Notes · AccountingUK · A-Levels

Limited companies (advanced)

This chapter extends company accounting to share issues and the additional statements. It covers issuing shares at par and at a premium, rights and bonus (capitalisation) issues and their effect on equity, the statement of changes in equity, and the statement of cash flows (indirect method) and its interpretation - the reconciliation of profit to cash being a recurring theme.

4 sections~17 min reading time3 competenciesLevel Standard 1 · Advanced 3

T·101010 / 18

Exam profile

AO1 · Understand share issues, reserves and the additional company statementsAO2 · Account for share, rights and bonus issues and prepare the statement of changes in equity and the statement of cash flowsAO3 · Analyse and evaluate a company's financing and its cash position

Operators:preparecalculateexplainreconcileanalyseevaluate

basic level

AS-Level covers the basic company statements; the advanced share issues and cash-flow statement are A-Level (A2) content.

higher level

The full A-Level expects rights and bonus issues, the statement of changes in equity, and the preparation and interpretation of the statement of cash flows.

Depth

Text

Contents · 4 sections

Limited companies (advanced)

Issuing shares at par and at a premium#

StandardAQA 7127 3.16

A company raises new equity finance by issuing shares, and the accounting depends on the price at which they are issued relative to their nominal value. Shares issued at par are issued at exactly their nominal value - £1 shares for £1 - so the whole of the proceeds is recorded as share capital: debit bank, credit ordinary share capital. Shares issued at a premium are issued for more than their nominal value - £1 shares for £1.40 - and here the proceeds are split: the nominal value goes to share capital and the excess (the premium) goes to the share premium account. This split matters because the share premium is a capital reserve with restricted uses, as met in the earlier company chapter.

The double entry for an issue at a premium is straightforward once the split is clear. For an issue of, say, 50,000 £1 shares at £1.20, the total received is £60,000: debit bank £60,000; credit ordinary share capital with the nominal £50,000; credit share premium with the excess £10,000. The share capital line in the statement of financial position rises by the nominal value only, and the premium is reported within the reserves. Established, successful companies can usually issue at a premium because their shares are worth more than their nominal value, so the premium reflects the market's valuation of the company above the par value of its shares.

There are practical steps in a share issue - application (investors apply and pay), allotment (shares are allocated), and any calls (later instalments) - but at A-Level the focus is usually on the net effect once the shares are fully paid: the cash received and its split between share capital and share premium. The important understanding is what an issue does to the company's position: it increases cash (an asset) and increases equity (share capital plus any premium) by the same amount, strengthening the statement of financial position and providing permanent finance that never has to be repaid and carries no fixed dividend obligation - the classic advantages of equity over debt.

Issuing shares is one of the two main ways a company raises long-term finance (the other being debt), and the choice has the consequences discussed under gearing. A share issue brings in permanent capital without fixed interest or a repayment date, but it dilutes the existing shareholders' control and their share of future profits and dividends, and shareholders expect a higher return than lenders. The premium at which shares can be issued reflects the company's standing. This section provides the mechanics; the rights and bonus issues of the next section are particular forms of share issue with their own purposes and effects on the equity of the existing shareholders.

\text{Share premium} = (\text{Issue price} - \text{Nominal value}) \times \text{Number of shares issued}

Share premium on an issue

The excess of the issue price over nominal value. Nominal value goes to share capital; the premium to the share premium account (a capital reserve).

Worked example

Recording a share issue at a premium

A company issues 50,000 ordinary shares of £1 nominal value at a price of £1.20 each, all received by cheque. Show the entries and the effect on equity.

Total proceeds
50,000 shares x £1.20 = £60,000 received into the bank.
Split the proceeds
Nominal value = 50,000 x £1 = £50,000 to ordinary share capital. Premium = 50,000 x £0.20 = £10,000 to the share premium account.
The double entry
Debit bank £60,000; credit ordinary share capital £50,000; credit share premium £10,000. Equity rises by £60,000, matched by £60,000 more cash.

Result: Cash and equity each rise by £60,000: share capital increases by the nominal £50,000 and the share premium account by the £10,000 excess.

Typical mistakes

Crediting the whole issue proceeds to share capital instead of splitting off the premium.
Treating the share premium as distributable profit rather than a capital reserve.

Active revision

A company issues 50,000 ordinary £1 shares at £1.20, received in full. Show the double entry and the amounts added to share capital and share premium.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

Rights and bonus issues#

AdvancedAQA 7127 3.16

Rights issue versus bonus issue

Fig. 1A rights issue raises cash and increases equity; a bonus issue raises no cash and merely converts reserves into share capital, leaving total equity unchanged.

