Week 9 - Accounting for companies: format of financial statements, capital and liabilities

Question 1

What are the main types of business entities?

Answer 1

Sole trader, partnership, and company (limited liability company).

Question 2

What are the features of a sole trader business?

Answer 2

Owned and run by one person

Not a separate legal entity from the owner

Separate for accounting purposes only

Owner is personally liable for debts

Profits belong to the owner

Question 3

What are the features of a partnership?

Answer 3

Owned by two or more individuals

Partners share profits, losses, and liability

Not a separate legal entity

Governed by a partnership agreement

Each partner is jointly and severally liable

Question 4

What are the features of a limited liability company?

Answer 4

Separate legal entity from its owners

Perpetual existence

Shareholders have limited liability

Ownership is separate from management

Can have one or many shareholders

Directors manage the company on behalf of shareholders

Question 5

What does ‘limited liability’ mean for shareholders?

Answer 5

Shareholders are only liable for the amount they invested (nominal value of their shares). They are not personally responsible for the company’s debts beyond this

Question 6

How is a company legally different from a sole trader?

Answer 6

A company is a separate legal person, meaning it can own property, sue, and be sued in its own name.
A sole trader is not legally separate from the individual owner – the business and the person are the same legally.

Question 7

What are the two main types of UK companies limited by shares?

Answer 7

Public Limited Company (PLC)

Private Limited Company (Ltd)

Question 8

What are the key characteristics of a Public Limited Company (PLC)?

Answer 8

Shares can be traded publicly on stock exchanges like the London Stock Exchange

The general public can buy and sell shares

Shares are usually bought from other investors, not directly from the company

Company can issue new shares to raise funds, but this is infrequent and regulated

Must meet specific requirements to be listed (e.g., minimum share capital, disclosure rules)

Question 9

What are the key characteristics of a Private Limited Company (Ltd)?

Answer 9

Cannot offer shares to the public

Shares are privately held, usually by founders, family, or a small group of investors

Shares can be transferred, but often restrictions apply (e.g., shareholder approval needed)

Common structure for small and medium-sized enterprises (SMEs)

Less strict disclosure and regulatory requirements compared to PLCs

Question 10

What is the key difference between a PLC and an Ltd in the UK?

Answer 10

A PLC can offer shares to the public and be listed on stock exchanges; an Ltd cannot make a public offer of shares and remains privately owned.

Question 11

How are expenses divided in a company’s income statement?

Answer 11

Distribution costs – costs related to selling and delivering products (e.g., advertising, delivery costs)

Administration expenses – general running costs (e.g., salaries of office staff, rent, utilities)

Other expenses – any remaining costs that don’t fit into the first two categories

Note: Allocation to each heading involves management judgement.

Question 12

How is taxation treated in a company’s income statement?

Answer 12

Included as an expense

Deducted from the company’s profit

As companies are separate legal entities, they pay corporation tax on their profits

This is shown as a tax expense in the income statement

Question 13

Why doesn’t income tax appear in the accounts of a sole trader?

Answer 13

Sole traders are not separate legal entities from their owners

Owners pay personal income tax on total income, including business profits

Therefore, income tax is a personal expense, not shown in business accounts

Question 14

What is the key difference between companies and sole traders in terms of tax?

Answer 14

Companies pay tax as separate entities, and tax appears in their accounts

Sole traders pay tax personally, and it does not appear in business financial statements

Question 15

Are there major differences in the assets section of the balance sheet between a sole trader and a company?

Answer 15

No. The assets section of the balance sheet typically has the same layout and contents for sole traders and companies. Assets are classified into current and non-current (or fixed), including cash, inventory, receivables, plant, equipment, and intangible assets.

Question 16

What kinds of liabilities can companies have that sole traders typically do not?

Answer 16

Companies can have additional liabilities such as:

Debentures or bonds issued to raise capital

Corporate tax liabilities

Dividends payable

Deferred tax liabilities

Provisions for employee benefits or legal obligations

Question 17

What is a provision on a company’s balance sheet?

Answer 17

A provision is a liability of uncertain timing or amount.
It’s recorded when:

A present obligation exists (legal or constructive),

It’s probable that an outflow of resources will be needed, and

The amount can be reliably estimated.
Example: Provision for warranty claims.

Question 18

What is a contingent liability?

Answer 18

A contingent liability is a potential obligation that may arise depending on the outcome of a future event.

Not recorded on the balance sheet, but disclosed in notes.

Example: Pending lawsuits, guarantees.

Question 19

How is equity different between a sole trader, partnership, and company?

Answer 19

Equity reflects the legal ownership structure:

Sole trader: Equity = Capital introduced + Profit - Drawings

Partnership: Equity includes each partner’s capital and current account

Company: Equity is more complex, typically includes:

Share capital

Share premium

Retained earnings

Other reserves (e.g., revaluation reserve)

Question 20

Why is equity more complex in a company?

