Elvis

Limited Liability Companies: Statement of Financial Position

For this post, I will be touching on the Statement of Financial Position (SoFP for short) for a Limited Liability Company. The format of the SoFP is similar to both Sole Proprietorship and Partnership Accounts, although a little bit different. Before I show you the format of the SoFP, it’s crucial to know few new items that are included into the SoFP.

Intangible Assets: Intangible assets are assets that do not have a “physical” existence. Despite lacking in physical existence, these assets are useful/valuable to the company; therefore, there are treated as an asset in the SoFP. Example of intangible assets are brand (like MacD and Coca-Cola) and proprietary rights.

Proposed Dividend: Dividend that has been proposed (put forward) to the shareholders but the company has yet to pay them. Therefore, proposed dividend is a current liability to the company.

Debenture Loan: I did mention previously that debenture loan is like a bank loan.. this is not totally correct because of the confusion that this might cause you. If you think the explanation later will confuse you more, just understand that debenture loan is like a bank loan. Companies can choose to issue debenture certificates to lenders (the lenders can be anyone like government, other companies, and banks) using the companies’ assets as collateral. The rationale behind this is to bypass the use of bank because of the high interest rate, companies that has strong balance sheet can then choose to raise money from the market by issuing debenture loan (with lower interest rate than bank of course). Debenture loan is a long-term liabilities.

Share Premium Account: This is presented after called-up capital. Share premium account is used when the stock price is higher than the par value. The par value of most stocks are $1 but it can be anything else so do read properly! So if the stock price is $15, then the share premium is $14 ($15-$1) multiply by the number of shares outstanding.

General Reserve: The directors of the company may decide to reinvest/retain some of its profits into the company instead of paying it out to the shareholders as dividends. Because it belongs to the shareholders, general reserve is treated as an equity.

Retained Earnings (at Year End) = Retained Earnings from Previous Year + Profit leftover after deducting Tax, Dividends and Transfer to General Reserve. Please see Profit and Loss Appropriation account for more.

Here is the format of SoFP for a Company.

Company Balance Sheet - Vertical Format A

Company Balance Sheet - Vertical Format B

Summary: Get the format and reminders right!

Limited Liability Companies: Appropriation Account – Part 2

This blog post will aim to explain a little bit more on the reasons why you need to follow the format of Limited Liabilities Company’s Appropriation Account and the failure to do so will result in you losing marks. You will still need to get familiar with some of the introductory terms from earlier posts. If you have not, please revisit them here.

For ease of reference, I have also included similar content from previous topic on Profit and Loss Appropriation Account.

limited-liabilities-companies-appropriation-account

In general, let me classified everything in its simplest form into:

Banker,
Government (for Tax), and
Shareholders.

1. If you owe bank money, you are absolutely required under contractual obligation to pay back bank on time! This is actually quite logical. The bank do not need to know how the business is performing. Their only concern will be on whether the business is paying the bank on time! In your Profit and Loss, as can be seen from sole proprietorship and partnership account, this will appear in the debit side of the profit and loss. The same thing applies to a corporate account. But remember that you will be expected to see a new term called debenture loan. The next time you see a debenture loan, treat it as an expense to the Profit and Loss Account!

2. The next person you are required to settle as soon as possible will be the government, because not paying them is a criminal offense! If you refer to the picture above, you will see that tax appears after profit before tax.

3. The last person to receive remaining profit will be the shareholders. Shareholders participate in dividend payment and capital appreciation (increase in stock price). Shareholders also have rights in decision making for the company. With that being said, shareholders are actually at an advantageous position due to their (usually) higher return. As a result of assuming the highest risk of the company, they were the last to receive any returns (whether big or small) from the company.

Shareholders are further classified into preference and ordinary shareholders. Preference shareholders were the first one to receive dividend before ordinary shareholders. You might be questioning why but if you look at how preference share behaves, it is actually quite similar to debenture loan (i.e. earning fixed return) with no voting rights. If you refer back to the picture above, you will be able to see that preference dividend appears first, followed by ordinary dividend.

In summary, the order of your P&L Appropriation Account will be:

Interest on Loan,
Debenture Loan,
Tax (to government),
Preference Dividend, and
Ordinary Dividend.

