0452 · 5.3Limited companies

Limited company ownership and liability

0:00Cedar Cycles Limited needs money for a larger workshop. It could obtain investment from its owners or borrow from lenders. Both methods provide finance, but they create different rights and different entries in its financial statements. This video covers limited liability, equity, share capital and debentures, and then the preparation of company financial statements. A limited company is a business owned by shareholders, legally separate from its owners and run by directors.

0:26Shareholders own shares, which represent portions of ownership. Directors manage the company on their behalf. In a small company, the same people may be both shareholders and directors. The legal structure does not determine the business activity. A limited company can be a trading, service, manufacturing business or a combination of these. Cedar Cycles Limited trades when it sells bicycles and provides a service when it repairs them. If it also makes bicycles, manufacturing becomes another part of its activities.

0:56Financial statements are summaries that show a business's profit or loss for a period and what it owns and owes at a date. For a company, they must keep finance supplied by owners apart from amounts owed to lenders. Assets are resources owned or controlled by a business that bring future benefit, while liabilities are amounts the business owes to others. Cedar Cycles Limited owns bicycles and equipment, and it owes money to its suppliers.

1:20Equity is the shareholders' interest in the company. It consists of share capital plus reserves and equals assets minus liabilities. Once amounts owed to outside parties are deducted, the remaining interest belongs to shareholders. Equity describes their financial interest, not a separate supply of cash waiting in the bank. Limited liability means shareholders are responsible for company debts only up to the amount they agreed to invest in shares. They can lose their investment if the company fails.

1:48Their personal assets are normally protected from claims by the company’s suppliers and lenders. Any unpaid amount they agreed to contribute for their shares remains payable. The company itself remains responsible for all its debts. Limited liability protects shareholders; it does not cancel amounts owed by the company. This protection can encourage people to invest without risking their personal homes or savings beyond their agreed investment. However, the shares themselves can still become worthless.

2:15Advantages of operating as a limited company include limited liability, access to investment from more shareholders and continuity. The company continues to exist when ownership changes or a shareholder dies. Raising large amounts of capital can therefore be easier than relying on one owner. This does not mean every company can automatically find willing investors. Disadvantages include formation costs, legal requirements and the need to make company accounts publicly available where required.

2:43Owners may lose some control when additional shareholders obtain voting rights. Profits available for distribution must also be shared among the shareholders entitled to them. Directors are required to follow company law when they prepare and file the financial statements.

Share capital, reserves and debentures

2:57Share capital is the amount contributed, or agreed to be contributed, by shareholders in exchange for shares. A dividend is a distribution of company profits to shareholders. Ordinary share capital represents investment by owners who normally have voting rights and receive a variable dividend. These shareholders receive dividends after any preference dividend entitlement has been met. The ordinary dividend depends on the profits available and the company’s decision about distribution.

3:23It is not a fixed payment promised in the same way as loan interest. Ordinary shareholders are also last to be repaid when the company closes. Lenders, suppliers and preference shareholders are repaid before them. Preference share capital represents investment carrying priority rights, usually including a dividend at a fixed rate. Preference dividends are paid before ordinary dividends. These shareholders usually have no voting rights. Their priority reduces some risks, but preference shares still represent ownership rather than borrowing.

3:53Retained earnings are accumulated profits kept in the company after dividends. Directors may transfer part of them to a general reserve, which is profit kept back and set aside for future use. The capital structure of a limited company comprises preference share capital, ordinary share capital, general reserve and retained earnings. Both reserves arise from profits kept in the business. Transferring profit to a general reserve changes its classification within equity.

4:20It does not create additional profit or increase total equity. Nor does it automatically move money into a separate bank account. The company’s retained profits may already support equipment, goods for resale or other assets. Loan capital, including debentures, is finance obtained through borrowing rather than ownership. Debentures are long-term loans to a company, usually carrying a fixed rate of interest. Their holders are lenders, not shareholders. Non-current liabilities are amounts due for payment after more than twelve months.

4:50These loans normally appear in that category. Expenses are the costs used up in running the business and earning revenue during a period. Debenture interest is an expense because it is the cost of borrowed finance. It is payable whether or not the company makes a profit. Dividends distribute profits to owners, so they are deducted from retained earnings after profit for the year is calculated. Each share has a nominal value, which is the stated value assigned to it.

5:15Issued share capital is the nominal value of the shares actually issued to shareholders. The company may ask for only part of this money at first. The amount shareholders have been asked to pay on their issued shares so far is called-up share capital. Paid-up share capital is the amount actually received from them. Consider an earlier issue by Cedar Cycles Limited of fifteen thousand shares with a nominal value of two dollars each.

5:38Fifteen thousand multiplied by two dollars gives issued share capital of thirty thousand dollars. The company asks for one dollar and fifty cents per share so far. Fifteen thousand multiplied by that amount gives called-up share capital of twenty-two thousand five hundred dollars. Shareholders have actually paid twenty-one thousand dollars. That is the paid-up share capital. Twenty-two thousand five hundred dollars minus twenty-one thousand dollars leaves fifteen hundred dollars called up but unpaid.

