CIMA CO2 Official Learning System - Fundamentals of Financial Accounting

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431

LEARNING OUTCOMES

When you have completed this chapter, you should be able to:

䉴 prepare a statement of comprehensive income, statement of changes in equity and

statement of ﬁ nancial position, from a trial balance, for limited companies;

䉴 prepare a statement of cash ﬂ ows.

13.1 Introduction

Many businesses are constituted in the form of limited companies. The nature of limited

companies was mentioned very brieﬂ y in Chapter 1 and you should refer back to refresh

your memory. In this chapter we look at some of the features of limited companies that

have an impact on the content and presentation of their ﬁ nancial statements.

We also look at two further accounting statements that companies are required to

include in their ﬁ nancial statements – the statement of changes in equity and the state-

ment of cash ﬂ ows.

The Financial

Statements of

Limited Companies

and the Statement of

Cash Flows

STUDY MATERIAL C2

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THE FINANCIAL STATEMENTS OF LIMITED COMPANIES AND THE STATEMENT OF CASH FLOWS

13.2 Limited companies

As trading organisations grow in size, the limited ﬁ nancial resources of their owners often

restrict the organisation’s ability to grow any further. In order to avoid this difﬁ culty many

larger organisations use a company structure. A company is a separate legal entity that may

sue and be sued. It may have many owners who may or may not be directly involved in

the day-to-day running of the business. Each of these owners is known as a shareholder

or member of the company; they buy shares in the company that when ﬁ rst issued form

the company’s capital. The liability of the members to the company is limited. This means

that if a company’s assets are insufﬁ cient to pay its liabilities the shareholders cannot be

required to pay more than the amount paid, or agreed to be paid for their shares, and thus

their personal assets are protected. This contrasts with the position of sole traders. In law,

the business of a sole trader and the individual owning the business are the same person.

Thus the business obligations must be met by its owner even if this means selling private

assets or leads to the individual being declared bankrupt.

The ﬁ nancial statements of a company are normally ﬁ led annually at a public bureau, in

a form prescribed by company law and international ﬁ nancial reporting standards (IFRSs)

(this is not within your syllabus and is not included in this Learning System). However,

the internal ﬁ nancial statements of companies are within your syllabus and use the same

principles as have already been learned to prepare the ﬁ nancial statements of sole traders.

13.2.1 The financial statements of companies

The accounting statements of companies comprise:

1. a statement of comprehensive income, which may include a manufacturing account

(if appropriate, depending on the organisation’s activities dealt with in Chapter 12) and

a trading account;

2. a statement of changes in equity;

3. a statement of ﬁ nancial position;

4. a statement of cash ﬂ ows.

The statement of comprehensive income comprises an income statement, which you will

already be familiar with from the previous chapters. It has an additional section which is

discussed in more detail in Section 13.2.8 below.

The only statements different from those of a sole trader are the statement of changes in

equity and the statement of cash ﬂ ows. The statement of changes in equity shows the increase

or decrease in equity in a company, where the equity is the name for ‘ capital ’ in a limited

company. Thus in a limited company the accounting equation is assets  equity  liabilities.

In a sole trader’s statement of ﬁ nancial position we show the change in capital as:

Capital brought forward at the beginning of the year X

Add : capital introduced (if any) X

Add : proﬁ t for the year X

Less : drawings for the year (X)

Capital at the end of the year X

This is effectively the same as the statement of changes in equity in a company, except that

in company ﬁ nancial statements the statement of changes in equity is shown as a separate

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE FINANCIAL STATEMENTS OF LIMITED COMPANIES AND THE STATEMENT OF CASH FLOWS

ﬁ nancial statement and only the ﬁ nal total is entered in the statement of ﬁ nancial position.

Also, in company ﬁ nancial statements any capital introduced would be ‘ share ’ capital, and

the money taken out by the owners is called ‘ dividends ’ , not drawings. The statement of

changes in equity is discussed in more detail in Section 13.2.9.

13.2.2 Presentation of company income statements

There are a few details in which the ﬁ nancial statements of a company will differ from

those of a sole proprietor. In some cases this is because there are new items, for example

dividends, and sometimes because a slightly different presentation is used to reﬂ ect the dif-

ferent nature of a limited company.

