Chapter 13 Company financial statements and associated matters Flashcards
13.1 Introduction to a company
A company is a separate legal entity, distinct from its owners (members or shareholders). This principle formed after a case law in 1987 Salomon v Salomon and Co Ltd. The word limited indicates members are only liable for any amounts outstanding on the shares they hold. Companies ending in plc, mean public limited company and indicates the company may issue shares to the general public, all companies on the stock exchange are plc’s. Sole traders cannot issue shares, the owner and the business are the same and there is no separate legal entity.
13.2 Differences of a company as compared to a sole trader
There are three main differences between the financial statements of a company and those of a sole trader:
• The way in which profit is dealt with in the profit and loss account
• The composition of capital in the balance sheet and
• The statutory requirements
Companies are required to prepare accounts that give a true and fair view of the financial position and the financial performance of the company. This means they must prepare their accounts in accordance with accounting standards, this could be FRS 102, 105 or IFRS. The format of the profit and loss account and balance sheet is governed by Companies Act 2006.
13.3 The presentation of the profit section in the financial statements - corporation tax accounting treatment
The presentation of profit in the P+L statement of a company is different to that of a sole trader, the terminology used is also different. FRS 102 allows a company to present the information in arriving at its profit or loss in either one statement or two separate statements. If they adopt for the two-statement approach you have an income statement and the statement of other comprehensive income. If the one statement approach is used FRS 102 calls it the statement of comprehensive income.
Corporation tax – a sole trader pays tax on his adjusted profits, but since they all belong to the trader, they are taxed personally to income tax, the tax is personal to the trader and does not appear in the accounts of the business. A company will pay tax on profits as it is a separate legal personality, this is shown as a deduction from the profit available to the owners or shareholders. The calculation for CT is a provision for the tax based on the profits for the year, it does not represent the tax paid because corporation tax is not payable immediately. The accounting entries for the tax charge are:
£ £
Dr Corporation tax charge (P+L) X
Cr Corporation tax creditor (balance X
sheet current liability)
During the next year, when tax is paid, the entry will be
£ £
Dr Corporation tax creditor X
Cr Bank X
13.3 The presentation of the profit section in the financial statements - value adjustments, revaluations, taxation and dividends for sole traders
Value adjustments – FRS 102 requires fair value adjustments on investment properties and certain financial instruments to be made each period. This requires the change in the market value of these items to be accounted for each year in the income statement.
Revaluations – FRS 102 allows a business to revalue certain fixed assets at each balance sheet date to their current market value. The movements in these values are to be accounted for in the statement of other comprehensive income.
Taxation – the tax expense in the profit and loss account (income statement) can include both the corporation tax charge for the period and a deferred tax expense. Deferred tax is an accounting adjustment to reflect the timing difference between items affecting the profit and loss account (income statement) in the accounts and the tax computation for the business. If an item of tax expense relates to an item that appears in the statement of other comprehensive income, then that the tax expense should also be recorded in the same statement.
Dividends – are payments to the owners of the company (shareholders) and are paid after all other expenses have been deducted. When a sole trader withdraws money, the double entry is:
£ £
Dr Drawings X
Cr Bank X
However, for a company where there are many shareholders this is not a practical for each shareholder to have a drawings account. Instead a system of dividend payments is used. The actual amount of dividend paid by a company is determined by many factors, the main one being the need to retain sufficient profits to provide for the future requirements of the company.
13.3 The presentation of the profit section in the financial statements - dividends
Dividend payments to shareholders whether interim or final dividends do not appear on the face of the profit and loss account (income statement). They are deducted from the accumulated profit or loss account that is shown on the company’s balance sheet as the profit and loss reserve (referred to as retained earnings). This is similar to the treatment of a partner’s drawings. Some companies pay an amount on account of the total dividend before the end of the year, known as an interim dividend, the accounting entry is:
£ £
Dr Profit and loss account reserve X
(balance sheet)
Cr Bank X
At the end of the year directors can declare a final dividend, the final dividend will not be shown in the accounts for the year it relates to, instead shown in the accounts of the year in which it is paid. In the unlikely event it was declared before the accounting period end it will be deduced from the P+L account reverse in the balance sheet of the year it relates. The amount will be shown as a liability or provision in the balance sheet as it will not be paid until the following year. The accounting entry would be:
£ £
Dr Profit and loss account reserve X
Cr Dividend creditor X
We will have two amounts for dividends entered into the P+L reverse – one being the final dividend from the previous period and the other being the interim dividend from the current period.
13.4 The balance sheet
The major different in the balance sheet of a company compared to a sole trader is in the capital section, reflecting the differences in the nature of ownership of a company as compared with an unincorporated business. There is a large amount of statutory control over disclosure of information in a company’s accounts.
A company would normally show the net book value of its fixed assets on the face of the balance sheet with the details of cost and provision for depreciation being provided by way of a note to the balance sheet. Similarly, a company would normally give a breakdown of its debtors (including provisions for doubtful debts, prepayments and accrued income) and creditors (including accruals and deferred income) in a supporting note.
There would normally be a third financial statement – the statement of changes in equity. This statement would reconcile the opening and closing shareholders’ funds and would show the movement on the profit and loss reserve due to both dividends paid and profits retained.
13.5 Statutory Requirements
The owners of the business will not necessarily be the people who run the business. To ensure the directors are running the company effectively and safeguarding the assets, they need to prepare financial statement. Shareholders have no say in the preparation, so they need to be confident they are correct, so therefore companies are subject to strict legal requirements.