6:06The three terms distinguish shares issued, payment requested and money received.

Preparing profit or loss

6:10The statement of profit or loss is the financial statement that shows the revenue, expenses and profit or loss for a period. Revenue is the income a business earns from its main activity, such as selling goods or providing services. Profit for the year is the amount by which revenue exceeds expenses over one financial year. A company uses the same basic calculation as other businesses, with debenture interest included as an expense.

6:35Inventory means goods held for resale. Opening inventory is the value of goods held for resale at the start of a financial period. The goods remaining at its end are called closing inventory. Cost of sales is the cost of inventory sold during a period, while gross profit is revenue minus cost of sales. For the year ended on the thirty-first of December, Cedar Cycles Limited has revenue of ninety-six thousand dollars.

7:00Opening inventory is nine thousand dollars, and goods purchased for resale cost fifty-five thousand dollars. Nine thousand dollars plus fifty-five thousand dollars gives goods available for sale of sixty-four thousand dollars. Closing inventory is twelve thousand dollars. Subtract twelve thousand dollars from sixty-four thousand dollars because the remaining bicycles have not yet been sold. Cost of sales is fifty-two thousand dollars. Ninety-six thousand dollars minus fifty-two thousand dollars gives gross profit of forty-four thousand dollars.

7:30We next deduct the other expenses belonging to this year. An accrued expense is a cost of the current year that is still unpaid at the year end. Cedar Cycles Limited paid wages of fourteen thousand eight hundred dollars and still owes twelve hundred dollars. Adding these gives this year’s wages expense of sixteen thousand dollars. A prepaid expense is a cost paid in advance that belongs to a future period.

7:53Rent paid was six thousand five hundred dollars, including five hundred dollars for the following year. Six thousand five hundred dollars minus five hundred dollars gives this year’s rent expense of six thousand dollars. Depreciation is the loss in value of a non-current asset over its useful life. It is an estimate that is charged as an expense in each year of use. The equipment depreciation expense is three thousand dollars.

8:17Debentures of twenty thousand dollars carry interest at five per cent per year. Twenty thousand dollars multiplied by five per cent gives annual interest of one thousand dollars. Sixteen thousand dollars plus six thousand dollars plus three thousand dollars gives total operating expenses of twenty-five thousand dollars. Add debenture interest of one thousand dollars, which has been paid in full. Total expenses after gross profit are twenty-six thousand dollars. Forty-four thousand dollars minus twenty-six thousand dollars gives profit for the year of eighteen thousand dollars.

Statement of changes in equity

8:47A statement of changes in equity shows movements in shareholders' funds during a financial period. Its columns separate ordinary shares, preference shares, general reserve, retained earnings and total equity. Start with the opening amounts, then record each change in its appropriate column. The closing amounts will supply the equity section of the statement of financial position. Opening ordinary share capital is forty thousand dollars, and preference share capital is ten thousand dollars.

9:14The general reserve is three thousand dollars, while retained earnings are seven thousand five hundred dollars. Forty thousand plus ten thousand plus three thousand plus seven thousand five hundred equals sixty thousand five hundred dollars. That is opening total equity. The company issues ordinary shares for six thousand dollars, fully paid at nominal value. This increases ordinary share capital and total equity by six thousand dollars. Profit for the year adds eighteen thousand dollars to retained earnings and total equity.

9:44Neither movement changes the preference share capital or the general reserve. The preference dividend rate is eight per cent. Ten thousand dollars multiplied by eight per cent gives a preference dividend of eight hundred dollars. An ordinary dividend of two thousand two hundred dollars is also paid. Eight hundred dollars plus two thousand two hundred dollars gives total dividends of three thousand dollars. Each dividend reduces retained earnings and total equity by its payment amount.

10:08The company also transfers four thousand dollars to the general reserve. Retained earnings decrease by four thousand dollars, while the general reserve rises by the same amount. The transfer changes total equity by zero dollars because both columns belong to equity. Ordinary share capital closes at forty thousand dollars plus six thousand dollars, which equals forty-six thousand dollars. Preference share capital remains ten thousand dollars. Three thousand dollars plus four thousand dollars gives a closing general reserve of seven thousand dollars.

10:39Retained earnings require the profit, both dividends and the reserve transfer. Seven thousand five hundred plus eighteen thousand minus eight hundred minus two thousand two hundred minus four thousand equals eighteen thousand five hundred dollars. That is closing retained earnings. Forty-six thousand plus ten thousand plus seven thousand plus eighteen thousand five hundred equals eighty-one thousand five hundred dollars. Closing total equity is therefore eighty-one thousand five hundred dollars.

Statement of financial position

11:07The statement of financial position shows assets, liabilities and owner's equity at a particular date. Owner's equity, also called capital, is the owner's investment in the business, or the amount the business owes the owner. For a company, the equity section separates the shareholders’ investment and reserves. Its figures must agree with the closing statement of changes in equity. Non-current assets are assets held for continuing use in the business rather than for resale.