One such detail is that in the income statement of a sole proprietor the last line is ‘ net

proﬁ t ’ . In the statement of comprehensive income of company accounts, it is normal to

calculate a proﬁ t called ‘ operating proﬁ t ’ which is the proﬁ t before any interest received

or paid.

An example is shown below:

Statement of comprehensive income of ABC Ltd for the year ended 20X8

$’000

Sales 1000

Cost of sales (640)

Gross proﬁ t 360

Expenses – (e.g. rent, power, telephone etc.) (100)

Operating proﬁ t 260

Interest received 5

Interest paid (20)

P r o ﬁ t before tax 245

Note that the line after interest paid is called ‘ proﬁ t before tax ’ .

13.2.3 Taxation in company financial statements

An additional item that appears in the ﬁ nancial statements of companies is that of taxa-

tion. In a sole trader’s business, this is a personal charge, and so does not appear in the

ﬁ nancial statements. But in the case of a limited company, a company is a separate legal

entity and as such is liable to pay tax on its proﬁ ts and so it does appear in the ﬁ nancial

statements. At the end of each year an estimate is made by the company of the amount

of its taxation liability and an accrual is made in its accounts by debiting the tax expense

to the statement of comprehensive income and crediting a liability account ‘ income tax

liability ’ . When the liability is ﬁ nally agreed with the tax authorities there may be a differ-

ence compared with the estimate: the difference is compensated for when preparing the

estimate for the following year’s tax liability.

In this Learning System, the tax on company proﬁ ts is referred to by the generic name

‘ income tax ’ though in different countries it may have another name, for example corpora-

tion tax in the UK.

The income tax will appear in the statement of comprehensive income, continuing the

example above, as follows:

P r o ﬁ t before tax 245

Income tax (80)

P r o ﬁ t for the period 165

STUDY MATERIAL C2

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THE FINANCIAL STATEMENTS OF LIMITED COMPANIES AND THE STATEMENT OF CASH FLOWS

Note that the ﬁ nal line is ‘ proﬁ t for the period ’ . The period of the statement of compre-

hensive income will appear at the top of the statement, in this case year ended 20X8.

13.2.4 Directors of limited companies

Limited companies are owned by the shareholders, but it is not common, especially in

larger companies, for the shareholders to be involved in the day-to-day running of the

company. Instead, the shareholders appoint directors to carry out those duties. Directors

are merely employees of the company, and their duties are remunerated by salaries, fees,

commission and so on, all of which are regarded in the same way as wages paid to any

other employee, and appear in the statement of comprehensive income as an expense. Of

course, in some companies, directors also own shares, but the two roles (as director and

shareholder) are separate, and are recorded separately.

13.2.5 Sources of finance for a limited company

The statement of ﬁ nancial position of a company is similar to that of a sole trader, but

there are usually a number of different sources of ﬁ nance. Many companies raise their own

loan ﬁ nance in the form of debentures.

Debentures

Debenture.

The written acknowledgement of a debt by a company and normally contain-

ing details as to payment of interest and the terms of repayment of principal.

A debenture may be secured on some or all of the assets of the company. This means

that if the company fails to repay the loan, or cannot keep up with the interest payments,

the debenture holders can seize the assets on which their loan is secured and sell them to

recover their money.

In accounting terms, a debenture is the same as a loan; it may be a current or non-cur-

rent liability depending on the date of repayment of the principal. The interest payments

are compulsory, irrespective of the level of proﬁ ts, and are a normal expense, accounted for

on an accruals basis (i.e. the full amount of interest arising during the accounting period

must be charged in the statement of comprehensive income, regardless of the date of pay-

ment of that interest).

Share capital

The o

wners ’ investment is in the form of shares. The most common forms of share are

ordinary shares and preference shares.

Ordinary shares . Shares that entitle the holders to the remaining divisible proﬁ ts (and,

in a liquidation, the assets) after prior interests – for example, payables and prior-charge

capital – have been satisﬁ ed.

Preference Shares . Shares carrying a ﬁ xed rate of dividend, the holders of which, subject

to the conditions of issue, have a prior claim to any company proﬁ ts available for distribu-

tion. Preference shareholders may also have a prior claim to the repayment of capital in the

event of a winding up.

