(117)-NON STATUTORY RESERVES

Non Statutory Reserves

The company directors may choose to set up other reserves. These may have a specific purpose (e.g. plant and machinery replacement reserve) or not (e.g. general reserve). The creation of these reserves usually indicates a general intention not to distribute the profits involved at any future date, although legally any such reserves, being non-statutory, remain available for the payment of dividends.

Distinction between reserves and provisions

A reserve is an appropriation of distributable profits for a specific purpose while a provision is an amount charged against revenue as an expense. A provision relates either to a diminution in the value of an asset or a known liability, the amount of which cannot be established with any accuracy.

Provisions are dealt with in a company accounts in the same way as in the accounts of other types of business.

(116)-PROFIT AND LOSS RESERVES

Profit and Loss Reserves

The most significant non-statutory reserve is variously described as:

• Revenue reserve
• Retained profits
• Retained earnings
• Undistributed profits
• Profit and loss account
• Un-appropriated profits

These are profits earned by the company and not appropriated by dividends, taxation or other transfer to another reserves account.

Provided that a company is earning profits, this reserve generally increases from year to year, as most companies do not distribute all their profits as dividends. Dividends can be paid from it: even if a loss is made in one particular year, a dividend can be paid from previous years’ retained profits.

Very occasionally, you might come across a debt balance on the profit and loss account. This would indicate that the company has a accumulated losses.

(115)-RESERVES

Reserves

A company’s share capital will remain fixed from year to year, unless new shares are issued. Reserves are difficult to define neatly since different reserves arise for different reasons, but it follows from the above that:

Reserves = net assets – share capital

So the total amount of reserves in a company varies, according to changes in the net assets of the business.

A distinction should be made between:

• Statutory reserves, which are reserves which a company is required to set up by law, e.g., the revaluation reserve, and which are not available for the distribution of dividends.
• Non statutory reserves, which are reserves consisting of profits which are distributable dividends, if the company so wishes.

(114)-SHARE CAPITAL

Share Capital

The net fixed assets of a company, plus the working capital (i.e. current assets minus current liabilities) minus the long term liabilities, are “financed” by the shareholders’ capital.

Shareholders’ capital consists of both:

• The nominal value of issued capital (minus any amounts not yet called up on issued shares
• Reserves.

The share capital itself might consist of both ordinary shares and preference shares. All reserves, however, are owned by the ordinary shareholders, who own the “equity” in the company.

Called up share capital

A company’s issued share capital is it’s called up share capital, provided that there are no shares in issued which have so far only been partly called up.

(113)-TYPES OF SHARES

Types of Shares

We can distinguish three types of shares,

• Preference shares
• Deferred shares
• Ordinary shares

Preference shares

Preference shares are shares which confer certain preferential rights on their holders.
The rights attaching to preference shares are set out in the company’s contribution. They may vary from company to company, but typically:

• Preference shareholders have a priority right over ordinary shareholders to a return of their capital if the company goes into liquidation.
• Preference shares do not carry a right to vote.
• If the preference shares are cumulative, it means that before a company can pay an ordinary dividend it must not only pay the current year’s preference dividend, but must also make good any arrears of preference dividends unpaid in previous years.

Deferred shares

Deferred shares are equity shares that will receive a dividend only after other classes of shares including ordinary shares have received a specified rate of dividend, or will receive a dividend only after a specified time from issue.

Ordinary shares

Ordinary shares are shares which are not preferential with regard to dividend payments. Thus a holder only receives a dividend after fixed dividends have been paid to preference shareholders.
Ordinary shares normally carry voting rights; they are effective owners of a company. They own the “equity” of the business, and any reserves of the business belong to them.

(112)-THE SHARE PREMIUM

The Share premium

By “premium” is meant the difference between the issue price of the share and its nominal value. When a company is first incorporated the issue price of its shares will probably be the same as their nominal value and so there would be no share premium. If the company does well the market value of its shares will increase, but not the nominal value. The price of any new shares issued will be approximately their market value.

The companies act states that “where a company issues shares at a premium, whether for cash or otherwise, a sum equal to the premiums on those shares shall be transferred to the share premium account”.

A share premium account is an account into which sums received as payment for shares in excess of their nominal value must be placed.

The share premium account cannot be distributed as dividend under any circumstances.

(111)-DIVIDENDS

Dividends

Shareholders are entitled to a share of the profits made by the company.

Dividends are appropriations of profit after tax.

