Chapter 17

  • Difference between ordinary and preference shares
  • Use of loans and debentures to raise finance
  • concept of reserves - capital and revenue
  • layout of income statement and balance sheet
  • recording revaluation of property
  • recording bonus issues and rights issues on company balance sheets
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Introduction to Limited Company Accounts

The financial statements comprise:

  • an income statement
  • a statement of changes in equity
  • a balance sheet 

 The main advantages of setting up a limited company are:

  •  limited liability
  • separate legal entity
  • ability to raise finance
  • benefit from economiesof scale 
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Shares issued by Limited Companies

Issued share capital is the amount of share capital the company has issued.
Share capital may be divided into types of share - ordinary or preference 

Ordinary sharesholders - take dividends as a reward for investing in the business. These dividends will vary and the business may not even pay them dividends if they don't make large profits. Interim dividends can be paid. They are paid just over half way through the financial year. A final dividend is paid early in the next financial year and is based on profits made. In the event of the company beng insolvent, ordinary shareholders are the last to reveive any payment. Ordinary shareholders have voting rights and attend meetings.

Preference shares - get a fixed percentage rate of dividends like 5% of nominal value. Their dividends are paid in preference to ordinary shareholders but they are only paid if a company makes a profit. If the company ceases trade, preference share holders will receive payments before ordianary share holders which can seem less risky for investors. They do not have voting rights. 

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Advantages and Disadvantages to ordinary shares

Ordinary shares 

Advantages to the company: 

  • ordinary shares are not normally repayable
  • a varuable dividend is paid, which is dependant on profits
  • If dividends are not paid in one year, the dividend if not carried forward
  • in the event of insolvency, they will get paid off last

Disadvantages to the comapny:

  • Ordinary shareholders can vote and speak at a general meeting, each share carries one vote. This could be a problem to the company if shareholders are dissatisfied.


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Advantages and Disadvantages to preference shares

Preference shares

Advantages to the company:

  • Dividend is fixed so if profits increase, more profit is retained in the company
  • Preference share holder cannot vote so they have little control over the company.

Disadvantages to the company:

  • Dividends must be paid each year, if not they have to be carried forward to the next year.
  • Shareholders can attend meetings of the company
  • preference shares may be redeemable in the future
  • in the even of insolvency, preference shareholders must be repaid in full before any money can be paid to ordinary shareholders.
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Key terms

Nominal value of shares - is the face value of shares. If they were 50p each and there were 100,000 shares then - 100,000 x 0.5= £50,000

Market value of shares- The price at which issued shares are traded. It can go up or down depending ion the success of the business.

Issue price - The price at which shares are issued to shareholders by the company. It is either the same as or above nominal value. The difference between the issue price and nominal value is known as share premium.

for example - if nominal value = £1 and issue price was £1.50 that makes shar premium 50p per share. This means new shareholders are paying extra to buy a stake in a profitable business. 

Loan - money borrowed from lenders like banks and investors. Lenders often require security for loans so if the loan is not repaid, the lender has an aseet that can be sold.

Debenture - A formal certificate issued by companies raising long term finance from lenders. They are also secured against assets. 

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Loans advantages/disadvantages to investors

Advantages to the investor:

  • The interest rate must be paid each year
  • a safer investment than shares as they are secured against assets
  • They are the first to get paid in the even of insolvency

Disadvantages to the investor:

  • Where a fixed rate of interest is paid, debenture holders will not receive any benefit from the increase of interest rates.
  • There are no prospects for capital growth
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The gearing ratio

Gearing meaasures the balance of the company's borrowings used to finance themselves (loans from the bank, debentures etc) It can be expressed as a ratio or percentage. The higher the gearing, the less secure the company as they have high borrowings. Debts is costly in terms of interest payments.

Investors don't want to see a gearing ratio exceeding 1:1 or 100%

Gearing ratio:  Debt (loan capital + preference shares)    if borrowings = equity stake then the 
                     -------------------------------------------------------     company will have difficulty making 
                      Equity (ordinary shares +reserves)         interest payments on their debts.

 

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Income Statement of Limited Cmpanies

A limited company uses a similar form of fianancial statements as a sole trader. BUT there are two expenses in the income statement that are not found in other business types.

Directors' renumeration - amounts that are paid to directors. It is like their wages so it is put amongst the expenses in the income statement.

Loan/ debenture interest - The interest on loans and debetures is shown as a finance cost in the income statement.

A figure is shown in the income statement for profit from operations.

Expenses                     x
Profit from operations x
Loan interest                 x
Profit before tax          x
Corporation tax              x
Profit for the year        x

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Statement of changes in equity

                                                      £          Dividends include interim and final dividends from 
Retained earnings (revenue reserve)   x         the previous year
Balance at start of the year               x
Profit for the year                             x         The balance at the end of the year is shown on 
Transfers from other reserves            x         the balance sheet as 'reatained earnings' in the
                                                    -----       equity section
                                                      x
Dividends paind in the year              (x)
Transfers to other reserves              (x)
                                                    -----
Balance at the end of year               x
 
Total equity = issued ordinary shares, capital reserves and revenue reserves. The total equity is the same concept as the owner's capital in a sole trader balance sheet.

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Dividends in the final accounts and Reserves

Dividends are profits from the business that have been distributed to shareholders as a return on their investment. A company can pay twice a year, interim dividends are payed in the middle of the year and a final dividend is paid early in the next financial year. The final dividend is discussed with shareholder and takes time to make an agreement. Because of timing delays the final dividend paid in the year will be paid from the previous year as this years dividend will actually be paid during the next year.

Reserves

Capital reserves are created as a result of a non trading profit. The reserves come from revaluation and share premium.

Revenue reserves are created as a result of profits from trading activities, they include the general reserve and retained profits. These are usually used to pay dividends.

Both are profits and not cash. 

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Statement of changes in equity format

                         Ordinary share    Share premium   Revaluation    Retained earnings    Total
                             Capital                                       Reserve      

Balance at 1st        100,000            20,000                50,000           27,000               197,000
 January

Revaluation                                                             13,000                                      13,000

Dividends paid                                                                             (12,000)              (12,000)

Profit for the                                                                                 35,000                 35,000
Year

Balance at 31st    100,000              20,000                63,000           50,000                233,000
December 

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Bonus and Rights Issues

Bonus issue is an issue of FREE shares to existing shareholder. It is funded by transferring reserves into the share capital. No money is raised from bonus issues; they are just used to re arrange the balance sheet. e.g 1 bonus issue for every 4 shares held.

Right issue is a meanas of raising money. The existing shareholders are given the right to purchase more shares often at a discount. 

Differences

 Bonus issue                                                                   Rights issue 

- shares given free to ordianary shareholders              - Additional shares offered for sale to 
                                                                             Existing hareholders in proportion to their 
- Distributed in proportion to existing shareholdings     Holdings
                                                                            - Offer price is below current market value
- No payment made for shares                                - shareholders can either buy additional 
                                                                               shares or sell the rights on stock market
- Stock market price of shares fall in proportion        - company recevies payment from shares
to bonus issue                                                      - stock market price may fall slightly

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