true or fair.

Answer 65

In earlier elements, you were introduced to the format of the Profit and Loss Account and Balance Sheet for a sole trader and a partnership. You also learned about the need to make year-end adjustments to the trial balance before such accounting statements can be drawn up, such as accruals, prepayments, depreciation and bad and doubtful debts. Such principles apply equally to companies as they do to sole traders and partnerships.

Answer 66

Accounts are used by a wide range of people for different purposes, for example by the management to determine the performance of the business, by potential investors or by the HMRC for the calculation of taxation. It is important that solicitors are able to interpret the accounts of businesses and companies, both for their own purposes as partners but also to enable them to put the commercial reality of their clients' business in context. In order to give comprehensive advice, a solicitor needs to know what effects an event will have on the accounts of their client and also what events the accounts may be concealing.

Answer 67

In practice, a common method of analysing accounts is to calculate a number of financial ratios (eg gearing - which we will look at in the context of debt finance) from figures in the Profit and Loss Account and Balance Sheet in order to give meaning and significance not readily apparent from the accounts.

Answer 68

A company is free to choose its own accounting reference period, subject to provisions of the Companies Act 2006. Under s 391(4) CA 2006, a company’s accounting reference date ('ARD') (the date on which the accounts are 'ruled off') is the last day of the month in which the anniversary of its incorporation falls. A company is, however, able to change its ARD to a date of its choice provided the provisions of s 392 CA 2006 are complied with.

Answer 69

Under s 442(2)(a) CA 2006, a private company must file its accounts at Companies House within nine months after the end of the relevant accounting reference period. Under s 442(2)(b) CA 2006, a public company must file its accounts at Companies House within six months after the end of the relevant accounting reference period. Note there will be changes to the types of company that need to file annual accounts as a result of the Economic and Corporate Crime and Transparency Act 2023. These provisions are not yet in force and updates will be provided as necessary .

Answer 70

1. Capital accounts: the bottom half of the balance sheet Company accounts follow a format which differs from those of sole traders and partnerships. The main difference relates to the bottom half of the Balance Sheet and this is because the capital of a company consists of share capital, reserves and retained earnings.

Answer 71

2. Tax Tax has not played a part in any of the accounting statements that you have seen so far. This is because partnerships and businesses run by sole traders do not have separate legal personality, and therefore do not pay tax. The partners or the sole trader pay tax by reference to their own personal tax computations. However, companies do have separate legal personality, and as such, they must pay tax on their own account. In practice, therefore, the Profit and Loss Account of a company includes a statement of the tax the company should pay on its profits. This is corporation tax and will ultimately affect the profitability of the company.

Answer 72

3. Dividends The owners of companies are shareholders. Shareholders' return on their investment is the dividend that they may receive. Like drawings that a sole trader takes from their business, a dividend is an appropriation of profits (after tax). It is not an expense of the business. In practice, dividends will usually appear in a financial statement called the 'statement of equity' (or 'statement of changes in equity') because they are transactions between the company and its shareholders.

Answer 73

For the purposes of this topic, dividends are included in an addition to the Balance Sheet called the Statement of Changes in Equity (SoCiE). This shows profits brought forward and added to current year profits subject to any deductions for dividends. The resulting 'Retained Earnings' will appear on the bottom half of the Balance Sheet, showing the total profits carried forward to the next accounting period.

Answer 74

Companies with one or more subsidiaries are required to publish accounts for the group of companies as a whole as well as their own annual accounts (s 399 CA 2006). This is because (subject to certain exemptions) shareholders of the parent company should have access to some information regarding the subsidiary company. In principle, every subsidiary in the group also has a duty to prepare its own individual accounts, but exemptions are widely available, so it is likely to be rare in practice for subsidiaries to do so (ss 394A and 479A CA 2006).

Answer 75

* Companies prepare accounts because they are obliged to do so by statute. * Companies are required to make up their accounts by their Accounting Reference Date. Companies are permitted to change their ARD. * Year-end adjustments such as accruals, prepayments, depreciation and bad and doubtful debts apply equally to companies as they do to sole traders and partnerships. * There are three main differences in the financial statements for companies:

Answer 76

* Format; * Tax * Dividends. * The bottom portion of the Balance Sheet, shows what is referred to as ‘Total Equity' or 'Equity and Reserves'. * Companies can make an adjustment to the financial statements to reflect the fact that their assets have decreased in value.

