Business Accounts Flashcards
List the two main financial statements prepared at the end of an accounting period.
The two main financial statements are the profit and loss account and the balance sheet.
What is the relationship between a business and its owner regarding capital contributions?
A business is treated as a separate entity from its owner, meaning that if an owner contributes capital, the business ‘owes’ that capital back to the owner.
Define ‘nominal ledger’ in the context of book-keeping.
A nominal ledger is a record where transactions of a similar type, such as payments for rent and electricity bills, are grouped together.
How does book-keeping contribute to financial management in a business?
Book-keeping contributes to financial management by providing a clear record of all transactions, which aids in budgeting, forecasting, and financial analysis.
How does a purchase of an asset affect the accounts in double entry book-keeping?
When a sole trader purchases an asset for £5,000, there is a £5,000 reduction in cash and a £5,000 increase in assets.
What must be true about the sum of debits and credits in double entry book-keeping?
The sum of all debits must equal the sum of all credits over the relevant accounting period.
Describe the business structure of Mr X.
Mr X operates as a sole trader running the business of XYZ Trading.
Define a trial balance.
A trial balance is a list of all the balances on a business’s ledgers/accounts at the end of an accounting period, showing debit balances in one column and credit balances in another.
Explain the relationship between a trial balance and financial statements.
A trial balance forms the basis of information from which financial statements, such as the profit and loss account and balance sheet, are compiled.
What are payables in a trial balance.
Payables represent the amounts owed by the company to creditors, indicating the company’s short-term liabilities.
What role do receivables play in a trial balance?
Receivables indicate the amounts owed to the company by customers, reflecting the company’s assets.
Identify the types of revenue included in a trial balance.
Revenue in a trial balance typically includes sales income, service income, and any other income generated by the business.
Explain the significance of the provision for doubtful debts in a trial balance.
The provision for doubtful debts accounts for potential losses from uncollectible receivables, impacting the net asset value.
Describe the relationship between purchases and inventory in a trial balance.
Purchases increase inventory levels, and the cost of goods sold is reflected in the expenses, impacting the overall profitability.
Identify the five types of accounts represented in a trial balance.
The five types of accounts are asset, liability, capital, income, and expense (ALCIE).
Describe the importance of the ALCIE classification in financial statements.
The ALCIE classification is important as it helps in categorizing different types of accounts, which is essential for preparing accurate financial statements like balance sheets.
What is a balance sheet.
A balance sheet is a financial statement that summarizes a business’s assets, liabilities, and equity at a specific point in time.
What is in a balance sheet extract.
A balance sheet extract typically includes fixed assets, current assets, current liabilities, long-term liabilities, and net assets.
Define net book value in the context of a balance sheet.
Net book value is the value of an asset after accounting for accumulated depreciation.
What are current assets in a balance sheet.
Current assets represent the assets that are expected to be converted into cash or used up within one year, indicating liquidity.
What are long-term liabilities in a balance sheet.
Long-term liabilities are obligations that are due beyond one year, impacting the company’s financial stability and leverage.
Discuss the importance of cash at bank in current assets.
Cash at bank is crucial as it represents liquid assets available for immediate use, impacting a company’s liquidity and operational flexibility.
How long must a company hold a fixed asset for it to be classified as such?
A company must hold a fixed asset for over a year for it to be classified as a fixed asset.
What are fixed assets also known as?
Fixed assets may also be called ‘non-current assets’.
Define current assets.
Current assets are cash and items owned by a business that can quickly be converted into cash, typically within one year.
Do current assets include items owed to the business?
Yes, current assets include items owed to the business, such as accounts receivable.
Describe the two main categories of liabilities.
Liabilities are categorized as current liabilities, which are due to be paid within a year, and long-term liabilities, which fall due after one year.
Give examples of current liabilities.
Examples of current liabilities include a bank overdraft (repayable on demand) and trade creditors (such as suppliers of raw materials).
Identify a common example of a long-term liability.
A common example of a long-term liability is a term loan, which falls due after more than one year.
What is another term for long-term liabilities?
Long-term liabilities are also known as non-current liabilities.
How does a sole trader pay themselves from the business profits?
A sole trader pays themselves through drawings taken from the profits of the business. They cannot employ themselves and pay a salary
How do year-end adjustments affect the trial balance?
Year-end adjustments correct imbalances in the trial balance, ensuring that expenses and income are accurately reflected for the current accounting period.
What happens if year-end adjustments are not made?
If year-end adjustments are not made, the financial statements may inaccurately reflect the business’s expenses and income, leading to potential financial misstatements.
Describe the purpose of a profit and loss account.
The profit and loss account records the income of a business throughout an accounting period minus the expenses incurred in that period, resulting in a profit or loss figure for the period.
What type of account is ‘cash at bank’ and where does it appear?
‘Cash at bank’ is an asset account and does not appear on the profit and loss account.
What is the significance of opening and closing stock in the Profit and Loss Account?
Opening stock is the value of inventory at the beginning of the period, while closing stock is the value at the end; they are used to calculate the cost of sales.
Explain the calculation of cost of sales in the Profit and Loss Account.
Cost of sales is calculated by adding opening stock to purchases and then subtracting closing stock.
How does closing stock affect the cost of sales calculation?
Closing stock reduces the cost of sales, as it is subtracted from the total of opening stock and purchases.
Describe the purpose of a balance sheet .
A balance sheet records the financial position of a business by detailing its assets, liabilities, and capital accounts, providing a complete view of its financial status at year-end.
Define the components of a balance sheet.
The components of a balance sheet include assets, liabilities, and capital accounts.
What role do liabilities play in a balance sheet?