A company might pay dividends in two stages during the course of their accounting year:

• In mid year, after the half year financial results are known, the company might pay an interim dividend.
• At the end of the year, the company might pay a further final dividend.
  The total dividend for the year is the sum of the interim and the final dividend. Not all companies pay an interim dividend. Interim dividends are, however, commonly paid out by public limited companies.

At the end of an accounting year, a company’s directors may have proposed a final dividend payment, which has not yet been paid. This means that the final dividend should be appropriated out of profits and shown as a current liability in the balance sheet.

Profits re-invested

Not all profits are distributed as dividends; some will be retained in the business to finance future projects. The “market value” of the share should, all other thing being equal, be increased if these projects are profitable.

(110)-THE CAPITAL OF LIMITED COMPANIES

The Capital of Limited Companies

The proprietors’ capital in a limited company consists of share capital. When a company is set up for the first time, it issues shares. These are paid for by investors, who then become shareholders of the company. Shares are denominated in units of 50 pence, 1$, 2$ or whatever seems appropriate. This “face value” of the shares is called their nominal value.

A distinction must be made between authorized, issued, called up and paid up share capital.

Authorized or nominal capital

Authorized or nominal capital is the maximum amount of share capital that a company is empowered to issue. The amount of authorized share capital varies from company to company, and can change by agreement.

Issued capital

Issued capital is the nominal amount of share capital that has been issued to shareholders. The amount of issued capital cannot exceed the amount of authorized capital. When share capital is issued, shares are allotted to shareholders. The term “allotted” share capital means the same thing as issued share capital.

Called-up capital

When shares are issued or allotted, a company does not always expect to be paid the full amount for the shares at once. It might instead call up only a part of the issue price, and wait until a later time before it calls up the remainder.

Paid-up capital

Like everyone else, investors are not always prompt or reliable payers. When capital is called up, some shareholders might delay their payment or even default on payment. Paid up capital is the amount of called up capital that has been paid.

(109)-THE BOARD OF DIRECTORS IN COMPANIES

The Board of Directors In companies

A company can have a large number of shareholders, or only a few. No matter how many there are, they delegate authority for the day to day management of the company to its directors, who are directly responsible to the shareholders for what they do. In some small companies, the directors of the company and its shareholders are the same people.

There must also be a company secretary. Company policy is decided at regular meeting of the board of directors.

The salary of a sole trader or a partner is not a charge in the profit and loss account, but is an appropriation of profit. However, the salary of a director is a profit and loss account expense. This is because the directors are considered to be employees of the company, even when a director is also a shareholder of the company.

It would be wrong to give the impression that all companies are large scale with many shareholders.

(108)-THE ACCOUNTING RECORDS OF LIMITED COMPANIES

The Accounting Records of Limited Companies

There is a legal requirement for companies to keep accounting records which are sufficient to show and explain the company’s transactions. The records should:

• Disclose the company’s current financial position at any time.
• Contain:
  1. Day to day entries of money received and spent.
  2. A record of the company’s assets and liabilities.
  3. Where the company deals in goods. A statement of stock held at the year end, and supporting stocktaking sheets. With the expectation of retail sales, statements of goods bought and sold which identify the seller and buyer of those goods.
• Enable the directors of the company to ensure that the final accounts of the company give a true and fair view of the company’s profit or loss and balance sheet position.

Registers: the statutory books

A company must also keep a number of non accounting registers. These include:

• Register of members
• Register of shareholders 3 per cent interests
• Register of charges and a register of debenture holders
• Register of directors and company secretaries
• Register of directors interests

These registers are known collectively as the statutory books of the company.

(107)-LIMITED LIABILITY

Limited Liability

Limited liability means that the maximum amount that an owner stands to lose in the event that the company becomes insolvent and cannot pay off its debits is his share of capital in the business.

Unlimited liability means that if the business runs up debts that it is unable to pay, the proprietors will become personally liable for the unpaid debts, and would be required, if necessary, to sell their private possessions in order to repay them.

Sole traders are generally fairly small concerns. The amount of capital involved may be modest, and the proprietor usually participates in managing the business. His or her liability for the debts of the business is unlimited.

Limited companies offer limited liability to their owners.

Thus limited liability is a major advantage of turning a business into a limited company. However, in practice, banks will normally seek personal guarantees from shareholders of a small owner managed company before making loans or granting an overdraft facility, and so the advantage of limited liability is lost.