Answer 77

In this element you will consider some of the entries in the bottom half of a company's balance sheet, particularly: * Called up share capital * Share Premium Account * Revaluation Reserve You might also see reference to a Capital Redemption Reserve ('CRR') on a company's balance sheet. A CRR can only be created as a consequence of certain transactions between the company and its shareholders under detailed provisions of the Companies Act 2006. Such transactions are relatively unusual and do not form part of the course of everyday business for any company. Therefore, you will not consider them any further in this module. Remember: the bottom half of a company's balance sheet shows the equity and will balance with the top half of the balance sheet (the Net Asset Value).

Answer 78

The share capital account tells the reader the aggregate amount that has been 'called up' (ie the amount of the nominal value of its shares that the company has required its shareholders to pay) on each class of issued shares, not including any premium. This called up value may, or may not, be the same as the aggregate of the nominal value of the issued shares, for example, if they are not fully paid. It is relatively rare to encounter shares which are not fully paid up.

Answer 79

A newly-incorporated company has issued 200,000 ordinary shares of £1 and has called up 75p per share. The value of the called-up share capital in the company’s Balance Sheet will therefore be £150,000 (200,000 shares x 75p).

Answer 80

Reserves can be described as the capital of the company in excess of the called up value of the issued share capital. Reserves can be split into two categories: * capital reserves (eg share premium account, revaluation reserve, capital redemption reserve), discussed later in this element; and * revenue reserves (eg retained earnings), discussed in the next element. Broadly speaking, assets representing the capital reserves cannot be distributed by way of dividend or other payment to shareholders. However, revenue reserves are distributable reserves and therefore, assets representing such reserves can be distributed to shareholders in the form of dividends.

Answer 81

The share premium account represents the difference between the nominal value of the shares and the amount that the shareholders actually paid for the shares ie the subscription price (if greater). Note: the market price of the shares, once they have been issued, has no bearing at all on the company's accounts and so, if their market price goes up or down, the share premium account will remain unaltered. The share premium account is a capital reserve. Assets representing it therefore cannot be distributed to shareholders, except in exceptional circumstances such as a bonus issue (see the next element).

Answer 82

A revaluation reserve is created when a company's directors, as a matter of accounting policy, wish to show more up to date values of non-current assets in the accounts. For example, the value of its real property portfolio may have increased, and so the company re-values the assets in question to their current value. The increase in the value of the asset in the Balance Sheet causes the figure for Net Assets to rise correspondingly ie in simple terms, the top half of the Balance Sheet has increased. It is therefore necessary to make a corresponding change to the bottom half of the Balance Sheet. This is achieved by creating or increasing an existing revaluation reserve by the same value.

Answer 83

The revaluation reserve represents a notional profit to the company from the rise in value of the asset. This profit is, however, unrealised until the asset is sold, and as such it is a capital reserve and is not distributable as a dividend until the company sells the asset and realises the profit (s 830(2) CA 2006). Any subsequent reduction in a re-valued asset's value can be set off against the revaluation reserve.

Answer 84

* The bottom half of a company's balance sheet shows the equity and will balance with the top half of the balance sheet (the Net Asset Value). * There are different entries to consider on the bottom half of a company’s balance sheet. * The called-up share capital is the amount of the nominal value of its shares that the company has required its shareholders to pay. * There are different kinds of reserves, ie: * Capital * Revenue * The share premium account represents the difference between the nominal value of the shares and the amount that the shareholders actually paid for the shares. * A revaluation reserve is created when a company's directors, as a matter of accounting policy, wish to show more up to date values of non-current assets in the accounts.

Answer 85

Retained Earnings The 'retained earnings' is the reserve account for retained profits. The retained earnings represent profits after tax earned by the company over its history and not distributed by way of dividend or appropriated to another reserve. It generally increases from year to year as most companies do not distribute all of their profits.

