Chapter 06 & 07 An introduction to the financial statements of limited liability companies

1. Chapter 06 & 07An introduction to the financial statements of limited liability companies

2. Limited companies Limited companies were created because of the number of people who invested in businesses but were not involved in the running of the businesses. The Companies Act 2006 governs limited companies. There are two classes of limited company – public limited companies and private limited companies.

3. Limited liability The capital of a limited company is divided into shares. The shares will have a nominal value but this value can be any amount. To become a shareholder, a person must buy one or more shares. A shareholder’s liability is limited to what they have paid for their shares – limited liability.

4. Management of the company The running of the business is carried out by directors. The shareholders hold voting rights and elect the directors at the AGM (annual general meeting). The directors report on their stewardship of the company at the AGM and release an annual report.

5. Share capital There are two types of shares: preference and ordinary. Preference shareholders get an agreed percentage rate of dividend before ordinary shareholders receive anything. Ordinary shareholders receive the remainder of profits available for dividends. The directors place some of the profit in reserves for later use and distribute some of the profit to shareholders as dividend.

6. Share capital (Continued) Authorised share capital is the total of the share capital which the company is allowed to issue to shareholders. Issued share capital is the total of the share capital actually issued to shareholders. Bonus shares are free shares, paid for by utilising the company’s reserves, issued to shareholders without them having to pay anything for them.

7. Loan notes The term loan note is used when a limited company receives money on loan, and a document called a loan note certificate is issued to the lender. Loan note interest has to be paid whether profits are made or not. Loan notes may be redeemable (repayable at a certain date) or irredeemable (repayable on liquidation). Other names used are debentures, loan stock or loan capital.

8. IAS 1 International Accounting Standard 1 (IAS1) states thatthere are four primary statements and gives the prescribed format for each of these: A statement of financial position. A statement of comprehensive income. A statement of changes in equity. A statement of cash flows.

9. IAS 1 Presentation of financial statements IAS 1 requires a complete set of financial statements to include: • Statement of financial position • Statement of comprehensive income (income statement) • Statement of changes in equity • Statement of cash flows • Notes

10. Statement of financial position Statement of financial position as at 31 December 2005 $000 $000 Non-current assets Tangible assets Land and buildings X Plant and machinery X Motor vehicles X X Intangible assets Goodwill X Development costs X Investments X X X

11. Statement of financial position (Cont’d.) Statement of financial position as at 31 December 2005 $000 $000 Current assets Inventory X Accounts receivable X Prepayments and accrued income X Investments X Cash at bank and in hand X X X Capital and reserves Ordinary share capital X 8% Preference share capital X

12. Statement of Financial Position (Cont’d.) Statement of financial position as at 31 December 2005 $000 $000 Capital and reserves X Share premium account X Revaluation Reserve X Accumulated profit X X Non-current liabilities X 10% Loan notes Current liabilities Trade accounts payable X Proposed dividends X Income tax liability X Loan note interest payable X X X Accruals and prepaid income X

13. Statement of changes in equity This shows: The retained profit for the period. The distribution of equity and contributions of equity. A reconciliation between the opening and closing carrying amount of each component of equity.

14. Statement of changes in equity Statement of changes of equity (SOCIE) Ordinary Share capital Share premium Revaluation reserve Accumulated profit total At 1 January 20X5 X X X X X X/(X) (X) Change in accounting policy - - - X X X X X Restated balance X/(X) X/(X) Revaluation surplus/deficits X Net gains and losses not recognised in the income statement

15. Statement of changes in equity (cont’d.) Statement of changes of equity Ordinary Share capital Share premium Revaluation reserve Accumulated profit total Share issue X X X Bonus issue X (X) (X) (X) (X) X X Retained profit for the year (X) (X) Dividends paid/proposed (see notes later) X X X X X At 31 December 20X5

