Limited companies: share capital, reserves and dividends

Last time

Before we start: last time, in Partnerships, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Owned by shareholders

A limited company is owned by shareholders, who may never work in it. Its accounts look different: capital is shares, profits kept are reserves, and owners receive dividends. This lesson covers each of these.

Limited liability

A limited company is a separate legal entity from its owners. Shareholders have limited liability: they can lose only the amount they paid for their shares. Directors manage the company on behalf of the shareholders.

Ordinary and preference shares

Ordinary shares carry voting rights, and receive a dividend that varies with profit. They are paid last if the company closes. Preference shares receive a fixed dividend, paid before ordinary shareholders, but usually carry no vote. A 6 per cent preference share of 50,000 dollars receives 3,000 dollars a year.

Debentures

Debentures are long-term loans to the company, not shares. Debenture holders are lenders, not owners. They receive fixed interest, which must be paid whether or not there is a profit. It is an expense. Debentures are non-current liabilities in the statement of financial position.

Dividends

A dividend is a share of profit paid to shareholders. An ordinary dividend of 5 cents a share on 100,000 shares totals 5,000 dollars. Dividends are not expenses: they are deducted from retained earnings, in the statement of changes in equity.

Reserves

Retained earnings are profits kept in the company, not paid out as dividends. They are a revenue reserve. A general reserve is retained profit set aside for future use. Share premium, the extra above the nominal value when shares are issued, is a capital reserve and cannot be paid as dividends.

The equity section

A company's equity section lists share capital and reserves. Their total is the shareholders' equity, equal to net assets.

Why depreciation method matters

A question asked why a company might use straight-line depreciation for fixtures and fittings. Because fixtures are used evenly over their life, so an equal charge each year matches cost to revenue fairly. And it is simple to calculate and apply consistently.

Companies vs sole traders

A sole trader's capital is one account; a company's is share capital plus reserves. Owners take drawings; shareholders receive dividends. And a company may pay interest on debentures, and must follow company law on publishing accounts.

Mistakes that lose marks

Mistake one: treating debentures as share capital. They are loans. Mistake two: putting dividends in the income statement as an expense. Mistake three: calling share premium a revenue reserve that can be paid as dividends. The fix: owners versus lenders, and the right reserve.

The full-marks tip

The full-marks tip: separate owners, who hold shares and get dividends, from lenders, who hold debentures and get interest. Revenue reserves can pay dividends; capital reserves cannot.

On one card

So, on one card: limited companies. Keep it for revision.