Notes · AccountingUK · A-Levels

Limited company accounts

This chapter adapts the financial statements to the limited company. It explains the company's capital structure - ordinary and preference share capital, the distinction between capital and reserves, and debentures - and shows how the income statement and the statement of financial position of a company differ from a sole trader's, especially in the equity section that records the shareholders' interest.

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

T·0999 / 18

Exam profile

AO1 · Understand company capital structure and the components of equityAO2 · Prepare a limited company income statement and statement of financial position in the correct formatAO3 · Analyse and evaluate a company's capital structure and financing

Operators:prepareexplaindistinguishcalculateanalyseevaluate

basic level

AS-Level introduces share capital, reserves and the layout of company financial statements.

higher level

The full A-Level expects confident preparation of company statements and analysis of capital structure, leading into the advanced company topic.

Depth

Text

Contents · 4 sections

Limited company accounts

Share capital: ordinary and preference shares#

StandardAQA 7127 3.7

Components of company financing

Fig. 1A company's long-term financing divides into equity (ordinary and preference share capital plus reserves) and debt (debentures and loans) - the basis of gearing.

A company raises long-term ownership finance by issuing shares, and the shareholders who buy them become the owners of the company. Shares have a nominal (par or face) value - often £1 or 50p - which is the value at which the share capital is recorded; this is not the same as the market value at which shares later change hands. The issued share capital is the nominal value of the shares the company has actually issued, and it forms the base of the equity section. Understanding that share capital is recorded at nominal value, with any excess over nominal recorded separately as share premium, is the foundation of company accounting.

Ordinary shares (equity shares) carry the residual ownership of the company. Ordinary shareholders bear the greatest risk and enjoy the greatest potential reward: they are paid a dividend only if the directors recommend one and only after preference shareholders have been paid, they rank last in a winding-up, but they usually carry the votes that control the company and they benefit fully from its growth. Their dividend is variable - high in good years, nil in bad ones - so ordinary share capital is genuinely risk-bearing 'equity'. This is why the ordinary shareholders are regarded as the true owners and why measures such as earnings per share focus on them.

Preference shares carry a fixed rate of dividend and rank ahead of ordinary shares both for that dividend and, usually, for the return of capital in a winding-up; in exchange they normally carry no votes. They are less risky than ordinary shares (the dividend is fixed and paid first) but they do not share in the company's growth. Preference shares may be cumulative (any dividend missed in a poor year must be made up before ordinary shareholders can be paid) or non-cumulative. Because a preference dividend is fixed, preference shares sit between ordinary shares and debt in the risk-return spectrum, and their treatment can vary, but at A-Level they are generally shown within share capital.

The distinction matters for both preparation and analysis. When appropriating profit, the fixed preference dividend is dealt with before any ordinary dividend, and earnings per share is calculated on the profit remaining for ordinary shareholders after preference dividends. In evaluation, the mix of ordinary and preference shares affects the risk and control of the company: issuing more ordinary shares dilutes existing owners' control and share of profit, while preference shares raise finance without giving away votes but commit the company to a fixed dividend. The choice is part of the wider question of how a company should be financed, taken up in the analysis and advanced-company chapters.

Worked example

Ordinary versus preference shares

A company has 200,000 ordinary £1 shares and 50,000 6% preference £1 shares. It made a profit and will pay the preference dividend and a 4p ordinary dividend. Calculate each dividend and comment on the risk to each shareholder.

Preference dividend
Fixed at 6% of the £50,000 nominal value = £3,000, paid before any ordinary dividend.
Ordinary dividend
4p per share x 200,000 shares = £8,000, paid only after the preference dividend and only if the directors recommend it.
Comment on risk
The preference shareholders receive a fixed £3,000 with priority - lower risk but no share in growth. The ordinary shareholders' £8,000 is variable and depends on profits and the directors, but they own the company's growth and carry the votes.

Result: Preference dividend £3,000 (fixed, paid first); ordinary dividend £8,000 (variable, paid second) - preference shares offer a steadier but capped income, ordinary shares more risk but ownership of the company's growth.