Liabilities represent the obligations or debts that a business owes to external parties, indicating the financial responsibilities of the business.
Describe the main difference between a balance sheet and a profit and loss account.
A balance sheet is a snapshot of a business’s financial position on a specific date, while a profit and loss account relates to a period of time, typically a year.
What information does a balance sheet provide about a business’s assets?
A balance sheet records the value of the total assets held by the business as of the specified date.
Describe the two key pieces of information provided by a balance sheet.
The balance sheet reveals the net worth or net asset value (NAV) of a business, which is the value of its assets minus its liabilities, and the capital invested in the business to achieve that net worth.
How is net worth represented on a balance sheet?
Net worth is recorded in the top half of the balance sheet as the net asset value (NAV), which is the value of the assets less the liabilities.
What does the bottom half of a balance sheet represent?
The bottom half of the balance sheet represents the capital invested in the business to achieve its net worth.
Explain the relationship between the two halves of a balance sheet.
The two halves of the balance sheet must always balance, meaning the net worth in the top half equals the capital invested in the bottom half, unless there is an error.
Define net asset value (NAV) in the context of a balance sheet.
Net asset value (NAV) is the value of a business’s assets minus its liabilities, indicating the business’s net worth.
How does the top half of the balance sheet relate to the bottom half?
The top half of the balance sheet shows how the money invested by the owners (shown in the bottom half) has been used to create the net worth of the business.
What would the accumulated depreciation be in the context of Marleys Department Store.
Accumulated depreciation refers to the total depreciation expense that has been recorded against an asset over time. In Marleys’ example, after Year 3, the accumulated depreciation would be £3,600.
Explain the significance of Net Book Value for a business.
Net Book Value is an estimate of the current value of the asset to the business, reflecting its worth after accounting for depreciation.
What formula is used to determine the Net Book Value of an asset?
The formula used is COST – ACCUMULATED DEPRECIATION = NET BOOK VALUE.
How is the current value of a fixed asset calculated?
The current value of a fixed asset is calculated by subtracting accumulated depreciation from the original cost of the asset.
What financial statements reflect the depreciation charges for the van?
The depreciation charges for the van are reflected in the Profit and Loss Account as expenses for each year and on the Balance Sheet as accumulated depreciation liabilities.
What is the total accumulated depreciation at the end of Year 3?
At the end of Year 3, the total accumulated depreciation is £5,856, which is the sum of Year 1 (£2,400), Year 2 (£1,920), and Year 3 (£1,536) depreciation charges.
Calculate the depreciation charge for Year 3 based on the accumulated depreciation.
The depreciation charge for Year 3 is calculated as 20% of the reduced balance, which is £12,000 - £4,320 (total accumulated depreciation after Year 2). This results in a depreciation charge of £1,536 for Year 3.
How does accumulated depreciation appear on the Balance Sheet after Year 2?
After Year 2, the accumulated depreciation appears on the Balance Sheet as a liability, totaling £4,320, which is the sum of Year 1 (£2,400) and Year 2 (£1,920) depreciation charges.
What is the depreciation charge for Year 2 based on the reduced balance?
The depreciation charge for Year 2 is calculated by applying the 20% depreciation rate to the reduced balance of £9,600. This results in a depreciation charge of £1,920.
How is the depreciation charge of 20% for Year 1 calculated for the van purchased by First Response Plumbers for £12,000?
The depreciation charge for Year 1 is calculated as 20% of the initial cost of the van, which is £12,000. Therefore, the depreciation charge is £2,400. £2,400 (Year 1 depreciation) = £9,600.
Describe the process of calculating depreciation using the reducing balance method.
The reducing balance method calculates depreciation by applying a fixed percentage to the asset’s book value at the beginning of each period. For example, if a van is purchased for £12,000 and depreciated at 20%, the first year’s depreciation is £2,400 (20% of £12,000). In subsequent years, the depreciation is calculated on the reduced balance after deducting previous depreciation.
Explain how accumulated depreciation affects the Balance Sheet
Accumulated depreciation is shown in a liability account on the Balance Sheet, which reduces the net book value of the asset, indicating the total amount of depreciation that has been charged against the asset.
What impact does depreciation have on the Profit and Loss Account
Depreciation is recorded as an expense on the Profit and Loss Account, reflecting the loss in value of the shelving as a cost to the business.
Define the accruals/matching concept.
The accruals/matching concept requires that all income and expenditure be matched to the relevant accounting period and that current obligations be anticipated as liabilities.
Marleys Department Store purchases shelving for £6,000, expected to last 5 years. The cost is spread evenly, resulting in an annual depreciation charge of £1,200. This charge accumulates each year, impacting the Profit and Loss Account as an expense and reducing the net book value of the asset on the Balance Sheet.
How is the annual depreciation charge calculated in the example of Marleys Department Store?
The annual depreciation charge is calculated by dividing the total cost of the shelving (£6,000) by its expected lifespan in years (5), resulting in a charge of £1,200 per year.
Explain when the straight-line method is most appropriate to use.
The straight-line method is most appropriate when the service provided by the asset continues consistently throughout its useful economic life.
How does the depreciation graph appear for the reducing balance method?
If plotted on a graph, the depreciation of the asset using the reducing balance method would form a curved line.
In what scenario is the reducing balance method typically used?
The reducing balance method is used where an asset is likely to lose a large part of its value in the first few years of ownership, such as motor vehicles.
What is meant by ‘charge to depreciation’?
The ‘charge to depreciation’ or ‘depreciation charge’ refers to the amount of depreciation expense allocated for an asset during a specific period.
How does a van’s depreciation differ from shelving?
A van tends to produce more revenue in its earlier years and loses value more quickly, making the reducing balance method more relevant compared to shelving.
