Business Accounts

Question 1

Book-keeping ledgers

Answer 1

The process by which businesses record money transactions is called ‘book-keeping’.

Each day there will be a number of financial transactions that take place within a business eg sale of stock or payment of employees’ wages. These need to be recorded in a logical and useful way. As such, transactions of a similar type (eg the payment of rent and electricity bills by the business) are grouped together and recorded in a single place referred to as a ‘nominal ledger’ (eg a nominal expense ledger).

There are several different types of ledgers (also referred to in a general sense as ‘accounts’). The collective name for all of the different ledgers/accounts used by the business is ‘books’.

Question 2

Double entry book-keeping

Answer 2

The principle of this system of book-keeping is that every money transaction that a business undertakes will have a dual effect in its accounts. For example, if a sole trader purchases an asset for £5,000, there will be a reduction of £5,000 in the record of its cash and an increase of £5,000 in the record of the assets of the business.

Having identified, in respect of a particular transaction, the types of account affected and whether there is an increase or reduction, the next step is that the transaction will be recorded in two places in the books of the business. One aspect will be recorded as a ‘debit’ entry and the other as a ‘credit’ entry.

As the value of every individual debit will be equal to the matching credit when all the debits/credits for all transactions are added together, the sum of the business’s debits should be equal to the sum of all its credits over the relevant accounting period.

Question 3

The accounting period and trial balance

Answer 3

To make sense of the financial performance of a given business, it is helpful to be able to compare the position year-on-year. Periodically, therefore, the ledgers/accounts of a business will be ‘ruled off’ so that the balances on the various accounts can all be looked at together. This is done at the end of each accounting period/financial year. Many businesses also prepare ‘interim accounts’ during the course of a financial year for various reasons and at different points during the year.

Due to double entry book-keeping, if we take all the balances on all of a business’s ledgers/accounts as at the end of an accounting period and list them, showing debit balances in one column and credit balances in another column, the total of each of the two columns should be the same. This list is called a trial balance.

A trial balance is usually put together by a business or its accountants and forms the basis of information from which the financial statements, principally the profit and loss account and balance sheet are then compiled.

Trial balance

What is a trial balance?

A trial balance is a list of all the balances on all of a business’s ledgers/accounts as at the end of an accounting period.

The trial balance shows debit balances in one column and credit balances in another column. The total of each of the two columns should be the same (and thus balance).

Question 4

The classification of ledgers/accounts

Answer 4

Every entry on the trial balance will relate to a ledger, which could be characterised as an asset, liability, capital, income or expense (ALCIE) account. You need to be able to recognise and classify the different types of account for the purpose of understanding the preparation of the financial statements.

Asset: something a business owns. A business will have a separate account for each category of asset (eg motor vehicles, cash at bank).

Liability: something a business owes. A business will have an account for each different type of liability (eg loans, trade debts).

Capital: usually identifiable as an injection of value from an owner or investor rather than money generated by the business.

Income: money earned by the business, usually from a regular source. Each main income source of the business will have a separate account (eg a theatre might record income from ticket sales and from venue hire in separate accounts).

Expense: money spent by the business. Each different type of expense is recorded in a separate account (eg heating and lighting).

Question 5

Assets – Fixed Assets

Answer 5

A fixed asset is any asset, tangible (such as a building) or intangible (such as a trade mark), owned by a business that will enable it to make profit.

To be defined as a fixed asset, it must be held by the company for over a year and provide some long lasting benefit to the company.

A tangible fixed asset is a physicalasset.

An intangible fixed asset does not have a physical existence, for example, a trade mark, patent or goodwill.

Fixed assets may also be called ‘non-current assets’.

Question 6

Assets – Current Assets

Answer 6

Current assets include cash and items owned by the business (or owed to the business) which can quickly be turned into cash (as a rule of thumb, within one year).

These assets are current as they are continually flowing through the business and therefore have a shorter-term nature; for example:

• stock (goods for use or resale), also known as ‘inventory’;
• debtors, which are people who owe money to the business (most commonly ‘trade debtors’, who are customers who have bought on credit and have not yet paid);
• cash, including cash that the business has in its bank account(s) and ‘cash in hand’/’petty cash’. When looking at the accounts of companies, the various types of cash are combined into a ‘cash and cash equivalents’ entry in the Balance Sheet.

Question 7

Liabilities

Answer 7

A liability is an amount owedby the business tosomebody else. These are categorised as current liabilities (broadly, those due to be paid within a year) and long-term liabilities (falling due after one year) (also known as ‘non-current liabilities’).

Examples of current liabilities include a bank overdraft (repayable on demand) and trade creditors(such as suppliers of raw materials). A trade creditor is the mirror image of a trade debtor.