Typical mistakes

Confusing the nominal value (at which share capital is recorded) with the market value.
Treating a preference dividend as variable - it is fixed and paid before the ordinary dividend.

Active revision

Explain the difference between ordinary and preference shares and advise an investor seeking a steady income which they might prefer.

Active recall

Recall the key points — then reveal.

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

Reserves: capital and revenue#

StandardAQA 7127 3.7

Reserves are part of the shareholders' equity that has arisen other than from the nominal value of shares issued - they represent accumulated profits and gains that belong to the ordinary shareholders. They are emphatically not pots of cash: a reserve is a claim recorded on the equity side of the statement of financial position, matched by assets of many kinds, not by a segregated bank balance. This is one of the most common misunderstandings in the subject, and getting it right - a reserve is part of the owners' claim, not money set aside - is essential to interpreting company accounts correctly.

Reserves divide into two kinds with different origins and rules. Revenue reserves arise from retained trading profits: the retained earnings (accumulated undistributed profit) and any general reserve to which profit has been transferred. Revenue reserves are distributable - they can be used to pay dividends - because they represent realised profits. Capital reserves arise from sources other than normal trading, principally the share premium account (the excess of the issue price of shares over their nominal value) and the revaluation reserve (the surplus recognised when non-current assets are revalued upwards). Capital reserves are generally not distributable as cash dividends, because the gains they represent are not realised trading profits.

The share premium account illustrates the logic. When a company issues shares for more than their nominal value - say £1 shares issued at £1.50 - the £1 nominal goes to share capital and the extra 50p per share goes to the share premium account. This premium is capital, not profit, so company law restricts its use: it may be applied to specific purposes (such as issuing bonus shares or writing off certain expenses of a share issue) but not paid out as an ordinary dividend. The revaluation reserve works similarly - an unrealised gain on revaluing property is credited to the reserve but cannot be distributed until it is realised through sale. These restrictions protect creditors by maintaining the company's capital base.

For preparation and analysis, the distinction determines what can be paid out and how the equity section is built. Total equity is the issued share capital plus all the reserves - capital and revenue - and it represents the total book value of the ordinary (and preference) shareholders' interest in the company. Analysts read the reserves to gauge how much profit a company has retained and reinvested (a healthy sign of self-financing) versus distributed, and to understand the make-up of the shareholders' stake. Confusing distributable revenue reserves with undistributable capital reserves - or treating any reserve as spare cash - leads to serious errors of interpretation.

\text{Total equity} = \text{Share capital} + \text{Capital reserves} + \text{Revenue reserves}

Total equity

The book value of the shareholders' interest. Capital reserves (share premium, revaluation) are not distributable; revenue reserves (retained earnings, general reserve) are.

Worked example

Recording a share issue at a premium

A company issues 100,000 ordinary shares of £1 nominal value at an issue price of £1.40, received in full by cheque. Show the effect on share capital and reserves and explain the treatment.

Split the proceeds
Total received = 100,000 x £1.40 = £140,000. Of this, the nominal value 100,000 x £1 = £100,000 is share capital; the excess 100,000 x £0.40 = £40,000 is share premium.
Record the entries
Debit bank £140,000; credit ordinary share capital £100,000 and credit share premium account £40,000.
Explain the restriction
The £40,000 premium is a capital reserve, not a trading profit, so company law prevents it being paid out as an ordinary dividend; it can be used for limited purposes such as a bonus issue.

Result: Share capital rises by £100,000 and share premium by £40,000 (total £140,000 in the bank); the premium is a capital reserve and cannot be distributed as a dividend.

Typical mistakes

Describing a reserve as a sum of cash set aside - it is part of equity, backed by assets of all kinds.
Treating the share premium or revaluation reserve as available to pay dividends.

Active revision

A company issues 100,000 £1 ordinary shares at £1.40. State the entries to share capital and share premium and explain why the premium cannot be paid as a dividend.

Active recall

Recall the key points — then reveal.