Answer 20

Because companies can raise capital through issuing different types of shares (ordinary, preference), and have legal obligations to shareholders (e.g., dividends).
They must also maintain detailed equity accounts in line with accounting standards and company law.

Question 21

How does the IASB Conceptual Framework (2018) define a liability? (Para 4.26)

Answer 21

A liability is a present obligation of the entity to transfer an economic resource as a result of past events

Question 22

According to the IASB Conceptual Framework (2018), what is an economic resource? (Para 4.4)

Answer 22

An economic resource is a right that has the potential to produce economic benefits.

Question 23

What does “present obligation” mean in the context of a liability?

Answer 23

It means that the entity is currently bound or required to transfer an economic resource due to a past event—the obligation exists now, not in the future.

Question 24

What are some examples of economic resources transferred to settle liabilities?

Answer 24

Cash

Goods or inventory

Other assets (e.g., equipment)

Services

Question 25

What are examples of past events that cause liabilities to arise?

Answer 25

Receiving goods or services without paying immediately (creates accounts payable) Borrowing money (creates a loan liability) Legal obligation from a court ruling Signing a binding contract for future payments

Question 26

Why must the event causing a liability be in the past?

Answer 26

Because the liability must reflect a present obligation—this obligation only exists if something has already occurred to create it.

Question 27

Can a liability exist without a legal obligation?

Answer 27

Yes, the obligation can also be constructive, meaning the entity has created an expectation through past practice or public statements that it will fulfill certain responsibilities.

Question 28

What are the two broad classifications of liabilities in financial statements?

Answer 28

Current liabilities Non-current liabilities These classifications broadly mirror those used for assets.

Question 29

What defines a current liability under IAS 1?

Answer 29

A liability is current if it meets any of the following: Held for trading Due to be settled within 12 months after the reporting period The entity does not have an unconditional right to defer settlement for at least 12 months

Question 30

Give examples of current liabilities.

Answer 30

Trade payables Short-term loans Accrued expenses Current tax liabilities Provisions due within 12 months

Question 31

What are non-current liabilities?

Answer 31

Liabilities that do not meet the definition of current liabilities. These are expected to be settled after 12 months from the reporting date.

Question 32

Give examples of non-current liabilities.

Answer 32

Long-term borrowings Deferred tax liabilities Long-term lease obligations Pension obligations

Question 33

How does the classification of liabilities align with asset classification?

Answer 33

Just like assets are split into current and non-current based on use or realisation within 12 months, liabilities are classified based on their expected settlement timeframe.

Question 34

What are some examples of current liabilities on a company's statement of financial position?

Answer 34

Bank loans and overdrafts Loans and debentures due within 12 months Current income tax liability Accrued interest on loans/debentures Short-term provisions

Question 35

What are non-current liabilities in a company’s financial statements?

Answer 35

Loans and debentures maturing in more than 12 months Provisions due after 12 months (Note: Deferred tax liabilities are usually included, but not required for this year's course)

Question 36

What’s the key difference between current and non-current liabilities?

Answer 36

Current liabilities are due within 12 months Non-current liabilities are due after 12 months

Question 37

Is accrued interest on a loan a current or non-current liability?

Answer 37

Current liability, because it’s expected to be paid in the short term.

Question 38

Are short-term provisions classified as current or non-current liabilities?

Answer 38

Current liabilities, as they are expected to be settled within 12 months.

Question 39

What are the two components of a loan repayment?

Answer 39

Interest charge (expense in the income statement) Capital repayment (reduces liability in the balance sheet)

Question 40

What is the journal entry for recording loan interest?

Answer 40

Dr: Interest Expense (Income Statement) Cr: Cash (Bank paid) This records the cost of borrowing for the period.

Question 41

What is the journal entry for recording capital repayment of a loan?

Answer 41

Dr: Loan (Balance Sheet) Cr: Cash (Bank paid) This reduces the loan liability on the balance sheet.

Question 42

Why do we separate interest and capital when recording loan repayments?

Answer 42

Because interest is an expense (affects profit), while capital repayment is a reduction in liability (affects the balance sheet, not profit).

Question 43

Where is loan interest shown in the financial statements?

Answer 43

In the Income Statement as Interest Expense.

Question 44

Where is the capital portion of a loan shown in the financial statements?

Answer 44

In the Statement of Financial Position (Balance Sheet) under Liabilities.

Question 45

Class exercise 1 - liabilities Vinto plc has an opening balance on its 10 year bank loan of £720,000 at 1 January 2019. – The interest due on this loan is at 5% annually. * During the year to 31 December 2019, the company pays £30,000 interest and it repays 10% of the capital on 31 December 2019. * Show the appropriate extracts from the financial statements in respect of this loan as at 31 December 2019 (no headings required).