A common example of a long-term liability (or non-current liability) (falling due after more than one year) is a term loan.

Question 8

Capital

Answer 8

Where a business is owned by a sole trader, the assets of the business are the sole trader’s property since the business has no separate legal personality and cannot own property on its own account. However, for accounting purposes, the business and its owner are seen as two separate entities. A sole trader may invest a lump sum of his own money in the business when setting it up. As well as any such original capital contribution, a sole trader’s capital account will include the profits the business has retained over the years.

A sole trader will hope to earn a living from the profits of his business. Since the business is not a separate person, it cannot employ its owner and pay him a salary. Instead, the owner pays himself by means of drawings out of the profits of the business. The account labelled ‘drawings’ in the trial balance is a capital account because it represents transactions between the business and its owner.

Question 9

Income and expense accounts

Answer 9

Expense accounts record day-to-day spending such as the examples in the previous summary, known as ‘revenue’ or ‘income’ expenditure. ‘Expenses’ for these purposes do not include spending on long-term assets (eg a car or a building) which are sometimes, confusingly, referred to as ‘capital expenditure’.

When a business pays for services or buys items that it will not hold for very long before it uses them up, it treats the purchase as an expense. By analogy to your everyday life, if you buy some bread from the supermarket you will think of this as a day-to-day living expense. However, if you buy a car or a television, you will think of this as acquiring an asset.

Income accounts record sums received by the business such as payments from customers in relation to sales of goods or services made by the business.

Question 10

Year-end adjustments

Answer 10

Before the trial balance can be used to prepare the financial statements, year-end adjustments will need to be made to some of the figures. The purpose of the year-end adjustments is to ensure that all income and expenditure shown on the final financial statements relate only to the relevant accounting period.

For example, if a business’s accounting period matches the calendar year and it pays a year’s rent in advance on 1 July, only half of this payment will correspond to the current accounting period (1 June – 31 Dec.). The remaining half (1 Jan – 30 June) will relate to the subsequent accounting period. According to the unadjusted trial balance, it will seem that the business has spent twice as much on rent for the current accounting period than it really has. The adjustments made effectively ‘correct’ this imbalance and you will see how this is done in a later element.

Question 11

The contents of a profit and loss account

Answer 11

As you have seen, the profit and loss account 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. A profit and loss account is therefore a summary of the fortunes of a business over a passage of time. It is always vital to note the period to which a profit and loss account relates in order to understand it. The accounting period to which it relates is recorded in the heading for the account, always with the words ‘for the period ending on [last day of the period]’ or ‘for the year ended [last day of the period]’.

As a general rule, only the income and expense entries from the trial balance are transferred into the profit and loss account.

For example, ‘sales’ in the trial balance is an income account and this appears at the top of the profit and loss account. In contrast, ‘telephone’, ‘postage’ is a business expense and appears in the expenses section of the profit and loss account.

‘Cash at bank’, on the other hand, is an example of an asset account and so does not appear on the profit and loss account.

Question 12

What is a balance sheet?

Answer 12

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.

The date of a balance sheet

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.

Question 13

The contents of a balance sheet

Answer 13

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.

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.

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.

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.

Question 14

What are year-end adjustments?

Answer 14

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.

Question 15

Year end adjustments

Answer 15

There are five year-end adjustments:

Depreciation

Accruals

Prepayments

Bad debts

Doubtful debts.

Question 16

Depreciation

Answer 16

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.

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.

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

Question 17

Depreciation methods

Answer 17

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.

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.

Straight-line method

• 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.

Reducing balance method

• 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.

Question 18

Net Book Value

Answer 18

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.

COST – ACCUMULATED DEPRECIATION = NET BOOK VALUE

The Net Book Value of an asset is an estimate of the current value of the asset to the business.

Question 19

Accruals

Answer 19

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.

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.

Question 20

Prepayments

Answer 20

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.

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.

Question 21

Bad Debts

Answer 21

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’.

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.

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.

Question 22

Doubtful Debts

Answer 22

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:

• Specific doubtful debts: 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.
• 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. it is estimated that 5% of its receivables may not be paid.

Specific and general provisions

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.

Question 23

Using A/L/C/I/E terminology, what type of an account is a provision for doubtful debts?

Answer 23

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.

Doubtful Debts as Expenses in the Profit and Loss Account

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.

Question 24

The Provision for Doubtful Debts on the Balance Sheet

Answer 24

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.

Question 25

Separate accounts for each partner

Answer 25

‘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.

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.

Applying the A/L/C/I/E classification, both these accounts are capital accounts.

Question 26

Appropriation of profits

Answer 26

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.

Notional ‘interest’ on capital

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.

Notional ‘salary’

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.

