The structure of limited companies In this section we cover the following topics:
- Features of limited companies
- Share capital - meaning of and accounting for
- Capital and revenue reserves
- Loan capital
- Preparation of internal final accounts and balance sheets of limited companies
Limited companies - an introduction
A quick and easy way for a firm to expand is to attract outside investors who would introduce extra capital into the firm. However, new and small firms are unlikely to attract many investors because of the risk that all sole traders face of unlimited liability. If a sole trader cannot settle the debts of a firm with business resources then the sole trader will have to use her own personal possessions to clear any business debts.
The problem of unlimited liability was realised in the nineteenth century as Britain underwent rapid industrialisation. As a result, the 1855 Companies Act created a new form of business organisation - the Limited Company.
Limited Companies differ from other forms of business organisations because they are seen as separate legal entities from the owners of these companies. The company exists in its own right and can be treated as separate from the owners of these companies. This means that if the business fails for some reason, the owners of this company cannot be made personally responsible for the debts of the company - in other words, their labiality (what they owe) is limited to what they invested in the company (and no more than that - the total amount that can be lost by an investor is limited to the amount hat they invested).
A company is owned by the shareholders of that company. Each shareholder 'owns' a share in the company. This share is really a proportion of the capital. Each company raises its initial capital by the issue of shares. Investors will give the company money in the hope of either dividend payments (which are paid out of the profits to all shareholders) and capital gains (the value of their share will increase if the firm is successful).
In most cases, limited companies cannot be run by shareholders, as there are too many in number. Therefore, each limited company will elect a board of directors. Each director is elected by the shareholders (votes are allocated in proportion to the amount of shares owned - the more shares, the more votes one has). The elected directors will run the company in the interest of the shareholders (in nearly all cases the objective of the directors will be to maximise profits so that shareholder returns are highest). Each board of directors will also appoint a chairperson who represents the company's most senior director. The chairperson will provide the overall guidance and strategy for running the company. Directors will have to be re-elected by the shareholders at each annual general meeting (AGM). In most cases, the directors have been elected due to the fact that they own a large number of shares - thus making it hard for them to 'lose' an election.
Setting up as a limited company
The creation of a limited company requires legal formalities to be followed. Two key documents that have to be drawn up are as follows:
- Memorandum of association
- Articles of association
These documents will contain the following details:
Memorandum of association
- Name and address of company
- Objectives of company and its purpose (i.e. its main activities)
- Amount of capital to be raised and number of shares
Articles of association
- Procedure for appointing directors
- Length of time of office for each director (before re-election is required)
- Frequency of company meetings (AGMs)
- Details of auditing arrangements for the final accounts
Once this procedure has been completed and the company is registered with Companies House then the company is, in effect, born. The company will be granted a certificate of incorporation. This means that the company now exists as a separate legal entity from its owners. The company must ensure that shareholders are informed of forthcoming AGMs and also the company must send a copy of the final accounts to the Registrar of Companies (a government official who will ensure that the public has access to company accounts).
Types of limited company
All limited companies must have a reference to the fact that they are a limited company after their name. In the UK there are two types of limited company. These are as follows:
- Private limited company
- Public limited company
Private limited companies
Any private limited company must have the term 'Limited' or 'Ltd' after its name to indicate what type of limited company it is. In a private limited company neither shares or debentures can be issued to the general public. As a result, private limited companies are usually smaller than public limited companies. This type of company is by far the most common in the UK, with around 1,000,000 in existence. A significant proportion of these companies are family businesses. Once would assume that they become companies to benefit from limited liability.
Public limited companies
Public limited companies will have the term 'plc' after their name to indicate what type of limited company they are. Many of the most famous companies in the UK are plcs. This is because, although relatively few in number (approx. 50,000), plc's are usually much larger than private limited companies and are therefore more likely to appear in the media.
Public limited companies are usually larger because their shares can be issued to the general public, and therefore share issues are usually of a much larger scale than for private limited companies. The minimum share capital of a public limited company is £50,000, which means that many family firms will only have the option of becoming a private limited company.