Answer 86

As mentioned earlier in this topic, profit for the year is not carried over directly from the Profit and Loss Account to the bottom half of the Balance Sheet. Instead, it is carried over into a separate calculation, the Statement of Changes in Equity (the 'SoCiE') which, for the purposes of this topic, is appended to the bottom of a company’s Balance Sheet, laid out as follows:

Answer 87

Retained Earnings: Brought forward X Profit for the year X Dividends paid (X) Retained earnings X

Answer 88

Dividends are paid or payable out of profits generated in the current or previous accounting periods. Any company can make a distribution (eg a dividend) provided that it has 'profits available for the purpose' (s 830(1) CA 2006). It is only after the financial statements have been completed that the profits generated in a given accounting period can finally be determined. In ALCIE terminology, dividends are recorded in a capital account as they are transactions between the business and its owner(s). For this reason, dividends do not belong on a Profit and Loss account. When a company declares a dividend, this will show up in the SoCiE. Example: X Co Ltd has drawn up its accounts for the year ending xxxx. During the course of that year, X Co Ltd has declared and paid a dividend. The accounting statements on the next slide are shown in simplified format.

Answer 89

There are two types of dividend that can be paid on ordinary shares; a final or an interim dividend. Both are calculated in exactly the same way, the only difference between the two being that: 1.The final dividend is declared after the year end and paid some time thereafter 2.The interim dividend is paid during, and in respect of, the current accounting period Final Dividend The size of the final dividend is declared by the company's directors in the Directors' Report, and approved by the company's shareholders by ordinary resolution, typically passed at the Annual GM if the company has one. If the directors have recommended a final dividend, but the shareholders have not yet approved it, the dividend is called a proposed dividend. A proposed dividend does not constitute a debt enforceable by the relevant shareholders until it is approved ie declared by an ordinary resolution of the shareholders. Therefore, any final dividend which is proposed but not been approved will not appear in the accounts of that accounting period.

Answer 90

A company with an accounting period of a year ending on 31 December 2024 wishes to pay a final dividend in respect of that accounting period. The directors of the company tell you that the final dividend will be approved by an ordinary resolution of the shareholders at a general meeting which is due to take place in April 2025. If the final dividend is declared by ordinary resolution at the general meeting, it will appear in the accounts for the period ending 31 December 2025.

Answer 91

A final dividend that has been approved by the shareholders is called a declared dividend. A declared dividend constitutes a debt of the company enforceable by the relevant shareholders. A declared dividend will be taken into account in the SoCiE, as a deduction in calculating the Retained Earnings (profit and loss carried forward) which will appear in the bottom half of the Balance Sheet (see X Co Limited). If the declared dividend has not yet been paid to shareholders by the time the accounts for that year have been prepared, it will appear in the Balance Sheet at the end of the year in which it was declared (as part of 'current liabilities'). It will also be taken into account in the SoCiE at that year-end. A declared dividend which has been paid to shareholders before that year end will only be taken into account in the SoCiE.

Answer 92

The articles of a company normally give the directors the power to decide to pay interim dividends (eg Model Article 30). Interim dividends can therefore be paid without the need for an ordinary resolution of the shareholders. Any board resolution to pay an interim dividend may be rescinded before the interim dividend is paid, so an unpaid interim dividend is not a debt that the shareholders are legally entitled to sue upon.

Answer 93

For this reason, the accounting treatment of interim dividends is different to the treatment of final dividends. Interim dividends will only be reflected in a company's accounts if they have actually been paid. When an interim dividend has been paid in any year the amount of the dividend will have been deducted from the assets, ie cash and cash equivalents, and will be shown as an item on the trial balance. A dividend is an allocation of profit and not an expense of the company so it will not be shown in the Profit and Loss Account. The interim dividend will be taken into account in the SoCiE (in this respect, interim dividends are treated the same as declared (and paid) dividends).

Answer 94

Example: Lennon Limited's accounting period ends on 31 March 2024. The directors decide to propose a final ordinary dividend of £10,000 in respect of that accounting period. Lennon Limited holds a general meeting in June 2024. As expected, the shareholders declare the final ordinary dividend proposed by the directors. The dividend is eventually paid to the shareholders in September 2024.

Answer 95

Accounting Period ending 31 March 2024: The final dividend will not appear in the financial statements for this accounting period (ie the period ending 31 March 2024) as it was not declared during this accounting period. Accounting Period ending 31 March 2025: Top half of Balance Sheet: the final dividend will not appear as part of Current liabilities on the Balance Sheet as at 31 March 2025 because it was paid in September 2024. Bottom half of Balance Sheet: the final dividend will impact on the Retained Earnings (profit and loss carried forward) as it will be taken into account in the SoCiE.