Share of profits/share of ‘residual profits’

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.

Question 27

Interpretation of accounts in practice

Answer 27

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.

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.

Question 28

Accounting Reference Date

Answer 28

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.

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 may be changes to the types of company that need to file annual accounts after the implementation of the Economic and Corporate Crime and Transparency Bill.

Question 29

What is different about company accounts?

Answer 29

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.

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.

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.

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.

Question 30

Consolidated accounts

Answer 30

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).

Question 31

Called up share capital

Answer 31

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).

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.

Question 32

Reserves

Answer 32

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.

Question 33

Share premium account

Answer 33

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).

Question 34

Revaluation reserve

Answer 34

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.

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.

Question 35

Retained Earnings

Answer 35

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.

Question 36

Statement of Changes in Equity

Answer 36

Retained Earnings:

Brought forward X

Profit for the year X

Dividends paid (X)

Retained earnings X

Question 37

Dividends

Answer 37

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

Question 38

Ordinary shares (‘ordinary dividend’)

Answer 38

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

Question 39

Final Dividend

Answer 39

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.

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 willappear 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.

Question 40

Interim dividend

Answer 40

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.

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).

Any profits after tax not paid to shareholders as dividends are retained in the company.

Question 41

Preference shares

Answer 41

(‘preference dividend’)

Preference dividends are usually paid in two instalments each year. Because of the nature of preference shares, the amount of the dividend will already be known each year.

Example:

A company which has issued 150,000 non-redeemable non-cumulative 7% preference shares of £1 each pays an annual dividend of 7 pence on each preference share (subject to there being sufficient profits to do so). If part of that dividend has already been paid to preference shareholders as an interim dividend in any year, that part will not appear on the top half of the company’s Balance Sheet for the relevant year.

However, it will appear as a deduction in the SoCiE to calculate the Retained Earnings in the bottom half of the Balance Sheet. The remainder of the preference dividend is declared by the shareholders, and though paid after the year end, will appear in the SoCiE to calculate retained earnings and be shown as a Current liability in the top half of the Balance Sheet.

Question 42

Bonus issue of shares

Answer 42

A ‘bonus issue’ of shares is also known as a ‘capitalisation issue’ or ‘scrip issue’.

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 for no consideration; in other words, shareholders do not have to pay for the bonus shares. ‘Pro rata’ means that the proportion of shares held by each shareholder pre- and post-bonus issue will not change, and therefore the proportions of voting rights will also remain the same.

Shares that are issued pro rata are often expressed by way of a ratio, ie x:y, where x is the amount of shares issued to the shareholder for every amount of shares (y) they currently hold.

This process does not raise any money for the company, but rather the company will use its reserves to fund the issue. A company may use its retained earnings or its share premium account to fund a bonus issue (s 610(3) CA 2006).

The assets and liabilities of the company are unchanged after the bonus issue.

Question 43

Equity finance: effect on the Balance Sheet

Answer 43

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.

Question 44

Price for Shares

Answer 44

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.

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.

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.

Top Half of the balance sheet

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

Bottom Half of the balance sheet

• 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.

Question 45

Earnings per share

Answer 45

‘Earnings per share’ is a commonly used ratio that can be used to measure the financial performance of a company.

'’Earnings per share shows the return due to the ordinary shareholders and is calculated by dividing profit after tax by the average number of ordinary shares in issue whilst the profit was generated.

An increase in the number of shares in issue will result in a dilution of the earnings per share figure.

Question 46

Debt finance: effect on the balance sheet

Answer 46

When a company takes out a loan, two changes will be recorded in the balance sheet of the company, both of which will be in the top half (ie the Net Assets) of the balance sheet.

• The company’s liabilities are increased by the amount of the loan;
• The company’s assets (cash) are also increased by the loan funds

The net assets therefore remain unchanged. Also, because the company has taken out a loan (debt) rather than issued new shares (equity), total equity is also unchanged.

Question 47

Gearing

Answer 47

The ratio of liabilities to shareholder funds (total equity in the balance sheet), or in simpler terms, the ratio of debt to equity, is an important indicator of the financial health of a company.

This ratio is known as a company’s gearing (or leverage). The higher the ratio of debt to equity, the more highly a company is geared.

Gearing is calculated by the formula:

Long term debt (Non-current liabilities) x 100%

Equity (Total Equity)

Gearing

The previous example shows that when a company takes out a loan, the net assets figure is not affected.

• The company’s liabilities are increased by the amount of the loan but,
• as the company’s assets (cash and cash equivalents) are also increased by the loan funds, the net assets remain unchanged.

Also, because the company has taken out a loan (debt) rather than issued new shares (equity), total equity is also unchanged.