What is the reducing balance method of depreciation?
The reducing balance method of depreciation applies a higher depreciation charge in the earlier years of an asset’s life, reflecting its rapid loss of value.
Explain why shelving uses the straight-line method.
Shelving uses the straight-line method because it is used consistently over its lifespan and generates a consistent amount of income.
Define the straight-line method of depreciation.
The straight-line method of depreciation allocates an equal amount of depreciation expense for each year of the asset’s useful life.
How should depreciation be carried out according to accounting principles?
Depreciation must be carried out in a systematic and regular manner, using a method that closely reflects how the asset loses value over the relevant accounting periods.
Describe the purpose of depreciation in accounting.
Depreciation is used to account for the decline in value of fixed assets over time and to spread the cost of the asset over its useful life, ensuring that the financial statements reflect a true position of the business.
How do year-end adjustments affect financial statements?
Year-end adjustments ensure that income and expenses are recorded in the correct accounting period, providing a more accurate representation of a company’s financial position.
Describe the situation regarding Panache Beauty Salon’s legal fees at the year end.
Panache Beauty Salon has a balance of £27,000 in the Legal Fees account but has incurred an additional £5,000 in legal fees for which it has not yet received a bill, bringing the total legal fees used to £32,000.
Define the term ‘Accrual’
An Accrual refers to an accounting adjustment that recognizes expenses that have been incurred but not yet paid.
Describe a prepayment
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 for the next year.
How does a prepayment affect financial statements?
If an adjustment is not made for the prepayment, the accounts will not reflect the true position of the business, potentially showing artificially low profits.
How can prepayments impact a business’s profit reporting?
Prepayments can lead to an artificially low profit reporting if the expenses are not properly matched to the period in which the benefits are received.
What is an example of an accrual
An accrual arises when an expense has been incurred but not yet recorded in the accounts, typically because an invoice has not been received.
How does an accrual affect the profit of a business?
If an accrual is not recorded, the profit of the business may appear artificially high, as the expense that should be accounted for in the current period is omitted.
Explain the importance of making adjustments for accruals.
Making adjustments for accruals is crucial to ensure that the financial statements provide a true and fair view of the business’s financial performance and position.
Do accruals impact the trial balance?
Yes, accruals impact the trial balance as they represent expenses that have been incurred but not yet recorded, affecting the overall financial results.
What is the Receivables account in a business context.
The Receivables account shows the amount of money owed to the business by debtors, representing an asset that the business expects to collect.
Explain what constitutes a bad debt.
A bad debt is a receivable that a business knows it will not collect, often due to the debtor’s insolvency.
What happens to bad debts in accounting?
Bad debts are written off, meaning they are removed from the Receivables account as the business gives up any prospect of collecting the debt.
How do bad debts affect the trial balance
Writing off bad debts during the accounting year affects the trial balance by creating a bad debts expense account. If no debts are written off, this account will not exist.
Define a doubtful debt.
A doubtful debt occurs when a business recognizes the possibility that a debt or debts may not be paid, without completely writing off the debt.
Describe the difference between a doubtful debt and a bad debt.
A doubtful debt is not written off completely, as the business still hopes to receive payment, while a bad debt is fully written off as uncollectible.
What are general doubtful debts?
General doubtful debts refer to a situation where a business lacks specific information about debtors but anticipates that a certain percentage of its receivables may not be paid due to overall market conditions.
How might a business estimate general doubtful debts?
A business may estimate general doubtful debts by analyzing market conditions and determining a percentage of receivables that are likely to remain unpaid, such as estimating that 5% of receivables may not be collected.
What actions might a business take when it identifies a specific doubtful debt?
When a specific doubtful debt is identified, a business may choose to monitor the debtor’s situation closely and may set aside a provision for the potential loss while still hoping for payment.
Define the term ‘Provision for Doubtful Debts’.
It is an account that reflects the estimated amount of receivables that may not becollected, serving as a financial cushion for the business.
What is the effect of a doubtful debts account?
Its nature is similar to that of a liability account, as it reduces the net asset value of the business.
What types of provisions can a business choose to make?
A business may choose to make a specific provision, a general provision, or a combination of both.
How is the expense for doubtful debts calculated in the Profit and Loss Account?
Only the increase in the provision for doubtful debts over the previous year’s provision is treated as an expense, not the whole amount.
What financial benefit does Nightingales experience in Year 3 due to the change in Provision for Doubtful Debts?
In Year 3, Nightingales experiences a financial benefit of £1,000 due to the reduction in the Provision for Doubtful Debts, which lowers their expenses.
How does the Provision for Doubtful Debts relate to the concept of prudence in accounting?
It reflects the principle of prudence by ensuring that potential losses from uncollectible debts are recognized in financial statements.
What alternative term is used for ‘Provision for Doubtful Debts’ in a company’s Balance Sheet?
It is referred to as ‘Impairments’ in the Balance Sheet.
Define the main difference in the Balance Sheet of a partnership compared to a sole trader.
The main difference is in the bottom half of the Balance Sheet, which denotes capital, as a partnership is owned by at least two different people.
Explain the additional step required to show the capital of a partnership on the Balance Sheet.
To show the capital of a partnership correctly on the Balance Sheet, it is necessary to prepare a profit appropriation statement.
What is the purpose of a profit appropriation statement in a partnership?
A profit appropriation statement records how the profits of the business for the relevant accounting period are divided between the partners.
Describe the purpose of ‘drawings’ in a partnership.
Drawings are withdrawals of profits by the partners during the year, allowing them to pay themselves based on an estimate of their share of expected profits.
How can excessive drawings affect a partner in a partnership?
