Chapter 8 - Trial Balance and Financial Statements: Financial Statements for Companies

Question 1

Companies

Answer 1

A company is legally recognised as such by law.
Most companies are ‘limited’, as it limits liability of the owners, if the business ends up being unsuccessful.
Directors are protected from poor decisions previously made, and shareholders only risk investment they have made.

Question 2

Limited Companies

Answer 2

There are 2 types of limited companies: private and public.

Both of them are owned by shareholders..

Directors manager the company on behalf of the shareholders.

Question 3

Shareholders

Answer 3

Whilst small companies are owned and managed by the same people, larger companies are owned by shareholders who take no part on the day to day management of the company.

The invest to create a return.

Shares will be continuously traded without affecting the day to day operations of the company.

Question 4

Company financial statements

Answer 4

They need to be lodged at the Companies House, and regulated by statute.

Question 5

Sources of Equity

Answer 5

In a small company, the source of equity is the Capital.

In a larger company it’s more complex, as it’s raised from several sources:

• shares and equity by shareholders
• retained earnings - accumulated profits not given to shareholders, and often to be used to invest again
• profits for the year just ended
• reserves from issued shares, when shares are sold above the nominal value
• reserves from accountancy treatments, such as re-evaluation (ex. property that increases it’s value

Question 6

Share Equity

Answer 6

Money required to run a business, which has been raised from members or owners of the company from the issue of shares.

Question 7

Authorised share capital

Answer 7

Total shares a company is allowed to issue under the terms of its issued Memorandum of Association.

Question 8

Issued Share Capital

Answer 8

The a mount of Shares that were actually issued to shareholders.

Question 9

Types of Shares

Ordinary Shares

Answer 9

Also known as Equity Shares, as they convey “ownership” rights.
Which means shareholders can vote, and are entitled to a variable dividend dependent of the levels of profit, availability of funds and directors’ policy.

Directors recommend the dividend to be paid, and shareholders approve at the annual general meeting.

Ordinary shareholders are the last ones to receive the shares of the profit/earnings and the last to be repaid their investment, if the company is wound up.

When profits are low, they may not receive a dividend at all.

If the company goes into insolvency, they may see nothing back.

Question 10

Types of Shares

Preference Shares

Answer 10

They don’t convey ownership, but bring other benefits.
They are raised for specific projects.

They don’t carry voting rights, but shareholders receive a fixed dividend, as long as there is distributable profit.
Ex. 6% of £5 Preference Shares, will pay £0.30 for every held share.
Unpaid dividend can be rolled over to subsequent years, that is, the share is ‘cumulative’.

They are called Preference shares, because shareholders receive their dividend before the ordinary shareholders.
This may mean there won’t be enough dividend to pay ordinary share dividend.

When Preference Shares are no longer needed to fnd the company, they can be bought back and cancelled out of circulation.

Question 11

Reserves

Revenue Reserves

Answer 11

Retaining profits.
After the reporting period, directors will decide how profit will be retained and distributed.
These are the options:
- paying dividend to Preference Shareholders, considering it’s ‘cumulative’ element;
- paying dividend to ordinary shareholders, with value set by the directors; but Preference Shares and it’s cumulative element need to be paid first
- retain the profits for financial strength and expansion, replacing assets, repaying loans. These will appear in the Statement of Financial Position as Revenue Reserves in the Equity and Reserves area.
Even thought they are not paid to shareholders, these dividends belong to them, and will be given to them if the company is wound up.

Question 12

Reserves

Revenue Reserves: profit retentions

Answer 12

Profit retentions don’t belong to preference shareholders, who only are entitled to their dividend if not cancelled, cumulative if agreed, repayment of their investment and no more, irrespective of what the profits are.

Question 13

Reserves

Revenue Reserves: profit retentions
Example

Answer 13

Profit after tax: £500,000
5% preference share dividend (1,000,000) £50,000
Total £450,000

Ordinary Dividend share (10% of 2,000,000) £200,000
Deduct from total above, then you get total retained profit: £250,000

Question 14

Reserves

Capital Reserve

Answer 14

Capital Reserve is one that is immediately available for distribution to shareholders and does not arise from trading, but from a capital transaction, such as selling shares at ‘a premium’, or ‘revaluing’ land to reflect its appreciation in value.

It needs to be included in the statement of financial position, as it is part of the ordinary shareholders’ funds and will be paid back if company wound up.