Becoming a public limited company
In addition to the memorandum and articles of association, a public limited company must also obtain a statutory declaration, which would state that the company has met all the requirements of the company legislation.
Once the company has been awarded the certificate of incorporation it can then begin the share issue to raise new capital. The process of becoming a public limited company is often refereed to as floatation.
Plc's will have to attract investors. Issuing a prospectus will help publicise that the company is looking for new investors. A prospectus is a document which outlines what the company is and how it aims to be profitable.
Shares and dividends
Limited companies are co-owned by shareholders - each owns a small proportion of the firm. The minimum number of shareholders is normally two (a private limited company can have one shareholder), but many large public limited companies will have many thousands of shareholders.
Share capital is no different from the capital injected into a firm by a sole trader. It will still appear on the balance sheet and represents the resources put into the firm by the owners. However, there are different types of share capital that need to be examined.
When a company (public or private) is formed, the firm will declare the size of its authorised share capital in its memorandum of association. The memorandum will cover the different types of shares, the face value of each share and the number of shares that a firm is allowed to issue. The face value of each share is the value that the share appears at on the balance sheet. This is also known as the nominal value or the par value.
(* it is possible that the original price that a share is issued at is not the face/par/nominal value. This occurs when the share is sold at a premium - where the issue price is higher than the face value suggests)
Firms may not decide to issue (offer for sale) all of their authorised share capital in one go. It is possible for firms to issue their shares over a number of separate issues. Authorised share capital should appear on the balance sheet of any published accounts (possibly as a note to the accounts), but it is only there for information purposes and is not 'added' to the other data on the balance sheet. On any internal balance sheets (i.e. those not for publication), authorised share capital is unlikely to appear.
Issued share capital
Issue capital refers to the value of the authorised share capital that has actually being issued - that is sold to investors. The issued share capital refers to the face value of certificates in their possession, rather than the amount of money that has been paid by investors. This is because payments may be requested by the company in stages or 'calls'. The issued share capital can be less than or the same as the authorised share capital but can never be higher. This issued share capital will appear on the 'financed by' section of the balance sheet and is added on to reserves to give us the balance sheet totals.
- Authorised share capital - Maximum amount of capital that can be raised
- Issued share capital - Actual amount of capital that has been raised
Shares come in two types; ordinary shares and preference shares
Nearly all shares that are issues in the UK are ordinary shares. Investors purchase ordinary shares for two main reasons:
- Capital gains
Dividends are distributed after post-tax profits. The dividend will be expressed as a percentage of the nominal value of each share. However, dividends on ordinary shares are not guaranteed and if the firm experiences poor profitability then dividends may either be low or actually may not be gene at all. Some firms prefer not to give dividends now because of the desire to reinvest more of the profits back into the firm.
Capital gains are made when shares are sold for a higher amount than the price initially paid for them. The market value of each share is what it can be currently sold for. If the firm is successful then its market value is likely to move higher than the nominal value. Since 1999, there has been a general decline in the value of share prices in most countries and therefore capital gains have not easily been made. However, over a long period of time, it is expected that share prices will rise. It must also be remembered that shares are bought and sold just as much on the basis of future expectations as they are on past performance.
Each ordinary share issued carries a vote at the AGM (annual general meeting). This means that each shareholder has some influence over the firm's policies. However, a shareholder in a large public limited company would need to purchase a significant amount of shares before there shareholding was big enough to actually influence policy (votes are made on the basis of one share equals on vote)
Preference shares are much less common than ordinary shares. They are no longer as popular in the UK as they once were due the changes in tax law. Preference shares carry no vote so no influence can be made over company policy irrespective of the size of the preference shareholding.
The dividend on preference shares is fixed as a percentage of the nominal value of the share. This means that the investor will know in advance what the return will be each year. In some cases, the firm may delay payment of the annual dividends for a period of time. However, the dividends on the preference share is guaranteed, so any delayed dividends will have to be paid at some later date on top of any other due dividends.