(106)-ACCOUNTING FOR LIMITED COMPANIES INTRODUCTIONS

Accounting For Limited Companies Introduction

The accounting rules and conventions for recording the business transactions of limited companies and then preparing their final accounts are much the same as for sole trader. For example, companies will have a cash book, sales day book, purchase day book, journal, sales ledger, purchase ledger and nominal ledger. They will also prepare a profit and loss account annually and a balance sheet at the end of the accounting year.

They are, however, some differences in the accounts of limited companies, of which the following are perhaps the most significant.

• The legislation governing the activities of limited companies is very extensive. Among other things, the company’s acts define certain minimum accounting records which must be maintained by companies. They specify that the annual accounts of the company must be field with the registrar of companies and so available for public inspection. They contain detailed requirements on the minimum information which must be disclosed in a company’s accounts.
• The owners of a company may be very numerous. Their capital is shown differently from that of a sole trader; and similarly the appropriation account of a company is different.

(105)-SUMMARY ABOUT PARTNERSHIP ACCOUNTING

Summary about Partnership Accounting

Accounting for a partnership is for the most part the same as accounting for a sole trader except in the following respects.

• The initial capital put into the business by each partner is shown by means of a capital account for each partner.
• Each partner also has a current account and drawings account.
• The net profit of the partnership is appropriated by the partners according to some previously agreed ratio.
• Partners may be charged interest on their drawings, and may receive interest on capital. If a partner makes a loan to the business, he will receive interest on it the normal way.
• Partnerships may be terminated either by closing down the business entirely or by disposing of the business as a going concern to a limited company.

(104)-APPROPRIATION OF NET PROFITS IN PARTNERSHIPS

Appropriation of Net Profits in Partnerships

The net profit of a partnership is shared out between them according to the terms of their agreement. This sharing out is shown in a profit and loss appropriation account, which follows on from the profit and loss account itself.

The accounting entries are:

• Profit and loss account with net profit c/d – Debit
  Profit and loss appropriation account with net profit b/d – Credit
• Profit and loss appropriation account – Debit
  The current accounts of each partner – Credit
  With an individual share of profits for each partner

The way in which profit is shared out depends on the terms of the partnership agreement. The steps to take are as follows.

• Step 1. Establish how much the net profit is.
• Step 2. Appropriate interest on capital and salaries first. Both of these items are an appropriation of profit and are not expenses in the profit and loss account.
• Step 3. If partners agree to pay interest on their drawings during the year
  Current account – Debit
  Appropriation of profit account – Credit
• Step 4. Residual profits, the difference between net profits plus any interest charged on drawings and appropriations for interest on capital and salaries is the residual profit. This is shared out between partners in the profit sharing ratio.
• Step 5. Each partner’s share of profits is credited to his current account.
• Step 6. The balance on each partner’s drawings account is debited to his current account.
  In Practice each partner’s capital account will occupy a separate ledger account, as will his current account.

(103)-ACCOUNTING ADJUSTMENTS FOR LOANS BY PARTNERS

Accounting Adjustments for Loans by Partners

In addition, it is sometimes the case that an existing or previous partner will make a loan to the partnership in which case he becomes a creditor of the partnership. On the balance sheet, such a loan is not include as partners’ funds, but is shown separately as a long-term liability. This is the case whether or not the loan creditor is also an existing partner.

However, interest on such loans will be credited to the partner’s current account if he is an existing partner. This is administratively more convenient, especially when the partner does not particularly want to be paid the loan interest in cash immediately it becomes due. Remember:

• Interest on loans from a partner is accounted for as an expense in the profit and loss account, and not as an appropriation of profit, even though the interest is added to the current account of the partners.
• If there is no interest rate specified, the partnership act provides for to be paid at 5% per annul on loans by partners.

(102)-CAPITAL AND CURRENT ACCOUNTS IN PARTNERSHIPS

Capital Account and Current Account in Partnership

Capital account

The balance for the capital account will always be a brought forward credit entry in the partnership accounts, because the capital contributed by proprietors is a liability of the business.
When a partnership is formed, each partner puts in some capital to the business. These initial capital contributions are recorded in a series of capital accounts, one for each partner. Partners do not have to put in the same amount.

In addition to capital account, each partner normally has:

• A current account.
• A drawing account.

Current account

A current account is used to record the profits retained in the business by the partner.
The main differences between the capital and current account in accounting for partnerships are as follows.

• The balance on the capital account remains static from year to year.
• The current is continually fluctuating up and down, as the partnership makes profits which are shared out between the partners, and as each partner takes out drawings.
• A further difference is that when the partnership agreement provides for interest on capital, partners receive interest on the balance in their capital account, but not on the balance in their current account.