Limited Liability Companies: The Appropriation Account

Similar to how a partnership will have an appropriation account, Limited Liability Companies have their own version of Appropriation Account too. The appropriation account shows how the net profits are to be appropriated (how the profits are to be used). Also, similar to partnership account, you will only open appropriation account after your Profit and Loss statement.

The format for company’s appropriation account is shown below, a reminder that this format is to be followed strictly! Failure to do so will make you lose quite a lot of marks! (This is a slightly complicated point to explain in a single post, will aim to explain more in the next post which is relevant to ‘A’ level but extremely beneficial if you understand them too.)

Note 1: Corporation Tax can be calculated using the following formula,

Corporation Tax = Profit before Tax x Tax Rate

So for the above example, if the tax rate is 20%, then the Corporation Tax = 20,000 x 20% = $4,000.

Note 2: Preference Dividend can be calculated based on the following formula,

Preference Dividend = No of shares in Preference Div. x % rate of dividend (pre-agreed)

When shareholders subscribed for preference shares, the % rate of dividend is pre-agreed (say 3%). This is not the same as ordinary shares, the % rate of dividend usually changes according to the performance of the company. So here is an important point, when calculating for preference dividend, the % rate of dividend does not change, and you can usually get this number very easily from the balance sheet.

Note 3: Ordinary Dividend can be calculated based on the following formula:

Ordinary Dividend = No of shares in Ordinary Div. x % rate of dividend

As explained earlier, the % rate of dividend is not pre-agreed, you should find them in the notes to financial statements, stating what is the % rate of dividend. You need to remember that if this is an interim dividend (six months only) then you need to divide it by 2! Refer to previous topic to know why.

More explanation on ‘A’ Level accounting in the next topic for Ordinary Dividend.

Note 4: Profits leftover are called retained profits. You will rarely see an exam question which test you on a company that just start-up. Exam questions will usually test you on subsequent years of operations so you will definitely need to remember to add your retained profits from last year.

Note 5: Transfers to reserves are something that a company wanted to keep for the future, for example: to replace for fixed assets in the future. You will need to remember that transfers to reserves must be shown in between profit after tax and proposed dividend.

Important Note: Proposed dividend refers to end of year dividend and is only a proposal, i.e. there is no cash payment yet. You will need to watch out for this trap. Because there is no cash payment, you will need to credit your creditors account to show that you owe the shareholders their dividend payments. The double entry is as shown below:

Summary: Get the format and reminders right!

Introduction to Limited Liability Companies

A quick recap so far, you have gone through sole proprietorship accounts, partnership accounts and not-for-profit organisation accounts. This will be the last set of accounts that you will need to be aware of, the limited liability companies’ accounts.

Let’s start with getting used to some of the new terms for companies’ accounts.

Authorised share capital is the maximum amount of capital that a company can issue. If a company has an authorised share capital of 1,000,000, then it can only issued up to 1,000,000 shares. Take note that I am referring to the number of shares, not the value of the shares. Depending on the price per share, a $1 per share will equate $1,000,000 capital and a $5 per share will equate $5,000,000 capital (and so on) for 1,000,000 shares.

Issued share capital is the actual number of shares held by the shareholders. Take note that it is not compulsory for the question to be set with the same authorised and issued share capital. Some people will just read “Authorised share capital” for xxx shares @ $xx and then straight away write this as the capital amount. This can be a trick to mislead you. Remember that issued share capital is the actual number of shares held by the shareholders – which should be translated to the capital amount.

Called-up capital is the amounts payable on each share that has been asked (or called) for payment. If a share is worth $1, but is call for $0.90, the called-up capital will be $0.90 per share.

Calls in arrears is the total amount for which payment has been asked (or called) for but payment has yet to be received from the shareholders.

Paid-up capital is the total amount of share capital which has been paid by shareholders. This can also be calculated as Called-up Capital – Calls in Arrears.

Shares can be divided into preference and ordinary shares. There are more types of shares but for now, let’s just keep this to preference and ordinary shares.

Preference shares get an agreed rate (in %) of dividend before the ordinary shareholders. Preference shares can be further sub-divided into non-cumulative preference shares and cumulative preference shares. As their names imply, non-cumulative preference shares cannot carry forward any shortage into future years while cumulative preference shares will be able to carry forward such shortages into future years.

Ordinary shares get the remainder share of the profits in dividends. However, not all profits will be distributed as dividend to shareholders. Profits are needed to be reinvested in to the company for growth. The leftover/reinvested amount is called “transfer to reserve.”