Question 15

Share Premium

Answer 15

Are a Capital Reserve:

• when ordinary shares are issued at their face value (amount that is stated in the share), the entire proceeds of this form the ordinary share capital in Equity and Reserves are in the Statement of Financial Position
• when ordinary shares are issued above ‘face value’ share, the difference between the actual price paid and the face value price is known as premium, and this value is posted to a Share Premium NL account in the nominal ledger.

ex. face value is £1, but sold at £3.50
Share Capital is £1
Premium £2.50

£1 x the number of shares issued is credited in the share capital account
£2.50 x the number of shares issued is credited in the Share Premium account (NL) - this is classed as Capital Reserve and part of non-distributable shareholder’s funds.

Question 16

Share Premium

Example

Answer 16

ex. face value is £1, but sold at £3.50
Share Capital is £1
Premium £2.50

£1 x the number of shares issued is credited in the share capital account
£2.50 x the number of shares issued is credited in the Share Premium account (NL) - this is classed as Capital Reserve and part of non-distributable shareholder’s funds.

Share Premium will appear in the Trial Balance.

Question 17

More on Retained Earnings

Answer 17

Profits may be retained rather than distributed as dividend, which will increase the funds available to the business, for investment or expansion.

Can be used for obtaining non-current assets or working capital.

this is the cheapest way of funding and growth, as there are no interest or charges, although shareholders will expect a dividend based on profits.

Question 18

Sources of Debt

Answer 18

Short term loans, such as overdrafts, will appear in the Statement of Financial Position as current Liabilities.

For larger companies, longer term debt of much larger values, are more significant. This is often to acquire non-current assets. It will be a secured loan, and it will appear in the Statement of Financial Position as a non-current Liability.

Question 19

Loan Debt (as compared to share equity)

Answer 19

Money raised externally to run to business. Lenders are a third party, non-member of the company.
There are usually charges, interest, fees associated with obtaining loans.
These costs will appear after the Operating Profit, but before Profit before Tax in the company statements.

Question 20

Debentures

Answer 20

Common form of corporate borrowing and lending.

They are written loan agreements or loan acknowledgements, they are often (not always) secured against assets of the company to reduce the lender’s risk.
When an asset is secured, it is often registered as such with the Companies House, in order to prevent having several lenders securing the same asset.

Question 21

Debenture Holders

Answer 21

Are not Shareholders or owners of the company.

They receive interest, not dividend, and they are a long term non-current liability to the company.

They are a secured creditor.

Question 22

Preparation of company financial statements

Expenses

Answer 22

Are included in the Income Statement (just like for the Sole Trader’s) and there are 3 categories:

• distribution expenses
• administration expenses
• finance costs

Distribution and administration expenses are deducted to establish the Operating Profit:

Distribution expenses - Administration Expenses = Operating Profit

Operating Profit - Finance Costs = Profit before Taxation

Question 23

Preparation of company financial statements

Directors’ Remuneration

Answer 23

Salaries and wages are included in the Income Statement as an expense.

Sole traders are not paid a salary, as they are entitled to the accumulated capital of their firm as drawings, because a sole trader is not an employee of their own firm. The firm is an extension of themselves, not a separate entity.

In a larger company, a director is a salaried executive, an employee of the company, and therefore a separate legal entity.

Question 24

Preparation of company financial statements

Corporation Tax

Answer 24

payable by the company and is predictable, as known and calculated in advance. It will be deducted from the profit before tax figure, to achieve a Profit for the Year,

Any tax not paid by the end of the reporting period must be treated as a current liability and accrued.

Question 25

Preparation of company financial statements

Reconciliation of Retained Earnings

Answer 25

For Sole Traders, it accrues to a single owner and adds to their capital.
The profits of a Limited Company increase its equity and the earnings belong to several parties.

The Financial Statement will include a note to reconcile the shareholder’s funds and retained earnings, which will include the below for the current reporting year:

• profit/loss for the year
• dividend payable to preference shareholders, if any
• dividend payable to ordinary shareholders, if any
• any balance of profits remaining of retained earnings

Question 26

Preparation of company financial statements

Reconciliation of Retained Earnings: declared dividends

Answer 26

The only dividends that need to be declared by the period end-date reporting will appear in the financial statements.

So it will include the previous accounting period’s financial dividend as well as the current.

A declared but unpaid dividend will need to be accrued. as a current liability.