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

Debentures and loan capital#

StandardAQA 7127 3.7

Shares versus debentures

Fig. 2A shareholder owns part of the company and receives a variable dividend; a debenture holder lends to it and receives fixed, prior interest - a creditor, not an owner.

A debenture is a long-term loan to a company, evidenced by a certificate, usually carrying a fixed rate of interest and a fixed repayment (redemption) date, and often secured on the company's assets. Debenture holders are creditors of the company, not owners: they lend money and are entitled to their interest and the return of their capital, but they have no vote and no share in profits or growth. This is the fundamental difference between a debenture and a share - the debenture holder is owed money, the shareholder owns a stake - and it drives every difference in their treatment.

The consequences of that difference run right through the accounts. Debenture interest is a finance cost - an expense charged in the income statement before profit is calculated - and it must be paid whether or not the company makes a profit; a dividend, by contrast, is an appropriation of profit paid only if profits and the directors allow. In a winding-up, debenture holders (especially if secured) are paid before shareholders. In the statement of financial position, debentures are shown as a non-current liability (or current, if due within a year), not as part of equity. And because debenture interest is a contractual, prior claim, heavy borrowing raises the company's financial risk.

This is the essence of gearing, developed in the ratio-analysis chapter. Debt finance (debentures and loans) is attractive because the interest is usually lower than the return shareholders expect, it does not dilute ownership or control, and the interest is an allowable expense. But it commits the company to fixed interest payments that must be met in good times and bad, and repayment falls due on a fixed date - so debt increases the risk that the company cannot meet its obligations if profits fall. A company financed mainly by debt is highly geared and riskier; one financed mainly by equity is low geared and safer but may give shareholders a lower return on their capital.

In evaluation, the choice between raising finance by shares or by debentures is a classic trade-off between cost, risk and control. Debentures keep control with the existing shareholders and carry tax-deductible interest, but add fixed commitments and financial risk; a share issue avoids fixed commitments but dilutes ownership and the ordinary shareholders' share of profit, and shareholders expect a higher return. There is no universally right answer - it depends on the company's existing gearing, the stability of its profits (stable profits can support more debt), interest rates, and the owners' attitude to control and risk. Recognising this trade-off, rather than asserting that one form is always better, is what earns the evaluation marks.

Worked example

Debentures versus a share issue

A company with low existing borrowing and stable profits needs £400,000. Its owners want to retain control. Evaluate whether it should issue 8% debentures or ordinary shares.

Assess the control objective
Issuing ordinary shares would bring in new shareholders and dilute the existing owners' control and share of profit; debentures bring in creditors with no votes, preserving control - which meets the owners' objective.
Assess cost and risk
8% debenture interest is a fixed, tax-deductible expense of £32,000 a year that must be paid regardless of profit; the company's low gearing and stable profits make this affordable, so financial risk stays acceptable.
Recommend with a caveat
Recommend the debentures: they preserve control, are cheaper than equity and are affordable given low gearing and stable profits. The caveat is that the fixed interest and eventual repayment add commitments, so if profits became volatile the extra risk would count against them.

Result: Debentures are recommended: they keep control with the owners, carry cheaper, tax-deductible interest, and are affordable given low gearing and stable profits - the fixed commitment being the price of preserving control.

Typical mistakes

Calling a debenture holder a shareholder, or treating debenture interest as a dividend.
Showing debentures within equity instead of as a non-current liability.

Active revision

A low-geared company needs £400,000 to expand and wants to keep control with its existing owners. Evaluate whether it should issue debentures or ordinary shares.

Active recall

Recall the key points — then reveal.

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

The company income statement and statement of financial position#

AdvancedAQA 7127 3.7

Company income statement

Fig. 3The company income statement continues below operating profit: finance costs (£20,000) and tax (£25,000) reduce the £120,000 operating profit to a £75,000 profit for the year.