16. Income statement Format per IAS 1 Income statement for the year ended 31 December 20x5 $000 Sales revenue X Cost of sales (X) Gross profit X Distribution costs (X) Administrative expenses (X) Other operating expenses (X) Operating profit X

17. Income statement (Cont’d.) Format per IAS 1 Income statement for the year ended 31 December 20x5 $000 Investment income X X/(X) Finance costs/Net interest cost (net of interest receivable and interest payable) X Profit before taxation Income tax expense (X) Profit after taxation/Net profit for the period X

18. Statement of recognised gains and losses Statement of recognised gains and losses $000 Surplus/deficits on revaluation of assets (e.g. land/buildings) X/(X) Net gains not recognised in the income statement X/(X) Net profit for the period X Total recognised gains and losses X

19. Non-Current Asset Note Land and buildings Plant and machinery Motor vehicles Total Cost At 1 January 20x5 X X X X Additions X X X X Disposals (X) (X) (X) (X) Revaluations X X X X At 31 December 20x5 X X X X Accumulated depreciation At 1 January 2005 X X X X Revaluations - - (X) (X) Charge for year X X X X

20. Non-Current Asset Note (Cont’d.) Land and buildings Plant and machinery Motor vehicles Total Accumulated depreciation Disposals (X) (X) (X) (X) At 31 December 2005 X X X X Net book value At 1 January 2005 X X X X At 31 December 20x5 X X X X

21. Trading and profit and loss accounts of companies The trading and profit and loss accounts for both private and public companies are drawn up in exactly the same way.

22. Statements of profit or loss There are two expenses that would only be found in the statement of profit or loss of a limited company: Directors’ remuneration Loan note interest

23. Allocation of expenses Most expenses will be classed as either: • Cost of sales; • Distribution costs or • Administrative expenses.

24. Fundamental accounting principles The following accounting principles must be followed when preparing company financial statements: A company is presumed to be a going concern. Accounting policies must be applied consistently from year to year. The neutrality concept must be followed. The accruals concept must be observed. Each component item of assets and liabilities must be valued separately. Amounts in respect of items representing assets or income may not be set off against items representing liabilities or expenditure.

25. The appropriation account Next under the profit and loss account is a section called the ‘profit and loss appropriation account’. The appropriation account shows how the net profits are to be appropriated, i.e. how the profits are to be used. This is similar in nature to the appropriation account you learnt about when you looked at partnership accounts, in that it involves distributing the profit. However, that is as far as the similarity goes.

26. We may find any of the following in the appropriation account: Credit side 1 Net profit for the year. This is the net profit brought down from the main profit and loss account. 2 Balance brought forward from last year. It is usually called retained profits.

27. Debit side 3 Transfers to reserves. The directors may decide that some of the profits should not be included in the calculation of how much should be paid out as dividends. These profits are transferred to reserve accounts. There may be a specific reason for the transfer such as a need to replace fixed assets. In this case an amount would be transferred to a fixed assets replacement reserve. Or the reason may not be specific. In this case an amount would be transferred to a general reserve account.

28. 4 Amounts written off as goodwill. • Goodwill, in a company, may have amounts written off it from time to time. When this is done the amount written off should be shown in the appropriation account and not in the main profit and loss account. (See also Section 45.16.) • 5 Preliminary expenses. • When a company is formed, there are many kinds of expenses concerned with its formation. These include, for example, legal expenses and various government taxes.

29. 6 Taxation payable on profits. Sole traders and partnerships pay income tax based on their profits. Such income tax, when paid, is simply charged as drawings – it is not an expense. In the case of companies, the taxation levied upon them is called corporation tax. It is also based on the amount of profits made. Corporation tax is not an expense, it is an appropriation of profits. However, for the sake of presentation and to make the accounts more understandable to the general reader, it is not shown with the other appropriations. Instead, it is shown as a deduction from profit for the year before taxation

30. 7 Dividends. • Out of the remainder of the profits the directors propose what dividends should be • paid. • 8 Balance carried forward to next year. • After the dividends have been proposed there will probably be some profits that have not been appropriated. • These retained profits will be carried • forward to the following year.

