Chapter 2 – Introduction to Limited Company Financial Statements Accounting terminology Advantages of forming a limited company The Companies Acts / Governing documents of companies Types of shares issued by limited companies Loans and debentures Statement of profit or loss and other comprehensive income Statement of financial position / Reserves Statement of profit or loss - Terminology

Advantages and disadvantages of incorporated status: Advantages when a company goes into liquidation the owners of the company (the shareholders or members, who hold at least 1 share) can only lose the amount of their investment (money already paid), together with any amounts unpaid on their shares the shareholders can share in the profits of the business without necessarily having to work day-today for the business companies are in a better position when borrowing money (for example: they can issue debentures / shares to raise finance) the company will continue in existence even if shareholders die (if a sole trader dies the business will only continue if someone buys it)

Advantages and disadvantages of incorporated status: Disadvantages a large company must normally have an audit of its accounts and therefore must pay audit fees a company must prepare its accounts in a format prescribed by legislation (recognised accounting standards) a company suffers a greater administration burden than a sole trader (for example: it must file its accounts with the Registrar of Companies and hold an AGM of its shareholders)

Differences between a sole trader and a limited company: A limited company is a separate legal entity and is distinct from its owners, it has shareholders and as such they have limited liability for the debts of the company Sole traders, whilst being treated for accounting as a single entity, are in fact not, they have unlimited liability for the debt of the business There are two types of limited company; Private – they must include Limited or Ltd in their name Public – they must include the letters ‘plc’ in their name (issued share capital > £50,000 and at least 2 members & 2 directors)

Types of limited company: The main difference between limited and ‘plc’s is that a limited company may not offer its shares to the public, whereas a ‘plc’s shares are available to the public, therefore all companies listed on the Stock Exchange are public companies A company limited by guarantee is not formed with share capital, but moreover relies on the guarantee of its members to pay a stated amount in the event of the company’s insolvency (charities, artistic and educational organisations are examples of these)

Articles of association is a governing document required by the Companies Act in the setting-up of a company, which; provides the constitution of the company regulates the affairs of the company to the outside world sets out the rules for running the company, including the powers of directors and the holding of company meetings

Types of shares issued to limited companies: The authorised share capital (nominal or registered capital) is the maximum share capital that the company is allowed to issue For companies formed prior to the Companies Act 2006, the statement of authorised share capital is given in a governing document of the company (Memorandum of Association) There is no requirement under the Companies Act 2006 to have authorised capital Where a company has an amount stated for authorised capital it can increase the amount by passing a resolution at a general meeting of the shareholders (where they may wish to expand the business) Authorised share capital can be shown on the statement of financial Position (or as a note to the accounts) but must not be added into the total of the statement of financial position (as it may not be the same as the issued share capital)

Types of shares issued to limited companies: The authorised and issued share capital may be divided into a number of classes or types of share Ordinary (equity) shares: These are the most commonly issued class of share which carry the main ‘risks and rewards’ of the business the risks are losing part or all of the value of the shares if the business loses money or becomes insolvent the rewards are that they take a share of the profits, in the form of dividends, after allowance has been made for all expenses of the business, including finance costs, tax and after preference dividends (if any) Profits may be retained to pay dividend in future years when profits are not so high or losses occur

Types of shares issued to limited companies: The authorised and issued share capital may be divided into a number of classes or types of share Preference shares: Preference shares differ from ordinary shares as they usually carry a fixed percentage rate of dividend (for example: 4% of nominal value) Their dividends are paid in preference to those of ordinary shareholders, but they are only paid if the company makes profits In the event of a company ceasing to trade, the preference shareholders will also receive repayment of capital before the ordinary shareholders Preference shares do not normally carry voting rights

Nominal and market values of shares: Each share has a nominal value (par)which is entered in the accounts Shares may be issued with nominal values for any amount (usually £1, £10 or £100) A company could therefore have authorised share capital of £250,000 divided as follows; 250,000 ordinary 0.50p each £125, ,000 4% preference £1.00 each. £125,000 £250,000 Note that some shares are issued with no par value

Nominal and market values of shares: The nominal value usually bears little relationship to the market value, the market value is the price at which issued (second-hand) shares are traded Share prices of a quoted public limited company may be listed in the Financial Times and other business newspapers Issue price: This is the price at which shares are issued to shareholders by the company (either when setting-up or when it needs to raise finance) The issue price is either at par (nominal value) or above nominal value (share premium) Issue price £2.50, nominal value £1.50, Share premium = £1.00

Loans and debentures: In addition to money provided by shareholders, who are the owners of the company, further funds can be obtained by borrowing in the form of loans or debentures Loans, monies borrowed by companies from lenders (usually banks) on a medium or long-term basis Security for loans will be required for the lenders, by making floating charges over some of the assets of the business lenders protect themselves from the financial risks associated with lending Debentures, are formal certificates issued by companies raising long-term finance from lenders and investors Debenture certificates issued by large public limited companies are often traded on the Stock Exchange Loan and debenture interest is payable whether the company makes a profit or not, also loan and debenture holders would be repaid before any shareholders

Statement of profit or loss and other comprehensive income: The statement of profit or loss and other comprehensive income for a limited company is very similar to that of a sole traders or partnerships, there are however two overhead items commonly found in the statement of profit or loss for limited companies; directors’ remuneration (overhead wages) debenture interest (finance costs) The statement of profit or loss and other comprehensive income records the profit for the year (although other items, such as the revaluation of property, are shown after profit in order to show the total comprehensive income of the company) The third of the statements is the statement of changes in equity, this shows how the profit for the year has been distributed and provide a link between the SPL&OCI to the SFP (see page 38)

Statement of financial position: The statement of financial position of a limited company follows a similar layout for those of sole traders or partnerships, there are however differences with the total ‘equity’ section Reviewing the notes and diagram on pages 44 & 45 we can see how the statement of financial position is laid out for a limited company This usually includes lines for amounts to be shown for total assets and total liabilities The total assets comprise the non-current assets and current assets, while the total liabilities comprise non-current liabilities and current liabilities In this way the accounting equation of assets minus liabilities equals equity can be proven

Reserves: There are two types of reserves that we need to consider for limited company accounts; Revenue reserves are profits generated from trading activities and have been retained so as to build up the company Revenue reserves include the balance of retained earnings from the statement of changes in equity. There may also be named revenue reserve accounts (for example: general or specific purpose reserves) Transfers to or from these named revenue reserve accounts are made in the statement of changes in equity Revenue reserves are distributable (they can fund dividend payments)

Reserves: There are two types of reserves that we need to consider for limited company accounts; Capital reserves include; Revaluation reserve – occurs when a non-current asset (most probably property) is revalued (increases), any revaluation is just purely a ‘book’ adjustment (no cash has changed hands) The amount of the revaluation is recorded as other comprehensive income and placed in a revaluation reserve on the statement of financial position, where it increases the value of the shareholders’ investment in the company (review the example on page 39) Capital reserves cannot be used to fund dividend payments if they are non-distributable

Reserves: There are two types of reserves that we need to consider for limited company accounts; Capital reserves include; Share premium account – an established company may issue additional shares to the public at a higher amount than the nominal value (seeking finance for future expansion) Although the shares may have a nominal value of say £1.50 each, because a company may be well established, the shares could attract a premium and be issued for say £2.50 each Here the £1.50 would be recorded in the issued share capital section and the extra £1.00 is the share premium