11:34The equipment cost fifty thousand dollars. Accumulated depreciation is the running total of depreciation charged on an asset since it was acquired. Before this year, the equipment had accumulated depreciation of eight thousand dollars. Eight thousand dollars plus three thousand dollars gives closing accumulated depreciation of eleven thousand dollars. Carrying amount is the asset's cost less its accumulated depreciation. Fifty thousand dollars minus eleven thousand dollars gives equipment carrying amount of thirty-nine thousand dollars.

12:03This year's depreciation expense has already reduced profit for the year, and it is also part of the accumulated amount deducted here. Current assets are assets expected to be turned into cash or used up within twelve months. Cedar Cycles Limited holds inventory of twelve thousand dollars and bank funds of forty thousand five hundred dollars. Trade receivables are amounts owed by credit customers who have not yet paid for goods or services.

12:27Customers of the company owe nineteen thousand two hundred dollars. Other receivables are current assets, such as amounts due to the business and payments for benefits not yet used. The prepaid rent of five hundred dollars belongs in other receivables. Twelve thousand plus nineteen thousand two hundred plus forty thousand five hundred plus five hundred equals seventy-two thousand two hundred dollars. Adding the equipment carrying amount of thirty-nine thousand dollars gives total assets of one hundred and eleven thousand two hundred dollars.

12:57Current liabilities are amounts due for payment within twelve months. At the year end, Cedar Cycles Limited still owes money to its suppliers and its staff. Trade payables are amounts owed to credit suppliers that the business has not yet paid. Unpaid expenses and money received before it is earned are grouped as other payables, which are current liabilities. The unpaid wages therefore appear as other payables. Trade payables are eight thousand five hundred dollars, and accrued wages are twelve hundred dollars.

13:24Eight thousand five hundred plus twelve hundred equals nine thousand seven hundred dollars. One hundred and eleven thousand two hundred dollars minus nine thousand seven hundred dollars gives one hundred and one thousand five hundred dollars. This is assets less current liabilities. The equity section repeats the closing figures from the statement of changes in equity. Forty-six thousand plus ten thousand plus seven thousand plus eighteen thousand five hundred gives total equity of eighty-one thousand five hundred dollars.

13:53Debentures of twenty thousand dollars are a non-current liability. Eighty-one thousand five hundred plus twenty thousand gives one hundred and one thousand five hundred dollars. Assets less current liabilities therefore equal equity and non-current liabilities, at one hundred and one thousand five hundred dollars each. The accounting equation states that assets equal liabilities plus owner's equity. Nine thousand seven hundred dollars plus twenty thousand dollars gives total liabilities of twenty-nine thousand seven hundred dollars.

14:22One hundred and eleven thousand two hundred dollars equals twenty-nine thousand seven hundred dollars plus eighty-one thousand five hundred dollars.

Year-end adjustments and exam skills

14:30The remaining year-end adjustments follow the same principles used for other businesses. Irrecoverable debts are amounts owed by customers that the business considers uncollectable. Writing one off reduces trade receivables and is charged as an expense. An allowance for irrecoverable debts is an estimate of trade receivables that may not be paid. A rise in the allowance is charged as an expense, while a fall is added to profit. The closing allowance is deducted from remaining trade receivables in the statement of financial position.

14:58Net realisable value is the expected selling price minus costs to complete and sell the goods. Closing inventory is valued at the lower of cost and net realisable value for each item. Its adjusted value affects both cost of sales and current assets. Accrued income is an amount earned in the current year but not yet received at the year end. It is added to this year’s income and shown within other receivables.

15:22Prepaid income is an amount received in advance for a period after the year end. That amount is left out of this year’s income and shown within other payables. Common examination mistakes concern the different reasons for payments and transfers. Debenture interest is an expense, while dividends reduce retained earnings after profit for the year has been calculated. A general reserve transfer changes two equity columns by equal and opposite amounts.

15:46Closing reserves describe shareholders’ funds, not the company’s bank funds. Paper One contains forty multiple-choice questions, and Paper Two contains five compulsory structured questions. Define means give precise meaning, while explain means give reasons, why and how, supported by evidence. In a calculation question, calculate means work out from given figures. For the statements in this video, prepare means present information in a suitable format, so headings, classifications and totals must be clear.

16:15For this question, identify the movement within the company’s equity. A suitable answer is that retained earnings decrease by the amount transferred. The general reserve increases by the same amount. Both are components of equity, so the equal and opposite changes leave total equity unchanged. A limited company separates shareholders’ ownership from the company’s legal responsibilities. Shares provide ownership finance, whereas debentures create liabilities and interest expense. Profit for the year enters retained earnings, dividends reduce equity, and reserve transfers only reclassify it.

16:50The closing equity figures then join assets and liabilities in a statement of financial position that balances.