Limited Liability Company is a private company whereby the shareholders are only responsible for its debts to the extent of the amount of capital that they invested.

Reserve account forms a part of the company’s capital. As can be expected, reserve account gets it value from “transfer to reserve.” For second subsequent year, reserve account will be: opening balance (from last year) + this year transfer to reserve.

Dividend is the sum of money paid by the company to the shareholders. A semi-annual dividend payout is called interim dividend. Since interim dividend is for six months only, you must remember to apportion it for six months only, i.e. if 1,000,000 shares @ $1.00 has an interim dividend of 5%, then the interim dividend is 1,000,000 x $1 x 5% x 6/12. If you forget to apportion it to 6/12 months, then you will have wrongly calculated the interim dividend.

Debenture is a term similar to loan. Other similar terms for loan include loan stock and loan capital. Debenture interest is similar to interest on loan, this is an expense to the company.

Directors’ remuneration is a form of monetary reward paid to director. The treatment is similar to salaries for employees, i.e. an expense to the company.

Hopefully some of the tricks and confusing parts that I pointed out above can help clear your confusions in this new topic.

Trading Account and Income & Expenditure Account

Even though a not-for profit organisations are not supposed to make money, there are certain activities (i.e. selling of snacks or food) in a not-for profit organisations that actually involve trading. If you have trouble identifying this activities, just remember if it involves having to keep inventories then you will need to draw up the trading account. The format of trading account is shown below. The format is very similar to a normal trading account.

nfp-trading-account

Income and Expenditure account is similar to Profit and Loss account, but you only use the term income and expenditure account when preparing for a not-for profit organisation. Even the format for income and expenditure account, and profit and loss account is very similar. In general, the income for a not for profit organisation contain subscription revenue, profit from bar, sales of ticket and donations received.

NFP - Income and Expenditure Account.PNG

Expenditure would be the same as what you would have expected in a profit and loss account. Just a note that you will not have net profit or net loss in income and expenditure account. This will be replaced as surplus of income over expenditure for net profit, and surplus of expenditure over income for net loss.

In the exam, a complete not for profit organisation question will require a balance sheet account to be opened. The only thing that you will need to watch out for is the wording for your “capital”. Instead of the word “capital”, this will be replaced with “accumulated fund”.

Receipts and Payments Accounts

This should be an easy topic with not much anticipated issues. Receipts and payments accounts are used for non-profit making organisation. Since their purpose of existence is not supposed to be profit-making, there is no need to prepare for an income statement. Instead, you are required to open either receipts and payments accounts or income and expenditure accounts.

Receipts and Payments Accounts is basically a new name for your cash book. The format is basically similar to cash book, with cash received being a debit entry and cash paid being a credit entry.

receipts-and-payments-accounts

The only concern with the above is the subscription amount. You will need to refresh your memory on accrued/prepaid revenue. As a club, their main revenue will be from collecting subscription fee from their members. Remember that accrued subscription means owing from members (or the members owe the club) and prepaid subscription means advances from members (or the club owes the members). This will definitely get tested, so do remember or understand it properly.

I will spend a little more time to explain this so do spend some time thinking through the examples below:

subscription-account-accrued-and-prepaid-revenue

At year end, your subscription account will look like this. (I showed this because I think most people will get confused on which entry should you put owing b/d or prepaid b/d).

If you bring forward the ending balance, then the subscription account will now looks like this.

subscription-account-2

Now, you have the format for subscription account! Remember that note 1 is actually your last step. In the exam, you will be given all the figures for owing b/d, owing c/d, prepaid b/d, prepaid c/d and bank except income and expenditure. After you have calculated this, you will need to put this figure into income and expenditure account.

Instead of calling profit and loss account, the name for profit and loss account has been changed to income and expenditure account. There are the same thing, but you will need to use income and expenditure account for non-profit organisation.

If you are still in doubt, do visit back previous chapter for Adjustment for Final Account.

Partnership Dissolution

This will be the last sub-topic for partnership account and will be relevant to GCSE ‘A’ Level.

You will need to be able to realise that any profit or loss on dissolution should be shared by all the partners in their profit and sharing ratios. If there are circumstances where the partner’s final balance on his capital and current accounts is in deficit, the partner will have to pay that amount into the partnership bank account.