31. Exhibit 45.5 IDC Ltd has share capital of 400,000 ordinary shares of £1 each and 200,000 5 per cent preference shares of £1 each. The net profits for the first three years of business ended 31 December are: 20X4, £109,670; 20X5 £148,640; and 20X6 £158,220. Transfers to reserves are made as follows: 20X4 nil; 20X5, general reserve, £10,000; and 20X6, fixed assets replacement reserve, £22,500. Dividends were proposed for each year on the preference shares at 5 per cent and on the ordinary shares at: 20X4, 10 per cent; 20X5, 12.5 per cent; 20X6, 15 per cent. Corporation tax, based on the net profits of each year, is 20X4 £41,000; 20X5 £52,500; 20X6 £63,000.

32. IDC Ltd Profit and Loss Appropriation Accounts (1) For the year ended 31 December 20X4 £ £ Profit for the year before taxation 109,670 Less Corporation tax ( 41,000) Profit for the year after taxation 68,670 Less Proposed dividends: Preference dividend of 5% 10,000 Ordinary dividend of 10% 40,000 (50,000) Retained profits carried forward to next year 18,670

33. (2) For the year ended 31 December 20X5 £ £ £ Profit for the year before taxation 148,640 Less Corporation tax ( 52,500) Profit for the year after taxation 96,140 Add Retained profits from last year 18,670 114,810 Less Transfer to general reserve 10,000 Proposed dividends: Preference dividend of 5% 10,000 Ordinary dividend of 121/2% 50,000 60,000 (70,000) Retained profits carried forward to next year 44,810

34. (3) For the year ended 31 December 20X6 £ £ £ Profit for the year before taxation 158,220 Less Corporation tax ( 63,000) Profit for the year after taxation 95,220 Add Retained profits from last year 44,810 140,030 Less Transfer to fixed assets replacement reserve 22,500 Proposed dividends: Preference dividend of 5% 10,000 Ordinary dividend of 15% 60,000 70,000 (92,500) Retained profits carried forward to next year 47,530

35. Income statement Format per IAS 1 Income statement for the year ended 31 December 20x5 $000 Sales revenue X Cost of sales (X) Gross profit X Distribution costs (X) Administrative expenses (X) Other operating expenses (X) Operating profit X

36. Income statement (Cont’d.) Format per IAS 1 Income statement for the year ended 31 December 20x5 $000 Investment income X X/(X) Finance costs/Net interest cost (net of interest receivable and interest payable) X Profit before taxation Income tax expense (X) Profit after taxation/Net profit for the period X

37. The trial balance of Molly, a limited liability company, as at 31 December 2005 was as follows: Dr Cr $ $ Sales and purchases 20,000 50,000 Inventory 8,000 Distribution costs 8,000 Administration expenses 15,550 Receivables and payables 10,000 20,000 Fundamental reorganisation costs 2,400 Cash at bank 8,100 Ordinary shares 50c 8,000 10% Preference shares $1 9,000 10% Loan notes 8,000 Non-current assets at net book value 35,000 Share premium 3,000 Accumulated profits at 1 January 2005 3,000 Loan note interest 400 Preference dividend 450 Interim ordinary dividend 1,600 Income tax 500 Suspense 8,000 109,500 109,500

38. The following is to be taken into account: (a) A building whose net book value is currently $5,000 is to be re valued to $11,000. (b) A final ordinary dividend of 10c per share is proposed before the year-end. (c) The balance on the income tax account represents an overprovision of tax for the Previous year. Income tax for the current year is estimated at $3,000. (d) Closing inventory is $12,000. (e) The balance on the suspense account represents the proceeds from the issue of 4,000 ordinary shares. Required: Prepare the following statements for the year ended 31 December 2005: (a) Income statement (b) Statement of Financial Position (c) Statement of changes in equity (d) Statement of recognised gains and losses

43. Activity