When presenting a company statement of ﬁ nancial position, each of these types of share

capital should be shown as a separate source of ﬁ nance.

When a company is formed, the legal documents state the authorised share capital

of the company. This is analysed into a number of shares, each having a nominal value.

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE FINANCIAL STATEMENTS OF LIMITED COMPANIES AND THE STATEMENT OF CASH FLOWS

The authorised share capital is the amount of capital that may be issued without obtaining

permission from the company’s shareholders. The nominal value is also known as the

par value .

Issues of shares by a company may be at nominal value or at a higher price. If they are

issued at the higher price, the difference between this and the nominal value is known as

the share premium .

When shares are issued, there are a number of stages before the share certiﬁ cates are

issued to their owners. Often, part of the issue price is payable on application for the

shares, with further payments being requested later.

Example 13.A

Z Ltd plans to issue 100,000 ordinary shares of $1 nominal value at an issue price of $1.50 each. $0.75 per

share is payable on application, $0.25 per share on conﬁ rmation that the shares have been issued and the bal-

ance of $0.50 per share on ﬁ rst call by Z Ltd in 3 months ’ time. This is for the share premium.

The double entry to record the receipt of the application monies is as follows:

Debit ($) Credit ($)

Bank 75,000

Application a/c (Being cash received from applicants.) 75,000

Allotment a/c 25,000

Application a/c 75,000

Share capital 100,000

(Being the creation of share capital from successful applications and the recording of amounts due on

allotment.)

When the allotment monies are received the entry is:

Debit ($) Credit ($)

Bank 25,000

Allotment a/c 25,000

In 3 months ’ time, Z Ltd will request the ﬁ nal payment of $0.50 per share. This is known as a call for payment.

In this example, this represents the share premium. The double entry would be:

Debit ($) Credit ($)

Bank 50,000

Share premium 50,000

Share premiums are also a type of reserve. Reserves are explained in more detail below. When the statement of

ﬁ nancial position is drawn up, the ‘Equity’ section will show:

Ordinary shares of $1 each 100,000

Share premium 50,000

STUDY MATERIAL C2

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THE FINANCIAL STATEMENTS OF LIMITED COMPANIES AND THE STATEMENT OF CASH FLOWS

13.2.6 Dividends

The amount paid to the company’s shareholders as a return for investing in the company is

known as a dividend. Dividends are often paid in two instalments: one during the year is

known as an interim dividend ; the other, which is usually paid after the end of the ﬁ nancial

year, is known as a ﬁ nal dividend . The total amount of the dividends is shown in the state-

ment of changes in equity.

Particular attention has to be given to the ﬁ nal dividend at the end of the year. The nor-

mal procedure is for directors to propose a ﬁ nal dividend; this is then voted upon as a reso-

lution at the annual general meeting which takes place after the year end. If the proposal

is approved, then the directors declare that a dividend will be paid. The key point here is,

at what time should we recognise the ﬁ nal dividend in company ﬁ nancial statements? The

answer is, only when the dividend has been declared.

This means that in most circumstances the dividends which are paid in a year are the

ﬁ nal dividends of the previous year and the interim dividend of the current year.

Example 13.B

A company has a year end of 31 December. On the 1 July 20X7, the directors declare an interim dividend of

$10,000. On the 31 December 20X7, the directors propose a ﬁ nal dividend of $12,000. On the 1 March

20X8 at the annual general meeting the proposed ﬁ nal dividend for 20X7 is approved, and the directors declare

that the dividend will be paid. On the 1 July 20X8, the directors declare an interim dividend of $11,000. On

the 31 December 20X8, the directors propose a ﬁ nal dividend of $13,000. On the 1 March 20X9 at the

annual general meeting the proposed ﬁ nal dividend for 20X8 is approved, and the directors declare that the

dividend will be paid.

What will be the dividends appearing in the statement of changes in equity in the year ended 20X8?

Final dividend for 20X7 $12,000

Interim dividend for 20X8 $11,000

$23,000

The $23,000 will appear in the trial balance for the year ended 31 December 20X8. The double entry will be

debit ‘dividends’, credit ‘bank’.

Directors do not have to pay the dividends in two instalments – interim and ﬁ nal – and in some companies

there may only be one dividend payment at the end of the year. In this case, the dividend that will normally

appear in the statement of changes in equity will be the dividend which was proposed in the previous year but

declared and paid in the current year. For example, the ﬁ nancial statements for 20X4 will include the proposed

dividend of 20X3.