Some firms will allocate dividends to shareholders during the financial year. These are known as interim dividends and are paid in addition to the dividend at the end of the financial year which is known as the final dividends.
The final dividend is likely to have been proposed but not yet paid for. In this case, the dividends should still appear as an appropriation of profit (this is the accruals concept) but because it has yet to be paid for, it will also appear as a current liability on the balance sheet. Interim dividends have normally been paid for by the time the balance sheet is drawn up.
Dividends are normally calculated, as a percentage of issued share capital, not authorised share capital. For example a 5% dividend on a £100,000 issue ordinary share capital would mean that the ordinary dividends allocated will be 0.05 x £100,000 = £5,000. Also, it is important that the dividend is calculated on the nominal value of the share capital, not the market value.
Which investment is best? Ordinary shares or preference shares?
This is no right or wrong answer to this question. The answer will depend on the investor themselves and what their own objectives are. However, the following factors will be taken into account.
The returns in on ordinary shares are more volatile. In good years, the firm is likely to be profitable and have more available for returns to in ordinary dividends. However, in poor years, then the firm may have to cut back, or even stop the ordinary dividends. Preference shareholders will be entitled to their returns, which will remain the same no matter how well or poorly the firm performs.
As outlined earlier, purchasing ordinary shares subject the investor to the risk that the firm may not perform well in the future. However, there is an additional factor to take into account. If the firm is forced into liquidation it will be forced to close and the assets of the firm will be normally sold. The money raised through this sale will be used to settle any debts the firm has. There is a list of who is entitled to the money in which order. This is as follows:
- Trade creditors
- Other lenders
- Preference shareholders
- Ordinary shareholders
Control over company policy
Preference shares carry no voting power. Ordinary shares allow a shareholder to influence control over the company. However, this idea may mislead you into believing that the ordinary investor can influence company policy. In most large public limited companies, one would needed to have accumulated a very large amount of shares before they had any real true sense of power over the company. Most shareholdings by private investors are tiny compared with the amount of shares in existence for that company. In most large public limited companies, one would needed to have accumulated a very large amount of shares before they had any real true sense of power over the company.
Capital and revenue reserves
When a sole trader earns profits, these will be added on to the capital figure - increasing the amount of resources within the firm. However, with a limited company, this does not happen and profits retained the company are not added on to the share capital figure.
Any profits that are remained within the firm are kept in reserves, which are listed alongside the share capital but are separate to the share capital. Reserves are part of the shareholder's funds (issued share capital plus the total of the reserves).
The term reserve is used to describe these retained profits that are kept within the firm for a variety of uses. Unfortunately, the term reserve tends to conjure up images of amounts of money being set aside within the firm that can be used in the same way the money in the bank can be used. It is important to drop this idea as soon as is possible - balance sheet reserves do not mean that there is any more cash set aside within the firm as a reserve. The money available the firm will always be the cash at hand and the cash at bank figure. Reserves are just a term used in accounting to illustrate where resources have arisen.
In actual fact, there are two types of reserves that can exist in limited companies - these are revenue reserves and capital reserves.
These reserves are created out of trading profits earned by the firm over a period of time. Once tax has been deducted, the firm can choose to allocate the remainder as dividends, or to retain this within the firm. The retained profit is known as the profit and loss account balance (this is a revenue reserves). However, the firm may also decide to transfer money to another designated reserve. This would then appear as a deduction in the profit and loss appropriation account.
The names of these revenue reserves are not necessarily an indicator of why the profits have been transferred into this reserve. For example, if the firm transfers profits into a reserve called the fixed asset replacement reserve, then this may mean that the firm would like to use some of its profits to replace the fixed assets. However, this is not necessarily the case. Profits are earned over a period of time and therefore they may be tied up in other assets, in stocks or in other investments. The name of the revenue reserve does not commit the firm to any type of actions. As a result, most revenue reserves are simply known as a general reserve.