If a partner draws too much, they may be liable to contribute a balancing payment back to the partnership, depending on the terms of the partnership agreement.
What does the Capital account represent in a partnership?
The Capital account represents the partner’s original investment in the partnership along with any subsequent investments, and this capital cannot be withdrawn in normal circumstances.
Explain the function of the Current account in a partnership.
The Current account records the partner’s share of ongoing business profits and shows any drawings that the partner has taken out over the year.
What is the significance of having separate accounts for each partner in a partnership?
Having separate accounts for each partner allows for clear tracking of individual investments, profits, and withdrawals, ensuring transparency and accountability.
How are the Capital and Current accounts classified in a partnership?
Applying the A/L/C/I/E classification, both the Capital and Current accounts are considered capital accounts.
Describe the process of profit distribution among partners in a partnership.
After calculating the overall profit, the profit is divided among partners by first allocating sums for any interest on their capital or salaries as per the partnership agreement, and then distributing the remaining profit according to an agreed profit share ratio.
Define notional salary in the context of a partnership.
Notional salary refers to an amount that one or more partners might receive as specified in the partnership agreement, treated as an appropriation of profits rather than an expense.
How should notional interest be treated in the Profit and Loss Account?
Notional interest should not be treated as an expense item in the Profit and Loss Account; it is an appropriation of profit.
Describe the treatment of salaries paid to partners in a partnership.
Salaries paid to partners are treated as appropriations of profit and will be considered as drawings.
What are residual profits in a partnership?
Residual profits are the profits remaining after each partner has appropriated their entitled amounts, such as notional interest and/or notional salary.
How are residual profits divided among partners?
Residual profits are divided among partners according to an agreed ratio as specified in the partnership agreement.
Explain the significance of a partnership agreement regarding notional salaries.
The partnership agreement specifies the amount of notional salary, if any, that partners may receive, influencing how profits are appropriated.
What happens to profits after partners appropriate their notional salaries?
After partners appropriate their notional salaries, the remaining profits are considered residual profits, which are then divided among the partners.
How does the Profit and Loss Account of a company differ from that of a sole trader or partnership?
The Profit and Loss Account of a company includes a statement of the corporation tax the company must pay on its profits, which is not applicable to sole traders or partnerships.
What sections of the Companies Act 2006 relate to the financial reporting of subsidiaries?
Sections 394A and 479A of the Companies Act 2006 relate to the preparation of individual accounts by subsidiaries.
Define the duty of subsidiaries in terms of financial reporting.
Every subsidiary in a group has a duty to prepare its own individual accounts, although exemptions are widely available, making it rare for subsidiaries to do so in practice.
Explain the reason shareholders of the parent company need information about subsidiaries.
Shareholders of the parent company should have access to information regarding the subsidiary company to ensure transparency and informed decision-making.
Describe the requirement for companies with subsidiaries regarding financial accounts.
Companies with one or more subsidiaries must publish accounts for the entire group as well as their own annual accounts, as mandated by section 399 of the Companies Act 2006.
What is the significance of the statement of equity for shareholders?
The statement of equity provides shareholders with insights into the company’s profit distribution and their returns on investment.
Do dividends affect the Balance Sheet?
Yes, dividends affect the Balance Sheet by impacting the retained earnings section, as they are deducted from profits.
What is retained earnings and where is it shown in financial statements?
Retained earnings represent the total profits carried forward to the next accounting period and appear on the bottom half of the Balance Sheet.
Explain the purpose of the Statement of Changes in Equity (SoCiE).
The Statement of Changes in Equity shows profits brought forward, current year profits, and deductions for dividends, ultimately reflecting retained earnings.
How do dividends appear in financial statements?
Dividends typically appear in the statement of equity or the statement of changes in equity, reflecting transactions between the company and its shareholders.
Are dividends considered an expense of the company
Dividends are distributed from the company’s profits after tax and are not considered an expense of the business.
Explain the importance of consistent presentation in company accounts.
Consistent presentation is crucial to ensure that the story told by the accounts is true and fair.
Explain why tax is not included in the financial statements of sole traders and partnerships.
Sole traders and partnerships do not have separate legal personality, so they do not pay tax as entities; instead, the partners or sole trader pay tax based on their personal tax computations.
Define the role of tax in the financial statements of companies.
Companies have separate legal personality and must pay tax on their own account, which is reflected in their Profit and Loss Account as corporation tax.
How do capital accounts differ in company accounts compared to sole traders and partnerships?
In company accounts, the capital accounts are detailed in the bottom half of the Balance Sheet, including share capital, reserves, and retained earnings, unlike sole traders and partnerships.
Define the filing requirements for public companies under the Companies Act 2006.
Public companies must file their accounts at Companies House within six months after the end of the relevant accounting reference period.
Define the filing requirements for private companies under the Companies Act 2006.
Private companies must file their accounts at Companies House within nine months after the end of the relevant accounting reference period.
Describe the accounting reference date (ARD) as defined by the Companies Act 2006.
The accounting reference date (ARD) is the last day of the month in which the anniversary of a company’s incorporation falls.
What events should solicitors be aware of that may affect their client’s accounts?
Solicitors should be aware of events that could impact financial performance, such as changes in market conditions, regulatory changes, or significant business transactions.
How do financial ratios assist in the interpretation of accounts?
Financial ratios assist in the interpretation of accounts by highlighting relationships between different financial figures, making it easier to assess performance and financial health.
What is the role of a solicitor in relation to their client’s accounts?
A solicitor’s role includes interpreting their client’s accounts to understand the implications of various events and to identify any concealed information within the accounts.
How do the accounting principles for companies compare to those for sole traders and partnerships?
The accounting principles apply equally to companies, sole traders, and partnerships.