It should be noted that the directors do not have to propose any dividends – the payment of dividends is

entirely at their discretion. If the shareholders were not happy with this situation, they would remove these direc-

tors and replace them with directors who were prepared to propose a dividend.

There may be some occasions where the directors declare a ﬁ nal dividend before the end of the year, but do

not pay the dividend until after the year end. This may occur where a meeting of the shareholders has been held

before the year end to approve a proposed dividend. In this situation, the accruals convention will be applied,

and the declared dividend will appear in the statement of changes in equity, and there will also be a ‘dividend

liability’ in the current liabilities in the statement of ﬁ nancial position.

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE FINANCIAL STATEMENTS OF LIMITED COMPANIES AND THE STATEMENT OF CASH FLOWS

Example 13.C

A company has a year end of 31 March. In the year ended 31 March 20X2 no interim dividend was paid, but

on the 29 March 20X2 the shareholders approved the payment of a proposed dividend of $15,000. The divi-

dend was paid on 15 April 20X2.

What entries would appear in the ﬁ nancial statements for the year ended 31 March 20 × 2 in relation to

dividends?

Statement of changes in equity $15,000

Statement of ﬁ nancial position – current liabilities – dividend liability $15,000

Dividends on ordinary shares

Ordinary shareholders are also known as equity shareholders. Their shares do not qualify for any special ben-

eﬁ ts, although they are often entitled to vote at general meetings. An ordinary shareholder is not entitled to any

particular dividend payment, although if the directors decide to declare a dividend it can be as small or as large

as they see ﬁ t. The ordinary shareholders are regarded as the ‘main’ shareholders in a company. The proﬁ ts that

are retained in the company belong to them, and would be repaid to them in the event that the company ceases

to exist.

Do take care, when computing dividends, to read the question carefully. If the question states that the ordinary

dividend is to be 10¢ per share, you need to calculate how many shares are in issue. For example, if the share capital

in the statement of ﬁ nancial position is described as ‘Ordinary shares of $0.5 ’ and they are stated at $500,000,

then there are 1 million ordinary shares. The dividend in this example would be 1 million 10¢  $100,000.

Dividends on preference shares

Preference shareholders are so known because they received preferential treatment in the payment of dividends,

and in the repayment of capital in the event that the company ceases to exist. A preference share carries a ﬁ xed

rate of dividend. The important point to remember is that if the ordinary shareholders are to receive a dividend,

then the preference shareholders must receive theirs ﬁ rst.

There are many different types of preference shares and you will study these in more detail in later studies. For

the purposes of this Learning System, it is assumed that all preference shares are ‘irredeemable’, which means

that the preference shares have no ﬁ xed repayment date. In any questions containing preference shares, the divi-

dends will have been paid and there will be no need to make any further adjustment.

13.2.7 Reserves

There are two types of reserves: capital reserves and revenue reserves . The difference between

these is that capital reserves may not be distributed as dividends. Examples of capital

reserves are share premium (see above) and revaluation reserves – created when a com-

pany revalues its assets (often land and buildings). Since the increase in value is based on a

professional valuation and has not been realised by a sale, the increase in value (or proﬁ t)

cannot be distributed to shareholders. For example, if a company had property in the

statement of ﬁ nancial position at $200,000 and it was revalued to $275,000, the property

would be increased to $275,000 in the statement of ﬁ nancial position and a revaluation

reserve would be created for $75,000.

Revenue reserves are the accumulated and undistributed proﬁ ts of a company. The most

common is the balance remaining on the statement of changes in equity at the end of each

year. This appears as a reserve called ‘ retained earnings ’ in the statement of ﬁ nancial posi-

tion. However, the directors may decide to set aside a portion of the remaining proﬁ ts into a

separate reserve account, for either general or speciﬁ c purposes. A speciﬁ c reserve is used to

identify the accumulation of proﬁ ts for a speciﬁ c future purpose. Despite the fact that sev-

eral revenue reserve accounts may exist, they are all available to be used for the payment of

dividends if required.

It is important to realise that the existence of reserves does not indicate a fund of cash.