Follow the link below to see an example of revenue reserves and the transfer of profits to the general reserve.
Summary of revenue reserves
- These are created out of the trading profits earned by the firm
- They can be used to give out as dividends to the shareholders
- They do not represent money but are allocations of profits earned over time
Capital reserves do not arise out of trading profits, which means that they cannot be used for distribution as dividends. They arise, largely out of changes to the balance sheet of the firm. There are two main capital reserves that you are likely to come across; the revaluation reserve and the share premium account (still a reserve)
It is a requirement of company law that all fixed assets (with the exception of freehold land) should be depreciated. Although property does eventually wear out, it is possible that its value will increase significantly over a period of time. If the value of any of the fixed assets becomes significantly greater than the balance sheet value then it is allowable for a firm to increase - revalue - this asset. This requires a simple upwards adjustment to the asset's value on the balance sheet.
However, if we increase the value of any fixed asset then the balance sheet would no longer balance. To remedy this, we simply create a 'revaluation reserve' (or add to one if one already exists) by adding the amount equal to the increase in the value of the asset (i.e. both sections of the balance sheet increase by the same amount - thus permitting the balance sheet to balance).
Follow the link below to see an example of the use of the revaluation reserve.
Share premium account
When limited companies issue shares, they may not always issue them all in one go. They may issue their shares in a number of stages. If this is the case, the shares issued later will still have to be issued at the same face (nominal) value of the shares that were originally issued. However, if the firm has well established, the market value of the firm's shares is likely to be higher than the face value of the shares.
The firm will probably issue these later shares at a premium. This means that the price paid for these shares will be closer to their current market value. However, the face value of these shares will still be as originally set out in the memorandum of association. This means that the firm will received more in cash than is indicated by the increase in the share capital (the value of the share capital is always based on the face value of the shares). This surplus money that is being received will be entered into the share premium account, which is a capital reserve.
Most long-term finance (i.e. money needed for at least one year) will come from two distinct sources. Most firms will use a combination of either loan capital (i.e. they borrow money) or equity capital (i.e. they issue shares).
Loan capital refers to any money borrowed over a long period of time (more than a year in all cases, and often for more than 10 years). There are different ways in which firms can acquire loan capital and these are as follows:
Firm can obtain loans from a variety of financial institutions (i.e. banks, finance companies and so on). These can either be secured or unsecured. If they are secured then the firm will have to offer assets (supposedly of equivalent value to the loan) that can be taken away by the lender if the firm that has borrowed the money cannot keep up repayments. Not keeping up with repayments is known as defaulting.
Mortgages are a form of secured loan. They are mainly used to finance the purchase of property. This means that the lender can repossess the property if repayments are not kept up. The interest on a mortgage is usually relatively low. This is because, the value of the property will not normally fall and therefore the lender is taking a relatively small risk in providing the funds for the mortgage (i.e. the property can be repossessed and sold - usually for a profit - in the worst case scenario).
A debenture is a long-term loan, with similarities to shares. A firm will borrow money of individual investors by issuing debentures. These are, in effect, certificates of debt that would appear as first glance as if they are a share. Whoever, has the debenture is entitled to receive the interest on this debenture which is fixed. Whoever holds the debenture on its redemption date (the end of the debenture's life) will receive repayment equivalent to the original issue price. These debenture certificates can be traded in the same way as shares are traded. The price of a debenture will rise and fall.
The price of a debenture will change because of the fixed interest element of a debenture. For example, if the debenture was issued with fixed interest of 5%, then if interest rates in the economy on alternative investments are higher, then people are unlikely to want to buy the debenture at face value - they could simply use their money to invest elsewhere. Therefore the price of this debenture is likely to fall to a level where the lower price compensates for the relatively lower rate of interest. Likewise, if interest rates of a debenture are higher than those on alternative investments then the price of the debenture is likely to rise.
When considering whether or not to use loan capital as a source of finance, a firm is likely to take the following factors into account.