A rights issue is an issue of new shares offered to existing shareholders in proportion to their current holding, usually at a price below the market price to encourage take-up. Its purpose is to raise cash, but from the existing owners rather than the wider market, which keeps the ownership structure broadly intact and is cheaper than a public offer. A '1-for-5 rights issue at £1.50' on 400,000 £1 shares offers each shareholder one new share for every five held - 80,000 new shares - raising 80,000 x £1.50 = £120,000 in cash. Of this, the nominal value (80,000 x £1 = £80,000) goes to share capital and the premium (80,000 x £0.50 = £40,000) to the share premium account. A rights issue therefore increases both cash and equity.

A bonus issue (also called a capitalisation or scrip issue) is quite different: it issues new shares to existing shareholders free of charge, in proportion to their holdings, by converting reserves into share capital. No cash is raised - the company simply reclassifies part of its reserves (share premium or retained earnings) as share capital. A '1-for-4 bonus issue' on 400,000 £1 shares gives 100,000 new shares, capitalising £100,000 of reserves: debit reserves £100,000, credit share capital £100,000. Total equity is unchanged; only its internal composition shifts from reserves to share capital. Bonus issues are made to bring a company's share capital into line with the assets it now controls, to lower the share price to a more marketable level, and to signal confidence.

The contrast between the two is a favourite exam theme because they look similar but do opposite things to cash. A rights issue brings new cash into the company from shareholders and increases total equity; a bonus issue brings in no cash and leaves total equity unchanged, merely converting reserves into share capital. A shareholder in a rights issue must pay for their new shares (or sell their rights); a shareholder in a bonus issue pays nothing. The effect on reserves differs too: a rights issue may increase the share premium account, whereas a bonus issue reduces reserves by the amount capitalised. Keeping these opposite effects clear is what secures the marks.

Evaluating each depends on the company's purpose. A rights issue is the right tool when the company needs cash and wants to raise it cheaply from loyal existing shareholders without diluting control among outsiders, though shareholders who cannot or will not take up their rights see their proportional stake fall. A bonus issue is appropriate when the company has ample reserves it wishes to capitalise - perhaps to make its share capital reflect the size of the business, to reduce a high share price to a more tradeable level, or to reassure the market - even though it raises no finance and leaves shareholders no better off in total value. Understanding what each achieves, and what it does not, is the basis of a sound evaluation of a company's equity decisions.

\text{Rights issue cash} = \text{New shares} \times \text{Issue price}

Rights issue

New shares = holding x the rights ratio. Split into nominal (share capital) and premium. Here 80,000 x 1.50 = 120,000.

\text{Bonus issue} : \; \text{Dr Reserves} \;\; \text{Cr Share capital (nominal value)}

Bonus issue

No cash; reserves are capitalised into share capital. Total equity is unchanged. Here 100,000 of reserves become share capital.

Worked example

Rights and bonus issues compared

A company has 400,000 ordinary £1 shares. (a) It makes a 1-for-5 rights issue at £1.50. (b) Separately, it makes a 1-for-4 bonus issue. Calculate the new shares and cash in each and the effect on total equity.

Rights issue
New shares = 400,000 / 5 = 80,000. Cash raised = 80,000 x £1.50 = £120,000, split into share capital £80,000 (nominal) and share premium £40,000. Total equity rises by £120,000.
Bonus issue
New shares = 400,000 / 4 = 100,000, capitalising £100,000 of reserves: debit reserves £100,000, credit share capital £100,000. No cash is raised.
Effect on equity
The rights issue increases total equity by £120,000 (new cash); the bonus issue leaves total equity unchanged, converting £100,000 of reserves into share capital.

Result: The rights issue creates 80,000 shares and raises £120,000, increasing equity; the bonus issue creates 100,000 shares but raises nothing, only reclassifying £100,000 of reserves as share capital - opposite effects on cash.

Typical mistakes

Treating a bonus issue as raising cash - it raises none, merely converting reserves.
Forgetting to split a rights issue's proceeds between share capital and share premium.

Active revision

A company with 400,000 £1 shares makes a 1-for-5 rights issue at £1.50 and, separately, a 1-for-4 bonus issue. Calculate the cash raised and the number of new shares in each, and state the effect on total equity.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

The statement of changes in equity#

AdvancedAQA 7127 3.16

Statement of changes in equity

Fig. 2Each column reconciles from opening to closing balance: profit adds to retained earnings, dividends reduce it, and the share issue raises share capital and premium - total equity rises from £310,000 to £415,000.