There are advantages and disadvantages associated with trading as a company and not a sole trader.
Advantages:
• If liquidation occurs the shareholders are only liable to pay amounts, they have not yet paid for the shares they hold. Sole traders are personally liable for all debts
• The shareholders get a share without having to workday today for the business
• Companies are in a better position for borrowing money, they can issue debentures
• The company can continue even if shareholders die, if sole trader dies the business only continues if sold
Disadvantages –
• Most companies require an audit of their financial statements and must pay auditors’ fees, unless the company is small and exempt from this requirement
• A company must prepare its financial statements in a format prescribed by regulations
• A company suffers a great administration burden than a sole trader. They must file its financial statements each year with the registrar of companies and may be required to hold an annual general meeting of its shareholders.
13.6 The Detail being a company’s balance sheet - share capital and types of shares
Share capital – ownership of a company is through shares. If a company issues 1,000 shares with a nominal value of £1 the account entries would be:
£ £
Dr Bank 1,000
Cr Share capital account 1,000
Although the owners of share capital changes this is not an accounting change on the balance sheet. Instead the company will keep a register of share owners and reflect the changes there.
Different types of share capital – the most important types of shares are:
Ordinary shares – majority of companies have only this type. The holders of the shares are essentially the owners of the company, also called equity shares.
Preference shares – the owners of the shares will have priority over the ordinary shareholders in the payment of their dividend which is usually of a fixed amount. Also, if the company is wound up, they normally are repaid their capital before the ordinary shareholders
The main difference is ordinary shareholders (risk takers) reward is related to how well the company performs and the preference shareholders (non-risk takers) entitlement is fixed.
13.6 The Detail being a company’s balance sheet - shares issued at a premium, profit and loss reserve and shareholder’s funds
Shares issued at a premium – the share premium account arises when a company issues shares at a premium over the nominal value of the shares. The premium over the nominal value must be credited to a share premium account leaving the nominal amount to be credited to a share capital account.
The profit and loss reserve – this reverse in the balance sheet represents the cumulative total of the company’s retained profits. The double entry is:
£ £
Dr Profit and loss account (income statement) X
Cr profit and loss account reserve (balance sheet) to X
transfer the profit for the year to reserves
Shareholder’s funds – total of share capital and reserves is described as shareholder’ funds or equity. This is directly comparable with the proprietor’s funds shown in a sole traders balance sheet. Shareholder’s funds represent the amount of capital subscribed and owned by the proprietors of a company.
13.7 Raising capital - bonus issue of shares and rights issue of shares
Sole traders are unable to raise funds via shares and can only do so by a bank loan, however companies can.
Bonus issue of shares – extra shares can be issued to shareholders without any money having to be paid for them. Known as a bonus, scrip or capitalism issue. The extra shares issued according to their current proportion. No cash changes hand but the accounting entry is as follows:
£ £
Dr Profit and loss account reserve X
Cr Ordinary share capital with the X
nominal value of the bonus shares issued
This will decrease the value of each individual share as net assets will remain the same, but the number of shares will increase. The value of each share is net assets divided by the number of shares.
Rights issue of shares – this differs from a bonus issue as the company raises cash. Existing shareholders are given the exclusive right to take up a new issue of shares at a favourable price. The number of shares they can buy is proportionate to the number of shares they have, a one for five rights issue means for every 5 shares they have, they can buy one. A shareholder has three options when they get this offer:
• Take up the rights and pay the required amount to the company
• Sell their rights to a third party who then may buy the shares from the company
• Do nothing and let the rights lapse
13.7 Raising capital - methods of debt issue
Unlike a sole trader, companies can issue a capital instrument to raise finance. Usually financial instruments are issued in respect of debentures, loans and debt instruments. These are types of creditors and are disclosed on the balance sheet.
Debentures is the most common form of loan finance by larger companies. They are typically loaning that are repayable on a fixed date in the future. When obtaining a debenture, there is usually a fixed amount of interest due on the amount borrowed, this interest is usually less than that on an overdraft or long-term loan, since this is considered more secure. The company is liable to pay interest before paying dividends to shareholders.
Financial instruments need to be disclosed but the terms of the financial instrument are such that the debt does not need to be repaid for a period of time, usually more than one year, so is disclosed as a long-term creditor. Financial instruments have an interest cost associated with them. This differs from a share’s debenture holders are not owners of a company, they merely act as a bank, receiving interest on their loan. The accounting entries are:
£ £
Dr Bank X
Cr Long term creditor with loan X
monies received by the company
Dr Interest paid X
Cr Bank with the annual interest X
paid to the providers of the loan finance
13.7 Raising capital - director’s loan accounts
Director’s loan accounts
Directors can operate a loan account with the company, more common in smaller companies. Rather than being paid a salary each month a director will typically draw cash out of the business as and when it is needed. The double entry is:
£ £
Dr Directors’ loan account X
Cr bank with the amount drawn by X
the director
At the end of the year (or whenever) the directors will vote themselves salary and bonuses. Rather than these being paid to the director they will go through the loan account to offset the amount withdrawn. The accounting entry is:
£ £
Dr Salaries (P+L account expense) X
Cr directors loan account (balance X
sheet creditor) with the amount of salary
or bonus
In the balance sheet the directors loan account could either be a debit or a credit depending on whether the amount drawn is it excess of the salary or under. This can give rise to issues relating to the timing of accounting for PAYE.