Explain the nature of capital reserves regarding distribution.
Assets representing capital reserves cannot be distributed by way of dividend or other payment to shareholders.
What legal reference governs the treatment of revaluation reserves in the UK?
The treatment of revaluation reserves is governed by section 830(2) of the Companies Act 2006.
Define the term ‘notional profit’ in the context of a revaluation reserve.
Notional profit refers to the unrealized profit that a company gains from the increase in value of an asset, which is recorded in the revaluation reserve until the asset is sold.
How does a company create a revaluation reserve?
A company creates a revaluation reserve by increasing the value of its non-current assets on the Balance Sheet, which in turn raises the figure for Net Assets.
Describe the purpose of a revaluation reserve in a company’s accounts.
A revaluation reserve is created to show more up-to-date values of non-current assets, reflecting increases in asset values on the Balance Sheet.
How does the market price of shares affect the share premium account?
The market price of shares has no effect on the share premium account; it remains unchanged regardless of fluctuations in market price after the shares have been issued.
Describe the share premium account.
The share premium account represents the difference between the nominal value of the shares and the actual amount paid by shareholders for those shares, known as the subscription price.
How can revenue reserves be utilized by a company?
Revenue reserves can be distributed to shareholders in the form of dividends.
What are revenue reserves and how do they differ from capital reserves?
Revenue reserves, such as retained earnings, are distributable reserves, meaning they can be distributed to shareholders in the form of dividends.
Describe the entries found in the bottom half of a company’s balance sheet.
The bottom half of a company’s balance sheet includes Called up share capital, Share Premium Account, and Revaluation Reserve.
Give examples of capital reserves.
Examples of capital reserves include the share premium account, revaluation reserve, and capital redemption reserve.
What are the two categories of reserves?
The two categories of reserves are capital reserves and revenue reserves.
Describe the share capital account.
The share capital account indicates the total amount that has been ‘called up’ on each class of issued shares, excluding any premium.
What is the Revaluation Reserve and why is it important?
The Revaluation Reserve reflects the increase in value of a company’s assets when they are revalued, providing a buffer for potential losses and enhancing the equity position.
Explain the purpose of the Share Premium Account.
The Share Premium Account records the amount received by a company over and above the nominal value of its shares when they are issued.
What is the significance of the Called up share capital in a company’s balance sheet?
Called up share capital represents the portion of share capital that shareholders have agreed to pay and is a key component of a company’s equity.
How does the bottom half of a company’s balance sheet relate to the top half?
The bottom half of a company’s balance sheet shows the equity and will balance with the top half of the balance sheet, which represents the Net Asset Value.
How do retained earnings affect a company’s financial statements?
Retained earnings appear on the balance sheet under shareholders’ equity and can influence the company’s ability to reinvest in operations or pay dividends in the future.
Describe the conditions under which a company can pay dividends.
A company can pay dividends if it has ‘profits available for the purpose’ as stated in section 830(1) of the Companies Act 2006.
How are dividends recorded in accounting terminology according to ALCIE?
Dividends are recorded in a capital account as they are transactions between the business and its owner(s).
Explain why dividends do not appear on a Profit and Loss account.
Dividends do not belong on a Profit and Loss account because they are distributions to owners rather than expenses or revenues of the business.
How is a final dividend different from an interim dividend?
A final dividend is declared after the year end and paid sometime thereafter, while an interim dividend is paid during the current accounting period.
When is an interim dividend paid?
An interim dividend is paid during the current accounting period.
When is a final dividend declared?
A final dividend is declared after the year end.
When is a proposed dividend considered a debt to shareholders?
A proposed dividend becomes a debt enforceable by shareholders only after it is approved by an ordinary resolution.
Describe the treatment of a declared dividend in the Balance Sheet if it has not been paid by year-end.
If a declared dividend has not been paid to shareholders by year-end, it will appear in the Balance Sheet as part of ‘current liabilities’.
Describe the power of directors regarding interim dividends.
The articles of a company typically grant directors the authority to decide on the payment of interim dividends without requiring an ordinary resolution from shareholders.
What happens to profits after tax that are not distributed as dividends?
Profits after tax that are not paid to shareholders as dividends are retained within the company.
Describe the two meanings of ‘debenture’.
- It refers to any form of debt security issued by a company. 2. It is also the name of the document that creates a security.
How do preference shares differ from traditional equity?
Preference shares differ from traditional equity when they have no fixed maturity date and dividends are only paid if declared by the company, making them more like equity.
What is the significance of fixed maturity dates in preference shares?
Fixed maturity dates in preference shares make them appear more like debt, as they obligate the company to redeem or purchase the shares at a specified time.
Discuss the implications of dividends on preference shares.
Dividends on preference shares may be fixed or contingent on the company declaring a dividend, affecting their classification as debt or equity.
Describe the purpose of a term sheet in a transaction.
A term sheet outlines the key terms of a transaction, such as loan amount, interest rate, fees, representations, undertakings, and events of default, agreed upon by the lender and borrower. It serves as a non-legally binding statement of understanding for entering into the transaction.
How does a loan agreement differ from a term sheet?
A loan agreement sets out the main commercial terms of the loan in much more detail, including interest amounts, payment dates, principal repayment dates, and any fees due, while a term sheet provides a summary of these terms.
Define a security document in the context of a loan.
A security document is a separate agreement negotiated and entered into when a loan is secured, detailing the collateral or security interests that back the loan.
What is the significance of the loan agreement in debt finance transactions?
The loan agreement is one of the most heavily negotiated documents in a debt finance transaction, as it establishes the detailed terms and conditions governing the loan.
Define the term ‘debenture’ in the context of debt finance.