When dissolving the business, you will need to get rid of the assets by either 1) disposing it or 2) the partner(s) to take it. All these entries will need to be made into realisation account.

realisation-account

Net realisable amount is the amount that you will receive in disposing assets. You will need to use this amount because it will be the actual amount that the business will receive.

Do not forget about dissolution costs! You must include them in the realisation account (debit) and bank account (credit).

T-accounts for disposing the assets are only recommended if the question asks you to do so! Otherwise, there is no need to do so! Here is an example of how to do it.

disposing-assets-in-dissolution-of-partnership

Next, you will need to open up capital account for each partner. This is to calculate how much each partner will receive or pay the business as a result of the dissolution. Remember that all partners have unlimited liability, if the business runs out of cash in dissolving the business, all the partners will have to settle the additional liabilities from their own pockets.

Here is the format for capital account.

partner-capital-account-in-dissolution-of-partnership

Finally, you will need to open a bank account. Bank account will be your last step in dissolution because there are no more extra calculations required, you only need to put all the numbers in the right places. It therefore act as your check if you have done everything correctly.

bank-account-in-dissolution-of-partnership

Things to note in order to score well,

You must include dissolution costs.
You must be able to remember all the formats (including the bank account).
Remember to use only net book value in the debit side and net realisable amount in the realisation account.
Do remember to include asset taken by partner into their respective capital account.
You must pay your creditors from your bank account.

Revaluation of Assets in Partnership Account

Assets are originally recorded at its original price, but when certain events occurred, such as 1) a new partner is admitted, 2) or a partner leaving the firm and 3) if the partners change their profit or loss sharing ratios, the assets will have to be revalued.

There are two rationales in doing such exercise, first, the true value of asset is being reflected correctly on the books and second, this is to ensure that new partner do not share the profit and loss on revaluation. The first point is pretty much updating the value of your assets from original price into a more recent price (or even market price).

Revaluation is pretty simple. You only need to follow three to five steps to do revaluation. For those with a weaker double entry skill, doing the first two steps are important, otherwise, you can skip to the third step.

The steps are:

Open the relevant T-accounts.
Identify the relevant entries to the increase or decrease in the T-account.
Post the double entry of item 2 in Revaluation account.
Compute the profit or loss in the Revaluation account.
Apportion the profit or loss of revaluation according to the partners’ profit and loss sharing ratio.

The first step is to open up a T-account for every item identified to be revalued. Most of the items that will be revalued are all fixed and current assets. As for the second step, you will need to know whether it increases or decreases the account. See below for a sample T-Account and some of its explanation.

The third step is to open up a Revaluation Account. This is the double entry for the T-account that you have opened in the first step. Revaluation account will be the reverse of any increase and decrease to the T-account. In the example above, the increase of $2,000 will be posted into the credit side of a Revaluation account (remember double entry!) At the end of the revaluation account, you will need to arrive at profit or loss on revaluation.

*If you are really good at double entry, you can start this step straight, but I do not really recommend this method because of the tendency to make more mistakes. If you still want to start from this step, do make sure you actually sketch T-accounts in question papers just to map out where the entries are.

The fourth step is to calculate whether or not you are making a profit or loss from the revaluation exercise. If there is more debit than credit, then it’s a revaluation loss, otherwise, it’s a revaluation gain (see Note 1 below).

Finally for the last step, apportion the profit or loss of revaluation according to the partners’ profit and loss sharing ratio (see Note 2 above).

This topic is an easy topic to score. However, in order to score well, you will need to know

The entries well.
Remember the format for Revaluation Account and calculate the profit or loss on revaluation.
Remember to open up Partner’s Capital Account to show the profit or loss of revaluation to their capital. (Remember to read the question carefully, you may or may not be required to open this Capital Account).

Treatment of Goodwill in Partnership

What is a goodwill? A simple realistic example is when you have something (maybe a toy, shirt, PC games or etc) that you wouldn’t want to give away to your friend, but your friend insisted on having them. In that case, you might be selling them at a higher price, say a limited edition toy that you purchased originally at $100 and your friend are willing to use $120 to purchase the toy (and it is also the price you are willing to give away.) You settled the deal because $120 is attractive! This extra $20 is actually the goodwill.

As for businesses, goodwill arises when the following events happened,

1) existing partners wanted to change profit and loss sharing ratios,

2) new partner is introduced, and

3) one of the partners retires or dies.