Shares are irredeemable - they are not normally paid back, ever. A shareholder can sell their shares but not back to the firm. Loan capital, on the other hand, has to be repaid at some point in the future.
In the UK, interest is a tax-deductible expense. This means that it is deducted form profits before the corporation tax (tax on profits) is calculated. Dividends on shares are not subtracted until after corporation tax has been calculated. Therefore a firm that wishes to minimise its taxation payable would chose loan capital - even if the dividends were going to be the same amount as the loan interest. This is true up to an upper limit - most firms have a 'ceiling' of borrowing in mind over which they will not go, for fear of 'financial distress' (e.g. not being able to keep up the interest payments). The upper limit depends on the attitude of the board and the type of share investor they are trying to attract.
Interest is the charge for borrowing money. This will have to be paid (some firms can defer payment of a period of time but this unusual). The interest charge itself will be based on the prevailing interest rates and the amount borrowed. Some interest rates on loan capital are fixed (i.e. on debentures) and some are variable (most mortgage rates are based on the current base arte set by the Bank of England). The interest charge will impose a cash outflow on the firm.
Voting rights and control
Issuing ordinary shares could mean that the directors lose control of the company. Issuing debentures and other forms of loan capital do not normally require the firm to lose any control. However, on occasion, a lender may impose certain conditions to be attached to the loan.
Issuing shares can be lengthy and costly experience. Loan capital, on the other hand, is relatively straightforward to organise. If the firm is looking for finance in a short space of time then loan capital will be more useful than equity capital. A debenture will require quite a lot or organisation compared with a bank loan or mortgage.
When lending money to a firm, the lender will want to ensure that they are going to get the money back. Inters rates are the compensation for taking the risk of lending a firm money. If the firm is seen to be a high risk (e.g. new firms and small firms are more likely to fail and therefore not repay their debts), then higher inters rates may be charged.
The final accounts and balance sheets of limitedcompanies
For the sole trader, there is no distinction made between the firm and the owner. Any tax calculated would be based on the owners overall earning over the financial year. Similarly, once the net profit has been calculated, then there are no further calculations needed. This is because the sole trader in entitled to all the profits of the firm - there is no one else.
For a limited company this is different. To show how the profits are allocated between the owners of the company we have to draw an additional section of the profit and loss counts. This is known as the appropriation account.
The appropriation account
The appropriation account begins with the net profits for the firm. The term appropriation really refers to how these profits are going to be divided up between the different claims that are made on these profits. Because the limited company exists as a separate legal entity, then the company will have its profits subjected to corporation tax. This is a UK tax and is calculated as a percentage of the firm's taxable profits.
Once the post-tax profits have been calculated the remainder of the profit will then be shared out. This will involve the decision of how much profit is to be distributed as dividends, and how much is to be retained within the firms (including transfers to other revenue reserves).
An appropriation account will take the following format:
Let us consider each item:
This is the profit after all expenses have been deducted. It is usually known as operating profit or profit before taxation and will include all forms of income and all types of expenses. Director's remuneration sometimes appears as an expense. This refers to the fees that are paid to the board of directors for their duties. Interest payments will also have been deducted before this profit calculation, as interest is tax deductible.
Corporation tax will be payable as a percentage of the firm's taxable profits (in the AS and A level we will assume this is based on the net profits). If you were instructed to provide for corporation tax then this would mean that the tax has yet to be paid. It will still appear as an expense though whether it is paid or not but would also appear as a current liability if the tax has not been paid.
Retained profit brought forward
This will be the balance on the profit and loss account from last year's balance sheet. This is normally found in the trial balance (credit balance) and this is added on the profits after tax.
The total here represents the maximum amount that is available for the shareholders for distribution as dividends (the current profits plus those profits retained in previous years). Technically, the maximum amount that could be used would include all the revenue reserves (e.g. the general reserve) but it is often assumed that the firm will only use the profit and loss reserve for dividends.