Drawing account

The drawings accounts serve exactly the same purpose as the drawings account for a sole trader. Each partner’s drawings are recorded in a separate account. At the end of an accounting period, each partner’s drawings are cleared to his current account.

Current account – Debit
Drawings account – Credit

The partnership balance sheet will therefore consist of:

• The capital accounts of each partner.
• The current accounts of each partner, net of drawings.

(101)-DIFFERENCE BETWEEN PARTNERSHIP ACCOUNTS AND SOLE TRADER ACCOUNTS

Difference between Partnership Accounts and Sloe Trader Accounts

Partnership accounts are identical in many respects to the accounts of sole traders.

• The assets of a partnership are like the assets of any other business, and are accounted for in the same way. The assets side of a partnership balance sheet is no different from what has been shown in earlier posts.
• The net profit of a partnership is calculated in the same way as the net profit of a sole trader. The only minor difference is that if a partner makes a loan to the business as distinct from capital contribution then interest on the loan will be an expense in the profit and loss account, in the same way as interest on any other loan from a person or organization who is not a partner.

(100)-ADVANTAGES AND DISADVANTAGES OF PARTNERSHIPS

Advantages and Disadvantages of Partnerships

Operating as a partnership entails certain advantages and disadvantages when compared with both sole trader and limited companies.

Partnership and sole trader

The advantages of operating as a partnership rather than as a sole trader are practical rather than legal. They include the following.

• Risks are spread across a larger number of people.
• The trader will have access to a wider network of contacts through the other partners.
• Partners should bring to the business not only capital but skills and experience.
• It may well be easier to raise finance from external source such as banks.

Possible disadvantages include the following

• While the risk is spread over a larger number of people, so are the profits
• By bringing in more people the former sole trader dilutes control over his business
• There may be disputes between the partners

Limited companies offer limited liability to their owners. This means that the maximum amount that an owner stands to lose in the event that the company becomes insolvent and must pay off its debts is the capital in the business. In the case of partnerships, liability for the debts of the business is unlimited, which means that if the business runs up debts and is unable to pay, the proprietors will become personally liable for the unpaid debts and would be required, if necessary, to sell their private possessions in order to pay for them.

Limited liability is clearly a significant incentive for a partnership to incorporate. Other advantages of incorporation are that it is easier to raise capital and that the retirement or death of one of its members does not necessitate dissolution and re-formation of the firm.

In practice, however, particular, particularly for small firms, these advantages are more apparent than real. Banks will normally seek personal guarantees from shareholders before making loans or granting an overdraft facility and so the advantage of limited liability is lost to a small owner managed business.

(99)-INTRODUCTION TO PARTNERSHIP ACCOUNTS

Introduction to Partnership Accounts

Partnership is defined as the relationship which exists between persons carrying on a business in common with a view of profit.

In other words, a partnership is an arrangement between two or more individuals in which they undertake to share the risks and rewards of a joint business operations.

It is usual for a partnership to be established formally by means of a partnership agreement. However, if individuals act as though they are in partnership even if no written agreement exists, they it will be presumed in law that a partnership does exist and that its terms of agreement are the same as those laid down in the partnership act 1890.

The partnership agreement

The partnership agreement is a written agreement in which the terms of the partnership are set out, and in particular the financial arrangements as between partners the items it should cover include the following.

• Capital
• Profit sharing ration
• Interest on capital
• Partners salaries
• Drawings
• Guaranteed minimum profit shares

In the absence of a formal agreement between the partners, certain rules laid down by the partnership act are presumed to apply instead.

• Residual profits are shared equally between the partners
• There are no partners’ salaries
• Partners receive no interest on the capital they invest in the business
• Partners are entitled to interest of 5% per annul on any loans they advance to the business in excess of their agreed capital

(98)-SUMMARY ABOUT INCOMPLETE RECORDS

Summary about Incomplete records

Incomplete records accounts is preparing accounts in the following situations,

• A trader does not maintain a ledger and therefore has no continuous double entry record of transactions.
• Accounting records are destroyed by accident, such as fire.
• Some essential figure is unknown and must be calculated as a balancing figure. This may occur as a result of stock being damaged or destroyed, or because of misappropriation of assets.

The approach to incomplete records questions is to build up the information given so as to complete the necessary double entry. This may involve reconstructing control accounts for:

• Cash and bank
• Debtors and creditors

Where stock, sales or purchases is the unknown figure it will be necessary to use information or gross profit percentage so as to construct a trading account in which the unknown figure can be inserted as a balance.