The statement of changes in equity (SOCE) is a company statement that reconciles the opening and closing balances of each component of equity - share capital, share premium, other reserves and retained earnings - showing every movement during the year. It exists because equity is not static: it grows with the profit for the year and any share issue, and shrinks with dividends paid and any losses, and users need to see these movements to understand how the shareholders' interest changed. The SOCE brings together information from the income statement (the profit for the year), the appropriation of profit (dividends) and the financing activities (share issues) into one clear reconciliation.

The statement is laid out as a grid: a column for each component of equity plus a total column, and a row for each type of movement. It begins with the balances at the start of the year, then adds the profit for the year (to retained earnings), deducts the dividends paid (from retained earnings), adds any share issue (to share capital and share premium), and shows any other movements (a revaluation, a bonus issue), ending with the balances at the end of the year. Each column reconciles from its opening to its closing balance, and the total column reconciles the total equity - a clear, disciplined presentation.

A worked SOCE shows the reconciliation. Suppose a company starts the year with share capital £200,000, share premium £20,000 and retained earnings £90,000 (total equity £310,000). During the year it makes a profit of £75,000, pays dividends of £30,000, and issues shares for £60,000 (£50,000 nominal, £10,000 premium). Retained earnings become £90,000 + £75,000 - £30,000 = £135,000; share capital becomes £250,000; share premium becomes £30,000. The closing total equity is £250,000 + £30,000 + £135,000 = £415,000, which also equals the opening £310,000 plus profit £75,000, less dividends £30,000, plus the share issue £60,000 - the reconciliation ties out both ways.

The SOCE is useful because it makes transparent how the shareholders' stake has changed and why, distinguishing changes that come from trading (retained profit) from those that come from transactions with the owners (share issues and dividends). This distinction matters to analysts: retained profit is internally generated growth in the shareholders' funds, whereas a share issue is new money from outside and a dividend is a return to the owners. Reading the SOCE alongside the income statement and the statement of cash flows completes the picture of a company's performance, financing and distributions, and preparing it accurately - with each column reconciling and the dividends kept out of the income statement - is the skill this section builds.

\text{Closing retained earnings} = \text{Opening} + \text{Profit for the year} - \text{Dividends}

Retained earnings movement

The core reconciliation in the SOCE. Here 90,000 + 75,000 - 30,000 = 135,000.

Worked example

Preparing a statement of changes in equity

A company begins the year with share capital £200,000, share premium £20,000 and retained earnings £90,000. It makes a profit of £75,000, pays dividends of £30,000, and issues shares for £60,000 (£50,000 nominal plus £10,000 premium). Prepare the statement of changes in equity.

Retained earnings column
Opening £90,000 + profit £75,000 - dividends £30,000 = £135,000.
Share capital and premium columns
Share capital: £200,000 + £50,000 = £250,000. Share premium: £20,000 + £10,000 = £30,000.
Total and check
Closing total equity = £250,000 + £30,000 + £135,000 = £415,000, which equals opening £310,000 + profit £75,000 - dividends £30,000 + share issue £60,000 = £415,000.

Result: Closing equity is £415,000 - share capital £250,000, share premium £30,000 and retained earnings £135,000 - reconciled from the £310,000 opening by the profit, dividends and share issue.

Typical mistakes

Putting dividends in the income statement instead of as a movement in the SOCE.
Failing to add a share issue to both share capital and share premium in the SOCE.

Active revision

Opening equity: share capital £200,000, share premium £20,000, retained earnings £90,000. During the year: profit £75,000, dividends £30,000, share issue £60,000 (£50,000 nominal, £10,000 premium). Prepare the statement of changes in equity.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

The statement of cash flows#

AdvancedAQA 7127 3.16

Operating cash flow (indirect method)

Fig. 3The indirect method reconciles operating profit to cash: adding back non-cash depreciation and adjusting for working-capital changes gives £153,000, and after interest and tax £108,000 of operating cash.

The statement of cash flows explains how a company's cash changed over the year, and it is invaluable because profit and cash are not the same thing - a profitable company can be draining cash, and understanding why requires this statement. It classifies cash flows into three activities: operating activities (the cash generated by the day-to-day trading), investing activities (buying and selling non-current assets and investments), and financing activities (raising and repaying share capital and loans, and paying dividends). Together these explain the movement from the opening to the closing cash balance, and the operating section is usually the most important, because a healthy business should generate cash from its core operations.