Answer 96

* Shareholders' return on their investment is the dividend that they may receive. * Dividends are paid or payable out of profits generated in the current or previous accounting periods. * Dividends do not belong on a Profit and Loss account; when a company declares a dividend, it will show up in the SoCiE. * Dividends can be interim or final. * Some shares will pay a preference dividend. * A company may decide to convert some of its reserves into share capital by issuing fully paid shares to existing shareholders on a pro rata basis.

Answer 97

You have previously considered the way in which a company can raise finance by issuing shares (equity finance). For many private companies, it may in practice be difficult to raise money through equity finance, since private companies are unable to offer shares to the public (s 755 CA 2006). An alternative option to raise finance for any company is to borrow money (debt finance), usually from a bank or other lenders.

Answer 98

Most companies will have unrestricted power to borrow. However, it is necessary to consider when the company was incorporated and to check the company's Articles to ensure that there are no restrictions.

Answer 99

Although there are many types of debt finance available under different names, they can all be classified as either: Loan facilities or Debt securities A lender will wish to ensure that they are protected as far as possible from the possibility that the borrowing company may be unable to repay the loan. A key method of protection is for the lender to take security over the assets of the borrowing company. Note that it is important not to confuse the term “debt security”, which is a type of debt, with the term “security for a debt” which is something that the lender will take over the assets of the borrower in order to protect their interests. In this element you will consider the different types of debt finance. The next element will explore the various forms of security, what happens if the company becomes insolvent and how and why security must be registered at Companies House.

Answer 100

A loan facility is an agreement between a borrower and a lender which gives the borrower the right to borrow money on the terms set out in the agreement.

Answer 101

* Overdraft: this is an on-demand facility, which means that the bank can call for all of the money owed to it at any point in time and demand that it is repaid immediately. This makes overdrafts unsuitable as a long-term borrowing facility. Interest is paid to the bank on the amount that the customer is ‘overdrawn’. * Term loan: this is a loan of money for a fixed period of time, repayable on a certain date. The lender cannot demand early repayment unless the borrower is in breach of the agreement. The lender will receive interest on the loan throughout the period. Term loans which are repayable in a single lump sum at the end of the agreement are referred to as having a ‘bullet repayment’. Alternatively, the loan may be repayable in instalments, in which case it is referred to as ‘amortising’. * Revolving credit facility: this is a loan of money for a specified period of time, but unlike a term loan, the borrower can repeatedly borrow and re-pay loans up to the agreed maximum overall amount when it chooses. This helps the borrower keep interest payments down, by borrowing only when it needs funds and repaying loans when it has available cash. It therefore combines some of the features of overdrafts and term loans.

Answer 102

Debt securities have similarities to equity securities as they are a means by which the company receives money from external sources. In return for finance provided by an investor, the company issues a security acknowledging the investor's rights. The security is a piece of paper acknowledging the debt, which can be kept or sold onto another investor. At the maturity date of the security, the company pays the value of the security back to the holder.

Answer 103

A classic example is a bond. Here the issuer (the company) promises to pay the value of the bond to the holder of that bond at maturity. The company also pays interest at particular periods, usually biannually. Bonds are issued with a view to being traded. The market on which bonds may be traded is known as the capital market. Whoever holds the bond on maturity will receive the value of the bond back from the issuer. Private companies can only issue bonds to targeted investors and not to the public indiscriminately. To do otherwise risks contravention of s 755 CA 2006.

Answer 104

Convertible bonds Convertible bonds are bonds which can be converted into shares in the issuer. On conversion, the issuer issues shares to the bondholder in return for its agreement to give up its right to receive interest and repayment of the principal amount invested. Note that a convertible bond has the characteristics of both debt and equity, but not at the same time. It starts off as a debt security but later on, if the investor so elects (in accordance with the terms of the bond issue) the bond is swapped for shares.

Answer 105

Preference shares A preference share is wholly equity, but it is often called a hybrid because it has elements that make it look similar to debt. The holder of a preference share commonly has no voting rights, and will usually get a definite amount of dividend ahead of other shareholders (making it look similar to interest). If the preference share has a fixed maturity date on which the company must redeem or purchase the share and/or such preference dividend is fixed, then the preference share actually looks more like debt. However, if the preference share does not have such a fixed maturity date and/or the preference dividend will only be paid if the company declares a dividend (unlike interest, which has to be paid), then this share is more akin to traditional equity.