(97)-STEPS TO DEALING WITH INCOMPLETE RECORDS

Steps to Dealing with Incomplete Records

The nature of the “incompleteness” in the records will vary from problem to problem, but the approach, suitably applied, should be successful in arriving at the final accounts whatever the particular characteristics of the problem might be.

The approach is as follows.

• Step one. If possible, and if it is not already known, establish the opening balance sheet and the proprietor’s interest.
• Step two. Open up four accounts these are Trading account, a cash book, a debtors account, a creditors account.
• Step three. Enter the opening balances in these accounts.
• Step four. Work through the information you are given line by line; and each item should be entered into the appropriate account if it is relevant to one or more of these four accounts. You should also try to recognize each item as a profit and loss account income or expense item or a closing balance sheet. It may necessary to calculate an amount for drawings and an amount for fixed asset depreciation.
• Step five. Look for the balancing figures in your four accounts. In particular you might be looking for a value for credit sales, cash sales, purchases, the cost of goods sold, the cost of goods stolen or destroyed, or the closing bank balance. Calculate these missing figures, and make any necessary double entry.
• Step six. Now complete the profit and loss account and balance sheet.

(96)-TWO COLUMN CASH BOOK FOR SINGLE ENTRY

Preparing Two Column Cash Book for Single Entry

Where there appears to be a sizable volume of receipts and payments in cash, then it is also helpful to construct a two column cash book.

A two column cash book is a cash book with one column for cash, and one column for the business bank account.

A two column cash book is completed as follows in single entry accounting.

1. Step one. Enter the opening cash balances.
2. Step two. Enter the information given about cash payments and any cash receipts.
3. Step three. The cash receipts banked are a “contra” entry, being both debit bank column and credit cash in hand column in the same account.
4. Step four. Enter the closing cash in hand (cash in the bank at the end of the period is not known)
5. Step five. The closing balance of money in the bank is a balancing figure. Notice that this is a credit balance i.e. an overdraft.
6. Step six. Since all sales are for cash, a balancing figure that can be entered in the cash book is sales, in the cash in hand debit column.

Theft of cash form the till

When cash is stolen from the till, the amount stolen will be a credit entry in the cash book, and a debit in either the profit and loss account or insurance claim account, depending on whether the business is insured. The missing figure for cash sales, if this has to be calculated, must not ignore cash received but later stolen.

(95)-USING CASH BOOK FOR INCOMPLETE RECORDS

Using Cash Book for Incomplete Records

The construction of a cash book, largely from bank statements showing receipts and payments of a business during a given period, is often an important feature of incomplete records problems.

Information about cash receipts or payments might be needed to establish:

• The amount of purchases during a period
• The amount of credit sales during a period

Other items of receipts or payments might be relevant to establishing:

• The amount of cash sales
• The amount of certain expenses in the profit and loss account
• The amount of drawings by the business proprietors

It might therefore be helpful, if a business does not keep a cash book day to day, to construct a cash book at the end of an accounting period. A business which typically might not keep a day to day cash book is a shop, where:

• Many sales, if not all sales, are cash sales
• Some payments are made in notes and coins out of the till rather than by payment out of the business bank account by cheque.

(94)-ACCOUNTING FOR STOCK DESTROYED, STOLEN OR LOST

Accounting for Stock Destroyed, Stolen or Lost

When unknown quantity goods is lost, whether they are stolen, destroyed in a fire, or lost in any other way such that the quantity lost cannot be counted, then the cost of the goods lost is the difference between:

• The cost of goods sold
• Opening stock of the goods plus purchases less closing stock of the goods

When stock is stolen, destroyed or otherwise lost, the loss must be accounted for somehow. Since the loss is not a trading loss, the cost of the goods lost is not included in the trading account.

The account that is to be debited is one of two possibilities, depending on whether or not the lost goods were insured against the loss.

• If the lost goods were not insured, the business must bear the loss, and the loss is shown in the profit and loss account.
  Profit and loss account – Debit
  Trading account – Credit
• If the lost goods were insured, the business will not suffer a loss, because the insurance will pay back the cost of the lost goods. This means that there is no charge at all in the profit and loss account, and the appropriate double entry is:
  Insurance claim account – Debit
  Trading account – Credit
  The insurance claim will then be a current asset, and shown in the balance sheet of the business as such. When the claim is paid, the account is closed by,
  Cash – Debit
  Insurance claim account – Credit