Ch3: Company accounts

Question 1

What’s a ‘reserve’ on a company’s account?

Answer 1

The capital of the company in excess of the called up value of the issued share capital.

Question 2

Examples of capital reserves:

Answer 2

Share premium account, revaluation reserve, capital redemption reserve.

These cannot be distributed by way of dividend or other payment to shareholders

Question 3

What are revenue reserves?

Answer 3

Retained earnings

They can be distributed to shareholders in the form of dividends.

Question 4

What is a share premium account?

Answer 4

A capital reserve - cannot be distributed to shareholders, except in exceptional circumstances like a bond issue or on a buyback of shares.

Even if the market price goes up, the share premium account will remain unaltered.

Question 5

What is a capital redemption reserve?

Answer 5

Can only be created as a consequence of a transaction between the company and its shareholders, such as, a buyback of shares out of a company’s capital.

Question 6

What do you have to do with revaluation reserve?

Answer 6

The increase in the value of the asset in the Balance Sheet causes the figure for Net Assets to rise corresponding

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.

Question 7

What does the retained earnings represent?

Answer 7

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 8

What happens to dividends in a Statement of Changes in Equity?

Answer 8

Dividends do not belong on a Profit and Loss account.

When a company declares a dividend, this will show up in the SoCiE.

Question 9

What is a proposed dividend?

Answer 9

When the directors have recommended a final dividend, but the shareholders have not yet approved it.

It does not appear in the accounts of that accounting period.

Question 10

What is the procedure for final dividend?

Answer 10

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 General Meeting.

Question 11

What is a declared dividend?

Answer 11

Final dividend that has been approved by the shareholders.

It is a debt of the company enforceable by the relevant shareholders.

Question 12

How and where do you account for declared dividend?

Answer 12

It 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

Question 13

Name the various features of an interim dividend.

Answer 13

• Can be paid without the need for an ordinary resolution
• An unpaid interim dividend is not a debt that the shareholders are legally entitled to sue upon.
• Interim dividends will only be reflected in a company’s accounts if they have actually been paid.

Question 14

What do you do with an interim dividend on the SoCiE

Answer 14

When an interim dividend has been paid in any year the amount of the dividend will have been deducted from the assets, i.e. 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.

Question 15

What’s the legal treatment for final dividend (proposed)?

Answer 15

Not a legal debt, cannot be enforced by shareholders.

Question 16

What’s the legal treatment for Final Dividend – Declared but not paid?

Answer 16

Legal debt enforceable by shareholders.

Question 17

What’s the legal treatment for Final Dividend – Declared and paid?

Answer 17

Legal debt enforceable by shareholders.

Question 18

What’s the legal treatment for Interim Dividend – declared and paid

Answer 18

The interim dividend becomes a legal debt once it has been paid to the shareholders.

Question 19

What’s the accounting treatment for interim dividend?

Answer 19

The assets of the company will have been reduced by the amount of the dividend and the dividend will feature as an item in the trial balance. The dividend will be taken into account in the SoCiE at the end of the accounting period in which it is paid and will impact on the Retained Earnings (profit and loss carried forward) in the Balance Sheet.

Question 20

What’s the accounting treatment for final dividend - declared and paid?

Answer 20

The assets of the company will have been reduced by the amount of the dividend and the dividend will feature as an item in the trial balance. The dividend will be taken into account in the SoCiE at the end of the accounting period in which it is declared and will impact on the Retained Earnings (profit and loss carried forward) in the Balance Sheet.

Question 21

What’s the accounting treatment for final dividend - declared but not paid?

Answer 21

Dividend will be taken into account in the SoCiE at the end of the accounting period in which it is declared. In the unlikely event that the dividend has been declared but not paid as at the date of the Balance Sheet, it will also appear in the Balance Sheet as part of ‘Current liabilities’.

Question 22

What’s the accounting treatment for final dividend - proposed?

Answer 22

Dividend does not appear in the company accounts.

Question 23

What happens if part of the dividend has already been paid to preference shareholders as an interim dividend in any year?

Answer 23

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.

Question 24

What happens to the remainder of the preference dividend if part of it has already been paid to preference shareholders as an interim dividend?

Answer 24

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 25

What does pro rata mean?

Answer 25

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.

Question 26

What do you have to look out for in the exam for a bonus issue of shares?

Answer 26

A company may use its retained earnings or its share premium account to fund a bonus issue (s.610(3) CA 2006) - you should look out for which reserve the company will use to fund the issue.

Question 27

Why would a company pursue a bonus issue of shares?

Answer 27

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.

This also means that shareholders do not have to pay for the bonus sharers.

Question 28

What is the implication to money if a company considers a bonus issue of shares?

Answer 28

This process does not raise money for the company, but rather the company will use its reserves to fund the issue.

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

Question 29

If investments are held for the long term, what would they be on a Balance Sheet?

Answer 29

Non-current asset.

Income from investments (i.e. dividends received by a company) is shown in the Profit and Loss Account.

Question 30

If investments are held only for the short term, with the intention of selling them in the fairly near future, what would they be on a Balance Sheet?

Answer 30

A current asset in the Balance Sheet.

Income from investments (i.e. dividends received by a company) is shown in the Profit and Loss Account.

Question 31

Where can you assess profitability?

Answer 31

• Return on Capital Employed
• Profit Margin
• Earnings per Share

They tell you how profitable is the company.

Question 32

Why is profitability ratios important?

Answer 32

Profitability ratios will demonstrate the rate of return on the capital used in the business.

If net assets of the business are £1,000,000 and the profit is £10,000 then the return is only 1%.

As an investor, you may be able to obtain a better return on your capital elsewhere.

Question 33

What should you look at to see if the company has a safe capital structure or does it rely too heavily on debt as opposed to capital provided by its shareholders by subscribing for shares?

Answer 33

The gearing ratio for financial risk.

A company should not be over dependent on debt and must be able to meet interest payment obligations out of profits. Any change in the profits of a highly geared company will affect the shareholders more than in a company that has raised most of its capital via shares. Excessive debt could force the company into liquidation if profits decline.

Question 34

Where should you look to assess if a company has adequate liquidity?

Answer 34

Ratios comparing a company’s current assets to the amount of its current liabilities

Question 35

Why is it important to know if a company has adequate liquidity?

Answer 35

Having enough total assets to meet all liabilities is not enough. A company needs to pay bills as they come in. Liquidity means having enough cash to meet the company’s payment obligations to its debtors in the short term.

Question 36

Where do you assess if a company is using its working capital efficiently?

Answer 36

Ratios indicating how quickly inventory or receivables are converted into cash.

Question 37

Why is it important to know about a company’s working capital management?

Answer 37

Working capital management is concerned largely with avoiding excessive levels of inventory and unpaid debts.