Answer 45

Interest paid (£30,000): Dr: Interest expense £30,000 Cr: Cash £30,000 Interest accrued (unpaid 5% of £720,000 = £36,000 total – £30,000 paid = £6,000 accrued): Dr: Interest expense £6,000 Cr: Accruals £6,000 Capital repayment (10% of £720,000 = £72,000): Dr: Bank loan £72,000 Cr: Cash £72,000 Income Statement: Bank interest expense: £36,000 Statement of Financial Position (Balance Sheet): Current liabilities: Interest accrual: £6,000 Non-current liabilities: Bank loan: £648,000 (£720,000 – £72,000 repayment)

Question 46

What are the two main types of uncertain liabilities?

Answer 46

Provisions Contingent liabilities

Question 47

What is a provision?

Answer 47

A liability of uncertain timing or amount. It is recognised in the financial statements when: A present obligation exists Settlement is probable The amount can be reliably estimated

Question 48

How do provisions differ from accruals or payables?

Answer 48

Accruals/payables have more certainty about timing and amount Provisions involve uncertainty in either or both timing and amount

Question 49

Why is the concept of prudence important when dealing with provisions?

Answer 49

Prudence means that potential liabilities should be accounted for even if the exact amount or timing is uncertain, to avoid overstating profits or assets.

Question 50

What is a contingent liability?

Answer 50

A possible obligation that arises from a past event, depending on a future uncertain event that is not entirely within the control of the business.

Question 51

Key difference between provisions and contingent liabilities?

Answer 51

Provisions: Liability is probable and recognised on the balance sheet Contingent liabilities: Liability is only possible and not recognised, but disclosed in notes if material

Question 52

Give examples of provisions and contingent liabilities.

Answer 52

Provision: Warranty claims, legal obligations with expected payout Contingent liability: Pending lawsuit where the outcome is uncertain

Question 53

When should a provision be recognised in the financial statements?

Answer 53

A provision should be recognised only if all three of the following are met: A present obligation exists from a past event Payment is probable (more likely than not) The amount can be estimated reliably

Question 54

What does “probable” mean in the context of provisions?

Answer 54

“Probable” means there is a greater than 50% chance that an outflow of economic resources (e.g., cash) will be required to settle the obligation.

Question 55

What does it mean for a provision to arise from a past event?

Answer 55

There must be a legal or constructive obligation created by something that has already happened, such as a sale with warranty or contract signed

Question 56

Give two common examples of provisions.

Answer 56

Provision for doubtful debts – when customers may not pay what they owe Provision for repairs under guarantees/warranties – expected repair costs for sold goods under warranty

Question 57

Where are provisions recorded in the financial statements?

Answer 57

Statement of Financial Position (Balance Sheet): as a liability Income Statement: the expense related to the provision (e.g., warranty expense, bad debt expense)

Question 58

What’s the journal entry to record a provision?

Answer 58

Dr: Expense (e.g., Warranty Expense or Bad Debt Expense) Cr: Provision (Liability)

Question 59

What is the journal entry to create a provision of £50,000 for expected warranty claims?

Answer 59

Dr: Warranty Expense (Income Statement) £50,000 Cr: Provision for Warranty Claims (Balance Sheet) £50,000 This reflects the expected future cost based on current sales under warranty.

Question 60

What is the effect of this entry on the financial statements?

Answer 60

Income Statement: Increases expenses → reduces profit Balance Sheet: Increases liabilities via the provision

Question 61

Why is this provision created even though the exact claims aren't known yet?

Answer 61

Due to prudence, we recognise probable liabilities from past events (e.g., sales under warranty), even if the amount or timing isn't exact.

Question 62

Is this provision a current or non-current liability?

Answer 62

It depends on when the warranty claims are expected to be settled: Current if within 12 months Non-current if after 12 months

Question 63

Calculating a provision using expected value Jordanstown sell washing machines which have a 1 year warranty. Based on past experience, they expect: – 80% of machines sold to have no defects, – 12% will have minor defects and – 8% will have major defects. * If all products sold had major defects, repair costs would be £6,000,000 * If all products sold had minor defects, repair costs would be £1,000,000 * Calculate the expected value of the warranty expense for the year and the associated double entry

Answer 63

80% of machines have no defects, resulting in £0 repair costs. 12% of machines have minor defects, leading to £1,000,000 repair costs. 8% of machines have major defects, leading to £6,000,000 repair costs. The expected repair cost is the probability-weighted average of these scenarios. Expected warranty repair costs = (0.8 x £0) + (0.12 x £1,000,000) + (0.8 x £6,000,000) Expected warranty repair costs = £0 + £120,000 + £480,000 = £600,000 Now, we need to create the provision for the expected warranty expense of £600,000. Journal entry: Dr: Warranty Expense (Income Statement) £600,000 Cr: Provision for Warranty Expense (Balance Sheet) £600,000 This entry reflects the estimated cost of future warranty claims, as the company expects to incur £600,000 in repair costs based on the sales made during the year. In future years, if the actual warranty claims are higher than expected, the company will increase the provision by debiting the income statement and crediting the provision account. If the actual claims are lower than expected, the company will decrease the provision by crediting the income statement and debiting the provision account.