Answer 106

Term sheet This is a statement of the key terms of the transaction (eg loan amount, interest rate, fees to be paid, key representations, undertakings and events of default to be included in the loan agreement/bond terms and conditions) agreed by the lender and borrower. The term sheet is equivalent to heads of terms in other transactions. It is not intended to be a legally binding document, rather a statement of the understanding on which the parties agree to enter into the transaction.

Answer 107

The loan agreement sets out the main commercial terms of the loan such as amount of interest, dates on which interest will be paid, the date(s) on which principal needs to be repaid and any fees due. It will also include most of the other information from the term sheet but in much more detail. The loan agreement is one of the most heavily negotiated documents in a debt finance transaction.

Answer 108

If a loan is secured, a separate security document will be negotiated and entered into.

Answer 109

The word debenture has 2 separate meanings: Under s738 "debenture" covers any form of debt security issued by a company, including debenture stock, bonds and any other securities of a company, whether or not constituting a charge on the assets of the company. A debenture is a type of security document and one of the most commonly used in secured loan transactions. It is in this context that the term is generally used. The debenture is a separate document from the loan agreement. The loan agreement sets out the terms of the loan, and the debenture sets out the details of the security. The debenture is sent to Companies House for registration purposes.

Answer 110

Representations Representations, usually referred to as representations and warranties, are statements of fact as to legal and commercial matters made on signing of the loan agreement and repeated periodically during the life of the loan. Undertakings Undertakings (or covenants) are promises to do (or not do) something, or to procure that something is done (or not done). Event of default Representations and undertakings are important clauses. Breach of either gives the bank contractual remedies where the breach constitutes an Event of Default. The Events of Default clause is vital in terms of giving the bank the power to call in its money early if the borrower shows signs of becoming an enhanced credit risk.

Answer 111

* Types of debt finance include loan facilities and debt securities. * A loan facility is an agreement between a borrower and a lender which gives the borrower the right to borrow money on the terms set out in the agreement. *Loan facilities are classed as overdrafts, term loans or revolving credit facilities. * Debt securities eg bonds have similarities to equity securities as they are a means by which the company receives money from external sources. In return for finance provided by an investor, the company issues a security acknowledging the investor's rights. The security is a piece of paper acknowledging the debt, which can be kept or sold onto another investor. At the maturity date of the security, the company pays the value of the security back to the holder. * Convertible bonds and preference shares are examples of debt / equity hybrids. *The main documents required for a term loan are a term sheet, a loan agreement and a security document (if the loan is to be secured) commonly known as a debenture.

Answer 112

‘Security’, in this context, means temporary ownership, possession or other proprietary interest in an asset to ensure that a debt owed is repaid (ie collateral for a debt). The main benefit of taking security is to protect the creditor in the event that the borrower enters into a formal insolvency procedure. It is possible to improve the priority of a debt by taking security for it. It should not normally be necessary to enforce security if the borrower is still able to pay, although in some circumstances enforcing security may be a simpler way of obtaining repayment than suing the borrower.

Answer 113

Pledge - the security provider (usually the borrower or occasionally another company in the borrower’s group) gives possession of the asset to the creditor until the debt is paid back. Pawning a watch or an item of jewellery is a form of pledge. Lien - with a lien, the creditor retains possession of the asset until the debt is paid back. An example is the mechanic’s lien. This arises by operation of law and allows a mechanic to retain possession of a repaired vehicle until the invoice is paid.

Answer 114

Mortgage With a mortgage, the security provider (usually the borrower) retains possession of the asset but transfers ownership to the creditor (usually, the lender). This transfer is subject to: a) the creditor’s right to take possession of the asset and sell it if the security provider defaults; and b) the security provider’s right to require the creditor to transfer the asset back to it when the debt is repaid. With a mortgage, the security provider retains possession of the asset but transfers ownership to the creditor. This transfer is subject to the security provider’s right to require the creditor to transfer the asset back to it when the debt is repaid. This right is known as the ‘equity of redemption’. A type of mortgage (known as a charge by way of legal mortgage) is usually taken over land (although, unusually, ownership will remain vested in the security provider in this case).