The creation of a reserve may well be simply a bookkeeping transaction, debiting retained

proﬁ ts reserve and crediting general reserve.

STUDY MATERIAL C2

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THE FINANCIAL STATEMENTS OF LIMITED COMPANIES AND THE STATEMENT OF CASH FLOWS

13.2.8 Statement of comprehensive income

We introduced the statement of comprehensive income very brieﬂ y in Section 13.2.1.

We now return to this subject to discuss it in more detail. In previous chapters we have

referred to the income statement when discussing the revenue and expenses in sole propri-

etors. In limited companies this is referred to as the statement of comprehensive income.

The statement of comprehensive income has two sections – the ‘income statement’ sec-

tion and the ‘other comprehensive income’ section. The income statement section is simi-

lar to that of sole proprietors, except for differences in terminology and taxation noted in

Sections 13.2.2 and 13.2.3. respectively. The ‘income statement’ section includes all items

from ‘Sales’ to ‘Proﬁ t for the period’.

The section for ‘other comprehensive income’ can contain several items and you will

learn about these later in your studies at more advanced levels. With regard to the assess-

ment for Fundamentals of Financial Accounting, there is only one item you need to know,

and that is the revaluation of property. If a company revalues a property, then the amount

of the gain is included in ‘other comprehensive income’. This gain is added to the proﬁ t

for the period to give ‘total comprehensive income for the period’. An illustration of this is

given below.

Statement of comprehensive income of ABC Ltd

for the Year Ended 30 June 20X8

$’000

Sales 1000

Cost of sales (640)

Gross proﬁ t 360

Expenses (e.g. rent, power, telephone, etc.) (100)

Operating proﬁ t 260

Interest received 5

Interest paid (20)

Proﬁ t before tax 245

Income tax (80)

Proﬁ t for the period 165

Other comprehensive income

Gain on property revaluation net of tax 25

Total comprehensive income for the period 190

Although the ﬁ rst section has been referred to above as the ‘income statement’ section, this

title does not appear in the statement.

A company may choose to present its statement of comprehensive income as two sepa-

rate statements. In this case the two statements are called the ‘income statement ‘ and the

‘statement of comprehensive income’. The title ‘income statement’ does appear, and the

statement of comprehensive income begins with the proﬁ t for the period.

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE FINANCIAL STATEMENTS OF LIMITED COMPANIES AND THE STATEMENT OF CASH FLOWS

The two statements would be presented as follows:

Statement of comprehensive income of ABC Ltd for the Year Ended 30 June 20 × 8

As can be seen above, there is little difference in practice between the two presentations.

In this Learning System, it will normally be assumed that a single statement is prepared

and this will be referred to as the ‘statement of comprehensive income’. There will only

rarely be an ‘other comprehensive income’ section, as this only applies when there is a

revaluation of property.

A minor point is that the tax on the gain on the property revaluation should be dis-

closed. This can either be disclosed in the statement of comprehensive income or in a note.

For example, using ABC Ltd above, this could be shown as:

Alternatively the tax may be shown as a note.

Note 1: income tax on gain on property revaluation $5,000

The tax will be included as an accrual under non-current liabilities in the statement of

ﬁ nancial position.

The total comprehensive income for the year will be shown in the statement of changes

in equity, analysed between proﬁ t for the period and the net gain on property revaluation.

For purposes of the assessment, if the examiner refers to:

●

an income statement, then just an income statement is required

●

a statement of comprehensive income, then either:

– a statement with two sections is required, as in the ﬁ rst illustration above

– or, two statements are required, as in the second illustration above

Income Statement

$’000

Sales 1000

Cost of sales (640)

Gross proﬁ t 360

Expenses (e.g. rent, power, telephone, etc.) (100)

Operating proﬁ t 260

Interest received 5

Interest paid (20)

Proﬁ t before tax 245

Income tax (80)

Proﬁ t for the period 165

Statement of comprehensive income

Proﬁ t for the period 165

Other comprehensive income

Gain on property revaluation net of tax 25

Total comprehensive income for the period 190

Other comprehensive income $’000 $’000

Gain on property revaluation before tax 30

Less income tax (5)

Gain on property revaluation net of tax 25

Other comprehensive income

Gain on property revaluation net of tax (Note 1) 25