A debenture refers to any form of debt security issued by a company, including debenture stock, bonds, and other securities, regardless of whether they constitute a charge on the company’s assets.
How do convertible bonds function in terms of debt and equity?
Convertible bonds start as debt securities but can be converted into equity (shares) if the investor chooses, thus having characteristics of both debt and equity.
How does a debenture differ from a loan agreement?
A debenture is a separate document that details the security, while a loan agreement outlines the terms of the loan.
Explain the significance of the debenture document in debt finance.
The debenture document is crucial as it creates a security for the debt, providing details that are distinct from the loan agreement.
What types of securities can be classified as debentures?
Debentures can include debenture stock, bonds, and any other securities issued by a company.
What are undertakings in loan agreements?
Undertakings, also known as covenants, are promises made by the borrower to do or not do something, or to ensure that certain actions are taken or not taken.
Explain the significance of the Events of Default clause in loan agreements.
The Events of Default clause is crucial as it grants the bank the authority to demand repayment of the loan early if the borrower exhibits signs of becoming an enhanced credit risk.
How do breaches of representations and undertakings affect loan agreements?
Breach of either representations or undertakings provides the bank with contractual remedies, as such breaches constitute an Event of Default.
Define the term ‘Event of Default’ in the context of loan agreements.
An Event of Default refers to a situation where the borrower fails to meet the terms of the loan agreement, allowing the bank to take action, such as calling in the loan.
Define debt finance.
Debt finance refers to the method of raising capital by borrowing money, which must be repaid over time, typically with interest.
Describe convertible bonds.
Convertible bonds are bonds that can be converted into shares of the issuer. Upon conversion, the bondholder gives up their right to receive interest and repayment of the principal in exchange for shares.
How can a bondholder manage their investment before maturity?
A bondholder can keep the bond until maturity or sell it to another investor in the capital market.
What happens to the bondholder at the maturity date of a bond?
At maturity, the bondholder receives the value of the bond back from the issuer.
How do debt securities compare to equity securities?
Debt securities, like bonds, are a means for companies to receive money from external sources, similar to equity securities, but they represent a loan rather than ownership.
Explain the restrictions on private companies issuing bonds.
Private companies can only issue bonds to targeted investors and not to the public indiscriminately to avoid legal issues under s 755 CA 2006.
Describe the role of the issuer in a bond agreement.
The issuer, typically a company, promises to pay the value of the bond to the holder at maturity and also pays interest at specified intervals, usually biannually.
Explain the concept of a loan facility.
A loan facility is an agreement between a borrower and a lender that grants the borrower the right to borrow money under the terms specified in the agreement.
What is an amortising loan?
An amortising loan is a type of term loan that is repaid in instalments over the loan period, rather than in a single lump sum.
How does a bullet repayment work in a term loan?
A bullet repayment in a term loan refers to a repayment structure where the entire loan amount is repaid in a single lump sum at the end of the loan agreement.
List the types of debt finance mentioned in the content.
The types of debt finance mentioned are loan facilities and debt securities.
Why is it important for security to be registered at Companies House?
Registering security at Companies House is important to establish the lender’s legal claim over the borrower’s assets and to protect their interests in case of insolvency.
What happens if a borrowing company becomes insolvent?
If a borrowing company becomes insolvent, the lender may enforce their security over the company’s assets to recover the owed amount.
Explain the difference between ‘debt security’ and ‘security for a debt’.
‘Debt security’ is a type of debt instrument that represents a loan made by an investor to a borrower, while ‘security for a debt’ refers to the collateral taken by the lender over the borrower’s assets to protect their interests.
How do lenders protect themselves when providing debt finance?
Lenders protect themselves by taking security over the assets of the borrowing company, ensuring they have a claim on those assets if the borrower cannot repay the loan.
Describe the two classifications of debt finance.
Debt finance can be classified into two main categories: loan facilities and debt securities.
What is a pledge in terms of security?
A pledge is a form of security where the security provider gives possession of the asset to the creditor until the debt is paid back, such as pawning a watch.
Define a lien and provide an example.
A lien is a form of security where the creditor retains possession of the asset until the debt is paid back; an example is a mechanic’s lien, allowing a mechanic to keep a repaired vehicle until payment is made.
Define ‘equity of redemption’ in the context of a mortgage.
The equity of redemption is the security provider’s right to require the creditor to transfer the asset back to them once the debt is repaid.
Explain the relationship between the creditor and the security provider in a mortgage agreement.
The creditor holds ownership of the asset while the security provider retains possession, with specific rights and obligations for both parties.
How does a charge by way of legal mortgage differ from other types of mortgages?
In a charge by way of legal mortgage, ownership of the land remains vested in the security provider, even though a mortgage is taken over the land.
What rights does a charging document provide to a lender?
A charging document grants the lender certain contractual rights, such as the ability to appoint a receiver or administrator to take possession of the asset and sell it if the debt is not repaid.
Define the two types of charges mentioned in the content.
The two types of charges are fixed charges and floating charges.
Explain why fixed charges are generally considered better for creditors.
Fixed charges are generally seen as better for creditors because they provide a more secure form of security over specific assets.
What happens if a debt secured by a charge is not paid back?
If a debt secured by a charge is not paid back, the lender may take possession of the asset, appoint a receiver, or sell the asset to recover the owed amount.
How does a fixed charge affect the security provider’s ability to use the charged assets?
The security provider can use the charged assets in the ordinary course of business but is restricted from disposing of or creating further charges over them without the creditor’s consent.
What happens if a fixed charge becomes enforceable?
If a fixed charge becomes enforceable, the creditor can appoint a receiver for the asset or exercise a power of sale over it.