Answer 115

As with a mortgage, the security provider retains possession of the asset. However, rather than transferring ownership, a charge simply involves the creation of an equitable proprietary interest in the asset in favour of the creditor. As well as this equitable proprietary interest, the charging document will give the lender certain contractual rights over the asset – for example to appoint a receiver or administrator to take possession of it and sell it (or, exceptionally, to take possession of it itself to sell), if the debt is not paid back when it should be. There are two types of charge: fixed charges and floating charges. From a creditor’s perspective, fixed charges are generally a better form of security, but not all assets are suitable for charging by way of fixed charge.

Answer 116

A fixed charge is normally taken over assets such as machinery and vehicles. The key element of a fixed charge is that the creditor can control what the security provider can do with the fixed charge assets. This is usually done by the security provider undertaking not to dispose of, or create further charges over, the charged assets without the creditor’s consent. Note that ‘control’ in this context means the borrower can generally still use the asset in the ordinary course of business but is restricted from disposing or charging it. If the charge becomes enforceable, the creditor will have the ability to appoint a receiver of that asset or to exercise a power of sale of the asset.

Answer 117

· Company takes out a loan over a term of 5 years. Company grants fixed charge over machinery to the lending Bank. · Company cannot sell the machinery or charge it to another bank without Bank’s consent. It can continue to use the machinery for its business as it retains possession. · If the loan is not repaid, Bank has rights in the machinery. It can appoint a receiver to sell the machinery and applies the sale proceeds to satisfy the unpaid debt.

Answer 118

It is not always practical for a security provider to undertake not to dispose of its assets, eg a trading company needs to be able to dispose freely of its stock (ie the products it sells). In that case, a floating charge may be appropriate. A floating charge ‘floats’ over the whole of a class of circulating assets. Whatever assets in that class happen to be owned by the security provider at any given time are subject to the floating charge, and the security provider is free to dispose of the assets as it wishes until ‘crystallisation’.

Answer 119

Crystallisation means that the floating charge stops floating and fixes to the assets in the relevant class which are owned by the security provider at the time of crystallisation. The creditor thus acquires control of those assets and to this extent a crystallised floating charge is like a fixed charge. Crystallisation may occur by operation of law or may be triggered by certain events as contractually agreed between the creditor and security provider. Crystallisation will usually occur when the borrower has breached certain significant terms of the loan agreement (including by reason of its insolvency).

Answer 120

* As the security provider has freedom to dispose of the assets in the ordinary course of business, the creditor will not be sure of the value of the secured assets – they might all have been sold before crystallisation occurs. * There is a statutory order of priority of payment of creditors if a company is wound up. A floating charge generally ranks below a fixed charge (and note that crystallisation does not change that) and below preferential creditors when the company's assets are realised (ie sold) and the proceeds of realisation (ie the sale) applied to creditors on the winding-up of the company. However, if the floating charge document contained a term prohibiting the creation of a later fixed charge (a ‘negative pledge’ clause) but the company nevertheless created a later fixed charge, the floating charge will have priority if the later fixed charge holder had notice of this restriction.

Answer 121

* Floating charges created on or after 15 September 2003 are subject to a part of the proceeds of the assets being set aside. This is known as the ‘prescribed part fund’ for unsecured creditors. * Floating charges are capable of being avoided under s 245 Insolvency Act 1986 which is looked at further in one of the later insolvency topics on voidable transactions. * An administrator is free to deal with floating charge assets in their control without reference to the charge holder or the court and to pay their remuneration and expenses out of the proceeds of those assets. Administration is one of the insolvency procedures which will be examined in a later topic on this module.

Answer 122

Example: A Bank operates the company’s current account and has also provided a loan facility of £50,000 which is currently fully borrowed. To secure all monies due, the Bank has a floating charge over all the assets of the company present and future. The company can continue to deal with its assets in the ordinary course of its business until such time as the floating charge crystallises.

Answer 123

The Bank has rights in the assets but cannot exercise control over them. If the company defaults on the loan which is usually defined as an Event of Default which will enable the Bank to crystallise the floating charge. Crystallisation will give the Bank control over the assets and allow it to recover its money by appointing an administrator (or exceptionally exercising its power of sale over the charged assets).