A company's income statement follows the same two-stage shape as a sole trader's but continues below the profit from operations to reflect the company's distinctive costs. After revenue less cost of sales gives gross profit, and gross profit less distribution and administrative expenses gives the profit from operations (operating profit), the statement deducts finance costs (debenture and loan interest), giving the profit before tax; then deducts the corporation tax charge to arrive at the profit for the year. This bottom line is the profit attributable to the shareholders, from which dividends may be appropriated and the remainder retained. The extra lines - finance costs and tax - are what distinguish a company income statement from a sole trader's.

Dividends are not an expense in the income statement; they are an appropriation of profit, shown in the statement of changes in equity (covered in the advanced chapter) or deducted within retained earnings, because they are a distribution to the owners rather than a cost of earning profit. This mirrors the sole trader's drawings, which are also not an expense. Keeping dividends out of the income statement is a frequent exam point: the profit for the year is struck before any dividend, and the dividend is then dealt with as a movement in equity.

The company statement of financial position uses the same asset and liability structure as a sole trader's but replaces the single capital account with the equity section, which sets out the shareholders' interest in detail: the issued share capital (ordinary and any preference), the capital reserves (share premium, revaluation reserve) and the revenue reserves (general reserve and retained earnings). The total of these is the total equity, the company's net worth to its shareholders. Non-current liabilities such as debentures appear above the equity section, and the whole statement balances, with net assets equal to total equity - the company version of net assets equalling closing capital.

Worked figures show the layout. Suppose a company has revenue £800,000, cost of sales £480,000, distribution and administrative expenses £200,000, finance costs £20,000 and a tax charge of £25,000. Gross profit is £320,000, profit from operations is £320,000 - £200,000 = £120,000, profit before tax is £120,000 - £20,000 = £100,000, and profit for the year is £100,000 - £25,000 = £75,000. In the equity section, if the company has ordinary share capital of £200,000, share premium £30,000, a general reserve £20,000 and retained earnings £90,000, total equity is £340,000. Preparing these statements accurately, with the finance costs and tax in the right place and dividends kept out of the income statement, is the core skill this chapter builds.

\text{Profit for the year} = \text{Profit from operations} - \text{Finance costs} - \text{Tax}

Company profit for the year

Finance costs (interest) and tax are deducted after operating profit. Dividends are NOT deducted here - they are an appropriation of profit.

Equity section of a company

Fig. 4The equity section: issued share capital plus capital reserves (share premium) and revenue reserves (general reserve, retained earnings) give total equity of £340,000.

Worked example

Company income statement and equity

A company reports revenue £800,000, cost of sales £480,000, distribution and administrative expenses £200,000, finance costs £20,000 and a tax charge of £25,000. Prepare the income statement to profit for the year and calculate total equity given ordinary share capital £200,000, share premium £30,000, general reserve £20,000 and retained earnings £90,000.

Gross and operating profit
Gross profit = £800,000 - £480,000 = £320,000. Profit from operations = £320,000 - £200,000 = £120,000.
Profit for the year
Profit before tax = £120,000 - finance costs £20,000 = £100,000. Profit for the year = £100,000 - tax £25,000 = £75,000.
Total equity
Total equity = share capital £200,000 + share premium £30,000 + general reserve £20,000 + retained earnings £90,000 = £340,000.

Result: Profit for the year is £75,000 (operating profit £120,000 less finance costs £20,000 and tax £25,000), and total equity is £340,000.

Typical mistakes

Treating dividends as an expense in the income statement - they are an appropriation of profit.
Placing finance costs or tax in the wrong order, or omitting them, when moving from operating profit to profit for the year.

Active revision

From: revenue £800,000, cost of sales £480,000, expenses £200,000, finance costs £20,000, tax £25,000. Prepare the income statement to profit for the year, and state total equity given share capital £200,000, share premium £30,000, general reserve £20,000 and retained earnings £90,000.

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 company accounts

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

Limited company accounts

Key points

Ordinary versus preference shares

Key points

Recording a share issue at a premium

Key points

Debentures versus a share issue

Key points

Company income statement and equity

Sources

Limited company accounts

Key points

Ordinary versus preference shares

Key points

Recording a share issue at a premium

Key points

Debentures versus a share issue

Key points

Company income statement and equity

Sources