There are two ways in showing goodwill, one is to show them in the balance sheet (open a goodwill account) and the other one is to not show them in the balance sheet (do not open a goodwill account).

So, let’s start with opening a goodwill account. In the events (shown above), there will be a change in profit and loss sharing ratio. Something to note in mind that you don’t just ignore the OLD profit and loss sharing ratio, but you will need to do something with it. The steps to opening a goodwill account can be summarised as shown below:

1) Open a goodwill account and Dr the Goodwill amount based on old profit sharing ratio (Note that goodwill is an intangible asset)

2) Open up a capital account with opening balance and CR goodwill in Capital Account.

Here is an example with opening a goodwill account with partners A. B and C changing their profit sharing ratio from existing 2:1:1 to 2:2:1 and that the business has a goodwill value of $4,000. The capital brought forward from A, B and C are $5,000, $4,000 and $2000 respectively.

For second step, you will need to transfer goodwill above to it’s respective partners’ capital account (remember double entry) in which you have already done a Debit entry above and now you will need to Credit Capital account (shown below).

And that’s just it. It is pretty simple but for additional information, you will need to know the before and after adjustment of goodwill which is shown below.

So, if goodwill account is to be opened, you will actually find goodwill to be included in the balance sheet, increasing the total assets and that the two steps that you have done earlier will also help you to arrive at the new capital balances.

For the complicated bit will be where goodwill account is not to be opened. Even though it’s complicated but you don’t actually need to do a lot of work! It’s really just a one step working.

Step 1 (and ONLY) is to open up a capital account and then apportion goodwill account based on both OLD and NEW profit sharing ratio.

Then that’s done. Since goodwill account is not to be maintained, you skipped the need to open up a goodwill account and then did all the adjustments required in the capital accounts by debiting and crediting capital accounts (increase and decrease by $4,000 resulting in no movement in capital account – see below) but does affect the individual partners.

What happens to treatment of goodwill on new admission of a partner?

Same things applies as shown above for both ways but this new partner will never have apportionment using OLD profit sharing ratio. You will only need to apportion the new profit sharing ratio to this new partner.

What happens to treatment of goodwill on death or withdrawal of a partner?

Same things applies as shown above for both ways.

Things to bear in mind to score well in this topic:

1) For goodwill to be opened, you only apportion using OLD ratio. Whilst for goodwill not to be opened, remember to apportion using both ratio.

2) When preparing for balance sheet, do make sure to include goodwill account in intangible asset (if goodwill account is to be opened).

3) Remember the formats well.

Partnership Account – Capital and Current Account (also Fixed Capital or Fluctuating Capital Account)

This topic gets a little bit complicated to explain and I am aware that different teachers seem to have different approaches in teaching Capital and Current Account in partnership account. Some would encourage the opening of both capital and current account just because students will make less mistakes and more presentable answers but some would encourage throwing everything into Capital Account (don’t ask me why) but I have a feeling that it saves more time and you don’t have to open a current account.

As for now, I will try to explain opening both accounts instead of opening capital account alone (Fixed Capital Account).

Capital account works the same way as Sole Proprietorship account. For example, if Allen invests $10,000 and Ben invests $20,000 into AB Business, then you will have the following double entries:

Partnership Capital AC DE

So then that’s it. You wouldn’t be require to do anything to Capital Account anymore.

As for Current Account, since you will not be doing anything to the Capital Account, most entries will be posted to current account as shown below.

Partnership Account - Current Account So now it’s time to know how to do everything in Capital Account (Fluctuating Capital Account.) Referring to the diagram below, I have drawn both Allen Capital Account and Profit And Loss Appropriation account (in a T-account format). With these two accounts, you will now be able to see the link. If you see it carefully (remember double entry?) Try matching up interest on capital from Allen Capital Account to Profit And Loss Appropriation Account and try to match the rest of them! You will probably smile later.

Note: You can also match the current account above to the profit and loss appropriation account since it’s double entry kind of thing.

One thing to note is: You might not be able to see drawings in the profit and loss appropriation account because drawing is not an expenses, it is a direct cash withdrawal (it has a personal relationship to the partner but not the business operations) so it will not appear in your Profit and Loss account. To reiterate, anything that has no relationship to the business operations such as drawing and goodwill, will only affect the Balance Sheet accounts.