Define the role of consent in the context of a fixed charge.
Consent is required from the creditor for the security provider to dispose of or create further charges over the fixed charge assets.
Describe the concept of a floating charge.
A floating charge is a type of security interest that ‘floats’ over a class of circulating assets, allowing the security provider to dispose of those assets freely until crystallisation occurs.
What happens during the process of crystallisation in relation to a floating charge?
Crystallisation is the process where the floating charge stops floating and attaches to the specific assets owned by the security provider at that time, giving the creditor control over those assets.
What triggers the crystallisation of a floating charge?
Crystallisation can be triggered by certain events as agreed in the contract between the creditor and the security provider, often occurring when the borrower breaches significant terms of the loan agreement.
Describe the main disadvantage of a floating charge from the creditor’s perspective
The creditor cannot be sure of the value of the secured assets because the security provider has the freedom to dispose of the assets in the ordinary course of business, potentially selling them before crystallisation occurs.
How does a negative pledge clause affect the priority of a floating charge?
If a floating charge document contains a negative pledge clause prohibiting the creation of a later fixed charge, the floating charge will have priority over the later fixed charge holder if that holder had notice of the restriction.
What is an Event of Default in the context of a loan facility?
An Event of Default is a situation where the company fails to meet its loan obligations, triggering the Bank’s right to crystallise the floating charge.
What is a downstream guarantee?
A downstream guarantee is when a parent company (A) guarantees a loan made to its subsidiary (B).
Explain what an upstream guarantee is.
An upstream guarantee occurs when a subsidiary (B) guarantees a loan made to its parent company (A).
What is a cross-stream guarantee?
A cross-stream guarantee is when one subsidiary (B) guarantees a loan made to another subsidiary (C) within the same parent company.
Explain the role of guarantees in the context of bank loans.
Guarantees serve as a promise from a third party, such as the entrepreneur, to fulfill the loan obligations if the primary borrower defaults.
Describe the registration requirement for security created by a company in the UK.
Most security created by a company needs to be registered with Companies House, including charges over assets located both within the UK and abroad.
How long does a company have to register a charge after its creation?
A company has 21 days beginning with the day after the charge is created to register it with Companies House.
What documents are required for registering a charge with Companies House?
The required documents include a section 859D statement of particulars on Form MR01, a certified copy of the charge, and the relevant fee.
List the information that must be included in the section 859D statement of particulars.
The statement must include the company creating the charge, the date of creation, the persons entitled to the charge, and a short description of any relevant land, ships, aircraft, or intellectual property.
What happens if a company fails to register a charge within the specified 21 days?
If a company fails to register a charge within the specified 21 days, the charge may not be enforceable against third parties.
How is the certificate of registration significant in the context of charge registration?
The certificate of registration serves as conclusive evidence that the charge has been correctly registered, as outlined in sections 859I(3), (4), and (5) of the CA 2006.
Who is typically responsible for delivering the statement of particulars for charge registration?
Typically, the lender’s solicitors complete the registration formalities, as they have the most to lose in the event of non-registration.
Define the consequences of failing to register a charge within the specified period.
If a charge is not registered at all or not registered within the 21-day period, it becomes void against a liquidator, administrator, and any creditor of the company, and the debt becomes immediately payable.
Describe the requirements for record-keeping of charge by a company
A company must keep available for inspection a copy of every charge and every instrument that amends or varies any charge, which can be certified copies rather than originals.
What must a company inform Companies House about regarding location of the charge document
A company must inform Companies House of the place where the documents are available for inspection and any changes to that place.
Who is allowed to inspect the documents kept by a company under s 859Q CA 2006?
Any creditor or member of the company can inspect the documents free of charge, while any other person can do so upon payment of a prescribed fee.
Describe the order of payment for creditors during the winding up of a company.
Creditors are paid in the following order:
- Creditors with fixed charges,
- Preferential creditors (primarily wages, occupational pensions, certain sums owed to HMRC),
- Creditors with floating charges (which have crystallised),
- Unsecured creditors (to the extent not paid from the prescribed part fund),
- Shareholders (according to their share rights).
How are preferential creditors prioritized in the winding up of a company?
Preferential creditors are prioritized primarily for wages (up to £800 per employee), occupational pensions, and certain sums owed to HMRC.
Explain the significance of floating charges in the context of company winding up.
Creditors with floating charges are paid after fixed and preferential creditors, and their charges will have crystallised upon the commencement of the winding up. For floating charges created after 15 September 2003, a portion of the proceeds is set aside for unsecured creditors before floating charge holders are paid.
What is the ‘prescribed part fund’ in relation to floating charges?
The ‘prescribed part fund’ refers to a portion of the proceeds from floating charge assets that is set aside for payment to unsecured creditors before the floating charge holders receive their payments.
Identify the last group of creditors to be paid during the winding up of a company.
Shareholders are the last group to be paid, according to the rights attaching to their shares.
Discuss the impact of liquidation/administration costs on creditor payments.
The costs of liquidation or administration must be paid at various stages, which affects the total amount available for distribution to creditors.
Describe the general rules of priority among secured creditors.
In general, if multiple creditors have a fixed charge over the same assets, the first fixed charge created has priority, provided it was properly registered. Similarly, for floating charges, the first floating charge created has priority if properly registered.
How can the order of priority among secured creditors be varied?
The order of priority can be varied by agreement between the creditors through documents such as a Deed of Priority, an Intercreditor Agreement, or a Subordination Agreement.
Define the ranking of shareholders, unsecured, and preferential creditors.
Shareholders, unsecured creditors, and preferential creditors rank equally among themselves within their category, subject to any preferential rights attached to certain classes of shares.