Question 27

Preparation of company financial statements

Reconciliation of Retained Earnings: Corporation Tax

Answer 27

• Tax shown as a deducted from profit after interest (not an expense).
• Show tax as a current liability in the Statement of Financial Position, as it is owing at period end and will not be paid until the next financial year.
• It is an accrual, but should be shown separately

Question 28

Preparation of company financial statements

Reconciliation of Retained Earnings: Dividend

Answer 28

• Show as an appropriation of profit in the Retained Earnings Reconciliation (not an expense)
• Show as a current liability in the Statement of Financial Position, as it is owing, but not paid until the next Financial Year
• It is an accrual, but should be shown separately

Question 29

Preparation of company financial statements

Reconciliation of Retained Earnings: Debentures

Answer 29

For instance, 8% Debenture, is a long term loan and should appear in the Statement of Financial Position. The 8% represents the interest and it’s a finance cost.

Question 30

Preparation of company financial statements

Reconciliation of Retained Earnings: Ordinary Shares

Answer 30

It is the main source of equity funding and it appears in the Statement of Financial Position, in the Equity and Reserves Section and is part of the Shareholders’ funds.

Question 31

Preparation of company financial statements

Income Statement

Answer 31

Sales Revenue
Less Cost of Sales (opening inventory, purchases)
Less Closing Inventory
This will equal Gross Profit

Distribution Costs
(advertising, salaries, motor expenses, depreciation on motor vehicles)
Administration Costs
(directors remuneration, wages, light and heat, general expenses, depreciation on office equipment)

Add each of them, and deduct them from Gross Profit above equals Operating Profit

Less Finance Cost
(debenture interest)
Equals Profit before taxation
Less Corporation Tax
Equals Profit for the Year

(Corporation tax is 20% of the profit before tax)
Example: profit before tax £76,180 x 20% = 15,236
Profit for the year will be 76,180 - 15,236 = 60,944

Question 32

Preparation of company financial statements

Reconciliation of Retained Earnings, example

Answer 32

Year 1

Retained Earnings Reconciliation
Balance brought forward £0
Profit for the Year (from Income Statement): 60,944
Ordinary Dividend (20% of face value of issued shares*): (14,000)
Retained Earnings: 46, 944

• 70,000 issued shares, 20% of face value: 70,000 x 20 = 14,000

Question 33

Preparation of company financial statements

Statement of Financial Position

Answer 33

Non Current Assets
Include a column for the accumulated depreciation in the middle, and the last should be the net carrying value (NCV)

Current Assets

Deduct Current Liabilities

Current assets - current liabilities = net assets

Non Current Assets + Current Assets - Current Liabilities = Total (which will have the non-current liabilities below deducted from)

Non Current Liabilities
(debentures, long terms loans)

Non Current Assets + Current Assets - Current Liabilities - Non Current Liabilities = Net Assets

Equity and Reserves Section
Ordinary shares at £1 fully paid
Retained Earnings
The addition of these should equal the Net Assets amount

Question 34

Non Current Assets

Answer 34

The Statement of Financial Position should show the accumulated depreciation and the net carrying value.

Question 35

Current Assets

Answer 35

Should be entered in liquidity order (how fast they can be converted to cash)

Question 36

Current Liabilities

Answer 36

Only amounts payable within one year are included in this category (receivables, VAT, overdraft, corporation tax, share dividends, debenture, interest on loan).

Current Liabilities deducted from Current Assets = Net Current Assets.

Question 37

Non Current Liabilities

Answer 37

Any long term financing is shown in this section (debentures and any other long term bank loans).

Question 38

Equity and Reserves

Answer 38

Total financing that came from shareholders:

• share capital (ordinary and preference shares)
• share premium (if any)
• specific reserves
• retained earnings - represents undistributed profit carried forward from that source

Net Assets should equal the Equity and Reserves

Question 39

Retained Earnings Reconciliation for year 2

Answer 39

Balance brought forward from previous year
Profit for the year (from the Income Statement)
Less ordinary dividend share
Equals retained earnings (for that year)

Question 40

Interim Dividend

Answer 40

Companies with thousands of shareholders will pay dividend 6 months into the financial year, this will help with cash flow planning by making payments twice a year, instead of a large payment once a year.

1. Payment was made, so double entries will have been made during the year.
2. Interim dividend is shown as a deduction in the retained earnings reconciliation
3. No entry required in the Statement of Financial Position as there is no amount owing (unlike the final dividend, which is shown as a current liability and will only be paid at year end).