Answer 124

Strictly speaking, guarantees are not security, as guarantees do not give rights in assets. However, as their commercial effect is similar to security, security and guarantees tend to be treated together. A guarantee for a loan means an agreement that the guarantor will pay the borrower’s debt if the borrower fails to do so. Guarantees can come from companies or individuals (such as directors). A – B & C Above is a basic example of a group of companies. B and C are subsidiaries of A. A guarantee given by A of a loan made to B is a downstream guarantee. A guarantee given by B of a loan made to A is an upstream guarantee. A guarantee given by B of a loan made to C is a cross-stream guarantee.

Answer 125

Example: A Bank is intending to lend £20,000 to a company . The company was recently incorporated by an entrepreneur who is the majority shareholder in the company and is its managing director. The Bank will be granted a fixed charge over certain assets. However, the bank is concerned that the value of the assets might depreciate rapidly, leaving it exposed.

Answer 126

As the company is newly incorporated, it may not have substantial assets. The asset over which the Bank has a fixed charge is likely to quickly lose its value. The Bank could take security over future assets, but this will only be useful if the company acquires valuable assets. The Bank could also look to take a personal guarantee from the entrepreneur if they have valuable assets. If the company defaulted, the bank could call on the guarantee and, if the entrepreneur refused to pay, sue them for the money. They may also give security for the loan (eg by granting a mortgage over their home, subject to any rights of any other person living there with them).

Answer 127

Most security created by a company needs to be registered with Companies House. This includes charges created by an English company over assets located both within the UK and abroad. Pursuant to s 859A(2) CA 2006, the Registrar of Companies (the **‘**Registrar’) shall register any security created by a company at Companies House provided that the company or any person interested in the charge (ie the lender) delivers to Companies House (either electronically or by paper filing) within 21 days beginning with the day after the day on which the charge is created (s 859A(4) CA 2006):

Answer 128

* a section 859D statement of particulars set out on Form MR01 detailing: * the company creating the charge, * the date of creation of the charge, * the persons entitled to the charge, and * a short description of any land, ships, aircraft or intellectual property registered (or required to be registered) in the UK which is subject to a fixed charge; * a certified copy of the charge (s 859A(3) CA 2006); and * the relevant fee.

Answer 129

The Registrar allocates to the charge a unique reference code and includes it on the register with the certified copy of the charge (s 859I(2) CA 2006). The Registrar must issue a signed/authenticated ‘certificate of registration’ (s 859I(3),(4) and (5) CA 2006) which is conclusive evidence that the charge has been correctly registered.

Answer 130

Section 859A(2) CA 2006 provides that the s 859D statement of particulars may be delivered either by the company that created the charge or any person interested in that charge (eg the lender). In practice it will usually be the lender’s solicitors who will complete the registration formalities, as it is the lender who has most to lose in the event of non-registration.

Answer 131

Under s 859H CA 2006, if the charge is not registered at all, or is not registered within the 21-day period above: * the charge is void against a liquidator, administrator and any creditor of the company; and * the debt becomes immediately payable. As security is taken as protection against the effects of insolvency, the fact that the charge is not valid as against a liquidator or administrator means that the security will effectively be worthless if not registered.

Answer 132

Under s 859P CA 2006, a company must keep available for inspection a copy of every charge and a copy of every instrument that amends or varies any charge. Such copies may be certified copies rather than originals. These documents must be kept at either the company’s registered office or such other location as is permitted under the Companies (Company Records) Regulations 2008 (s 859Q(2) CA 2006).

Answer 133

A company must inform Companies House of the place where such documents are available for inspection and of any changes to that place (s 859Q(3) CA 2006). These documents must be available for inspection by any creditor or member of the company free of charge and by any other person on payment of a prescribed fee (s 859Q(4) CA 2006). If a company refuses such inspection, then the court may order that the company allows an immediate inspection. Under s 859Q(5) CA 2006, failure to comply with any of the above requirements will be an offence and the company (and every officer of the company who is in default) will be liable to a fine.