Under the indirect method (the one usually examined), the operating section starts from the operating profit and adjusts it back to a cash figure. Two kinds of adjustment are made. First, non-cash items charged in arriving at profit are added back - principally depreciation, which reduced profit but involved no cash outflow (and any loss on disposal added back, profit on disposal deducted). Second, changes in working capital are adjusted: an increase in inventory or receivables uses cash (deduct it), a decrease releases cash (add it); an increase in payables conserves cash (add it), a decrease uses cash (deduct it). These adjustments convert the accruals-based operating profit into the cash actually generated from operations.

A worked operating section shows the reconciliation. Suppose operating profit is £120,000, depreciation £30,000, inventory rose £10,000, receivables fell £5,000, and payables rose £8,000. Cash generated from operations = £120,000 + £30,000 - £10,000 + £5,000 + £8,000 = £153,000. From this, interest paid (£20,000) and tax paid (£25,000) are deducted, giving net cash from operating activities of £108,000. The investing section would then show, say, the purchase of non-current assets, and the financing section any share issue, dividends paid and loans raised or repaid; summing the three sections gives the net change in cash for the year.

Interpreting the statement of cash flows is where the analytical value lies. Strong, positive cash from operations shows the business is self-financing its trading, which is reassuring; weak or negative operating cash flow, even alongside a reported profit, is a warning - the profit is not turning into cash, perhaps because receivables or inventory are ballooning (overtrading). The statement shows whether investment is being funded from operations or from new borrowing, and whether dividends are covered by cash generated. Reading it alongside the income statement and the ratios completes the analysis: the income statement shows profit, the statement of financial position shows position, and the statement of cash flows shows the cash reality behind them - which, as the very first chapter warned, is often what determines whether a business survives.

\text{Cash from operations} = \text{Operating profit} + \text{Depreciation} \pm \text{Working-capital changes}

Indirect method

Add back non-cash items; deduct increases in inventory/receivables, add decreases; add increases in payables. Here 153,000 before interest and tax.

From profit to operating cash

Fig. 4The indirect method turns accruals-based operating profit into cash by adding back non-cash items and adjusting for working-capital movements, then deducting interest and tax.

Worked example

Reconciling profit to operating cash

A company has operating profit of £120,000 and a depreciation charge of £30,000. Inventory rose by £10,000, receivables fell by £5,000 and payables rose by £8,000. Interest paid was £20,000 and tax paid £25,000. Calculate the net cash from operating activities.

Add back non-cash items
Start with operating profit £120,000 and add back depreciation £30,000 (a non-cash expense): £150,000.
Adjust for working capital
Inventory up £10,000 uses cash (deduct); receivables down £5,000 releases cash (add); payables up £8,000 conserves cash (add): £150,000 - £10,000 + £5,000 + £8,000 = £153,000 cash generated from operations.
Deduct interest and tax
Net cash from operating activities = £153,000 - interest £20,000 - tax £25,000 = £108,000.

Result: Net cash from operating activities is £108,000: adding back depreciation and adjusting for working capital turns the £120,000 operating profit into £153,000 of operating cash, from which interest and tax are paid.

Typical mistakes

Deducting depreciation instead of adding it back, or getting the working-capital adjustments the wrong way round.
Confusing the statement of cash flows (cash) with the income statement (profit).

Active revision

Operating profit £120,000, depreciation £30,000; inventory up £10,000, receivables down £5,000, payables up £8,000; interest paid £20,000, tax paid £25,000. Calculate the net cash from operating activities.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA) · Ofqual - GCE AS and A level qualifications (Ofqual)

References & sources

Sources

AQA

AQA A-level Accounting 7127 specification

Ofqual

Ofqual - GCE AS and A level qualifications

Limited companies (advanced)

4 sections~17 min reading time3 competenciesLevel Standard 1 · Advanced 3

Limited companies (advanced)

Key points

Recording a share issue at a premium

Key points

Rights and bonus issues compared

Key points

Preparing a statement of changes in equity

Key points

Reconciling profit to operating cash

Sources

Limited companies (advanced)

Key points

Recording a share issue at a premium

Key points

Rights and bonus issues compared

Key points

Preparing a statement of changes in equity

Key points

Reconciling profit to operating cash

Sources