Explain the ranking of unsecured creditors during asset distribution when a company is wound up.
Unsecured creditors do not have priority over one another regardless of when the debt was incurred; they rank equally within their category during the distribution of asset sale proceeds.
How does the order of priority among creditors change with agreements?
Agreements like Deeds of Priority allow creditors to establish a specific order of priority, which can differ from the default rules.
How does debt finance affect a company’s balance sheet?
Debt finance does not change the net asset value of the company or the equity; it only affects the top half of the balance sheet.
Define equity finance.
Equity finance involves raising funds by issuing shares, which impacts both the net asset value and total equity - of a company.
Define debt finance.
Debt finance involves raising funds through loans, which does not change the net asset value or equity of a company.
Summarise how equity finance and debt finance affect the balance
When a company takes finance, equity finance affects both halves of the balance sheet, while debt finance only affects the top half.
Describe the effect on the balance sheet when a company issues shares at their nominal value.
When a company issues shares at their nominal value, the balance sheet will show an increase in share capital (bottom half) to reflect the nominal value of the shares issued, and an increase in cash (current assets - top half) to indicate the cash received for the shares.
What happens to the balance sheet of XYZ Ltd when it issues 100 ordinary shares of £1 each for cash?
When XYZ Ltd issues 100 ordinary shares of £1 each for cash, the balance sheet will reflect an increase in share capital by £100 and an increase in cash by £100.
How does the balance sheet illustrate what a company owns and where it came from?
The top half of the balance sheet shows what the company owns (assets), while the bottom half shows where it came from (equity and liabilities), providing a complete picture of the company’s financial position.
What components make up the price of a share?
The price of a share comprises the nominal value of the share plus a premium, although shares can also trade at a discount to nominal value.
What is the significance of a share trading at a discount to nominal value?
A share trading at a discount to nominal value indicates that the market perceives the company’s value to be lower than the stated nominal value of the shares.
Describe the impact on the balance sheet when a company issues shares at a premium.
When a company issues shares at a premium, the cash received increases the assets on the top half of the balance sheet, while the nominal amount of the new shares increases the share capital on the bottom half. Additionally, the premium per share is recorded in a separate share premium account.
Explain the limitations on the use of funds in the share premium account.
Funds in the share premium account can only be used for limited purposes as specified by law, ensuring they are not used for general business expenses.
Illustrate an example of issuing shares at a premium and its effect on the balance sheet. For example, if XYZ Limited issues 100 £1 ordinary shares for 150p each
,the nominal value of £100 increases the share capital, while the premium of £50 (100 shares x 50p) is recorded in the share premium account.
Define earnings per share (EPS).
Earnings per share (EPS) is a financial ratio that measures the return due to ordinary shareholders, calculated by dividing profit after tax by the average number of ordinary shares in issue.
Describe the impact of an increase in the number of shares on earnings per share.
An increase in the number of shares in issue will result in a dilution of the earnings per share figure.
Describe the changes recorded in a company’s balance sheet when a loan is taken out.
When a company takes out a loan, its liabilities increase by the amount of the loan, and its assets (cash) also increase by the same amount, leaving net assets unchanged.
Define the impact of debt finance on a company’s balance sheet.
Debt finance results in an increase in both liabilities and assets on the balance sheet, while net assets and total equity remain unchanged.
What is gearing?
The ratio of a company’s debt to its equity or capital. The higher the ratio of debt to equity, the more highly a company is geared.
What is the formula for calculating gearing?
Gearing is calculated using the formula: (Long term debt / Equity) x 100%.
What does a higher ratio of debt to equity signify for a company?
A higher ratio signifies that the company is more highly geared, indicating greater financial risk.
Explain the significance of total equity in the gearing ratio.
Total equity represents shareholder funds and is used as the denominator in the gearing ratio to assess financial leverage.
Calculate the gearing ratio for XYZ Ltd given a long-term debt of £750 and total equity of £1000.
The gearing ratio for XYZ Ltd is calculated as (750 / 1000) x 100% = 75%.
Explain the implications of a high gearing ratio for a company.
A high gearing ratio indicates that a company has a significant amount of long-term debt compared to its equity, which may suggest higher financial risk and potential challenges in meeting debt obligations.
Describe what gearing or leverage indicates about a company.
Gearing indicates how highly a company is leveraged, with a higher ratio of debt to equity suggesting more financial risk.
Describe the credit risk associated with highly geared companies.
Highly geared companies are seen as more of a credit risk by banks due to their lower equity levels, which makes it harder for them to raise further loans.
How do interest payments affect a highly geared company’s profits?
In a highly geared company, all of its profits could be consumed by interest payments required under loan agreements, leaving little to no profit for other uses.
why might a highly geared company struggle to secure new lenders?
A company with a lot of debt is less likely to have unencumbered assets to secure for new lenders, as existing debts are likely already secured against those assets.
Describe the potential benefits of a company choosing to be highly geared.
A company may choose to be highly geared to take advantage of profitable investment opportunities by borrowing money, allowing for larger investments than using only its own resources. If the investment performs well, the company retains all profits after paying interest, leading to higher earnings than if it had only used its own funds.
How is high gearing more favourable to shareholder returns than raising money through equity?
High gearing can enhance returns to shareholders because raising money through debt does not dilute existing shares. This means profits are not shared among more shareholders, allowing existing shareholders to retain a larger portion of the profits.
What are the risks associated with high gearing?
The risks of high gearing include the potential for greater losses if investments perform poorly, as the company must still pay interest on the borrowed funds regardless of investment performance.
Discuss the relationship between gearing and the potential for company losses.
Higher gearing increases the potential for larger company losses, as the scale of operations can exceed the available shareholders’ funds.