Answer 134

In respect of creditors of the company, they are paid in the following order upon the winding up of the company: * Creditors with fixed charges - entitled to the first call on the proceeds from the sale of those assets charged to them under a fixed charge. * Preferential creditors – primarily wages (up to £800 per employee), occupational pensions and certain sums owed to HMRC. * Creditors with floating charges (which will have crystallised, if not before, upon commencement of the winding up). For floating charges created on or after 15 September 2003, a proportion of the proceeds of the floating charge assets will be set aside for payment to unsecured creditors before the floating charge holders are paid from these proceeds. This is commonly referred to as the ’prescribed part fund’. * Unsecured creditors, to the extent not paid off from the prescribed part fund. * Shareholders (according to the rights attaching to their shares). This is a simplified version of the order of priority as the costs of the liquidation/administration will also need to be paid at various stages. You will consider this in more detail in the insolvency topics later on this module.

Answer 135

The rules of priority are complex but, in general, if more than one creditor has a fixed charge over the same assets, the first fixed charge created has priority (provided it was properly registered in accordance with s 860 or s 859A CA 2006). Similarly, if more than one creditor has a floating charge over the same assets, the first floating charge created has priority (provided it was properly registered).

Answer 136

However, this order can be varied by agreement between the creditors through a document known as a Deed of Priority, an Intercreditor Agreement or a Subordination Agreement. Such an arrangement has the benefit that creditors can make specific provision for the order in which they will rank and do not need to rely on the complex and sometimes uncertain rules mentioned above.

Answer 137

Summary * There are various different forms of security that may be granted for loans. The most common forms of security are fixed or floating charges. * A fixed charge prevents the borrower from dealing with the charged assets. * A floating charge floats over a class of assets. It does not prevent the borrower from dealing with the assets unless and until the floating charge crystallises.

Answer 138

* A fixed charge is a stronger form of security since the fixed charge holders are paid first in the order of priority in the event of a company's liquidation. * Charges must be registered within 21 days beginning with the day after creation under s 859A CA 2006 otherwise they will be void and the loan will become immediately repayable. * Charge holders have certain rights in an insolvency.

Answer 139

When a company issues shares or raises finance by way of a loan, it will need to record these changes in its accounts. Whether a company chooses equity finance or debt finance, it will have an effect on the balance sheet of the company. There will also be financial ratios that commonly used ratio that can be used to measure the financial performance of a company. When considering the types of finance the general rules are: EQUITY Both the net asset value of the company will change AND the total equity (ie both “halves” of the balance sheet will be affected by the finance) DEBT The net asset value of the company will not change as a result of the loan and the equity will not change (ie only the top half of the balance sheet will be affected by the finance)

Answer 140

When a company issues shares at their nominal value (ie the shareholder pays the same amount that the share has been issued for), two changes will be recorded in the balance sheet of the company: * increase share capital (bottom half of the balance sheet) to show the nominal value of the shares issued to the shareholder; and * increase the cash (current assets – top half of the balance sheet) to show the cash received for the shares by the company from the shareholder. ie the top half of the balance sheet shows you what the company owns and the bottom half shows you where it came from. They will balance as both top half and bottom half of the balance sheet will increase by the amount of the share issue.

Answer 141

Often shares will be sold at more than the nominal value. In simple terms, the price of a share is calculated by working out the value of the company as a whole and dividing it between the number of shares in issue. This will give a value per share, which can then be used to help determine the price.

Answer 142

There are various ways in which a company can be valued. For example: the ‘Balance Sheet’ valuation, looking at the value of the company’s assets minus its liabilities, or the ‘multiplier’ valuation, looking at the average profit of a company and multiplying it by a factor relevant to the particular industry. The value of a listed company (known as its ‘market capitalisation’) can be ascertained by multiplying the number of shares in issue by the share price at a given time.

Answer 143

The price of a share will comprise the nominal value of the share, plus a premium although shares cantrade at a discount to nominal value. Effect of issuing a share for more than its nominal value on the Balance Sheet When a company issues shares at a premium there are several changes which will need to be recorded in the balance sheet of the company.

Answer 144

* The cash received is shown by an increase in the assets on the top half of the balance sheet.

Answer 145

* The nominal amount of the new shares is shown by the increase of in the share capital. * The premium per share is shown in the newly-created share premium account. The share premium must be shown in a separate share premium account pursuant to s 610(1) CA 2006. Funds contained in the share premium account can only be used for limited purposes. Consider the following example: XYZ Limited issues an additional 100 £1 ordinary shares for 150p each in cash, ie at a premium of 50p per share.

Chapter 8: Debt Finance & Business Accounts Flashcards

(170 cards)