Some textbooks will add this on at the end instead - this does not matter.
These will consist of both interim and final dividends (even if they have yet to paid) on both types of share (ordinary and preference).
Transfers to revenue reserves
Technically, all the revenue reserves are available for distribution as dividends to shareholders. However, firms will often wish to keep profits within the firm as this helps them to expand. Transferring profits to these revenue reserves is a clear indicator that the firm does not wish all the profits to be available for dividends.
The total for each individual revenue reserve on the balance sheet will be the previous balance (credit entries in the trial balance) plus the amount transferred from the appropriation accounts.
It is possible for a firm to transfer from the revenue reserves and actually add back amounts on to the profits. This is only likely to occur if the firm wishes to maintain a certain level of dividends and current profits are quite low. In this case you would add back to transfer on and reduce the balance sheet reserve total. However, this is highly unusual.
Retained profit carried forward
Any amounts that have not bee appropriated as dividends or as transfers to reserves will be carried forwards as the new profit and loss account balance. This will appear with the other reserves, alongside capital, on the balance sheet.
Stromboli Ltd started in business on 1 January 2003. Its issued share capital was 100,000 ordinary shares of £1 each and 50,000 7% preference shares of £1 each. The following information is available:
- Net profits for the first two years of business were 2003 £15,400 and 2004 £21,900
- Corporation tax was: 2003 £5,200 and 2004 £6,800
- Transfers to general reserve: 2003 £1,000, 2004 £3,000
- Preference dividends were paid, whereas the ordinary dividends were as follows: 2003 4% and 2004 5%
Produce appropriation accounts for both 2003 and 2004 for Stromboli Ltd.
The balance sheet of a limited company is still constructed on the same principles as a balance sheet for a sole trader. If the balance sheet is for publication then there are certain formats and heading that must be present. However, if the balance sheet is for internal use only then most of the balance sheet will probably appear very similar to balance sheets that you are already familiar with - as in the case of a sole trader.
The main difference comes with the capital section of the balance sheet. In the case of a sole trader, the owner's capital figures was adjusted by the net profits and drawings to give the new capital figure, which would then be carried forward to the next year.
For a limited company, the share capital is kept separate and is not adjusted by any of the profits retained within the company. The section dealing with this is entitled capital and reserves.
Issued share capital is the amount of shares actually sold to investors and this is the amount that will appear in the capital and reserves section. Also, any reserves that have been generated - capital reserves or revenue reserves - will also appear in this section.
If we use the same data as in the previous example for Stromboli Ltd, then the balance sheet extracts (just the capital and reserves sections) would appear as follows:
Stromboli Ltd Balance sheet extracts as at 31 December
Note the following:
It is normal procedure to not only show the total amount of capital raised, but also the individual par value for each share, the number of shares issued and the (fixed) percentage dividend for preference shares.
It is the total figures for the reserves that appear on the balance sheet. In 2004, £3,000 was transferred to the general reserve, which already had a balance of £1,000. Thus the balance sheet value would be £4,000.
Any capital reserves that the firm has (share premium, or revaluation) would also appear in this section, alongside the revenue reserve. There is no particular order for the reserves - mixing up capital and revenue reserves, on the balance sheet, is not a problem.
Exam tips - limited company accounts
- It is vital that you learn the correct layout of the appropriation account and how to calculate the level of dividends
- Items that are only proposed will still appear in the appropriation account but will also appear as liabilities on the balance sheet.
- Questions are likely to focus on the capital and reserves section of the balance sheet of a limited company.
- The distinction between capital and revenue reserves is made frequently.
- You may have to write a report advising a potential investor on what types of share to purchase. In this case, it is crucial that you consider the context of the question.
- In any report, an evaluation will be required - you must make a decision - there may not necessarily be a right or wrong answer to this either!
These notes are aimed at people studying for AQA A Level Accounting Unit 3, but will also be suitable for other courses and exam boards.
Originally submitted by duke_stix on TSR Forums.