Limited companies are formed to enjoy the concept of limited liability.

Limited liability: only liable for the number of shares they own, personal assets are protected

There are two types of limited companies: public limited companies (PLC) and private limited companies (LTD). PLCs have shares which can be bought and sold only on the stock market whereas LTDs have shares that cannot be bought and sold on the open market.

A company will be set up by a legal firm who will prepare public documents. These documents will be sent to the Registrar of Companies. These documents include:

• Memorandum of Association — this document will state the following:

  • name

  • registered office

  • objects

  • authorised share capital; the maximum amount that can be issued by the company and taken up by investors

• Articles of Association — it will be issued with a Certificate of Incorporation upon completing the correct document. It is now a legal entity

  • The Articles of Association is the main constitutional document of a company that defines the existence of the company and regulates the structure and control of the company and its members e.g liability of members, directors’ powers, appointment and removal of directors, issue and transfer of shares, dividends and other distributions to members, and members’ decision-making and attendance at general meetings

Companies can issue three types of shares: ordinary shares, rights issues, and bonus issues. They will all affect the business’ equity.

Equity in the Statement of Financial Position

Ordinary Shares

Also known as equity shares. The ordinary shareholders are the owners of the company. Ordinary shares are high risk to the investor because the share price can fluctuate.

Ordinary shareholders have a vote. The ordinary shareholders may receive a dividend if the company has made a profit and has the available cash.

A company will issue ordinary shares to raise short-term finance for the business. This is an alternative to borrowing from the bank, which is known as debt capital.

An investor will purchase ordinary shares for the following reasons:

• capital growth

• an income in the form of a dividend

• ownership and control

Debentures

Debentures are also known as bonds. A company can raise finance by issuing debentures.

Debentures are a type of long-term loan. The debenture holder is paid a fixed rate of interest. The company will agree to repay the principal sum at a given date.

• Debenture interest is an expense and will be shown under the heading of interest payable in the profit and loss account.

The debenture holder does not have any ownership of the company, therefore, they cannot vote and does not affect control of the company.

Debentures are secured on the assets of the company. The debenture holder has a legal right to recover interest and the principal sum if the company cannot pay. As a result, the company will have to sell assets if the debenture holders cannot be paid.

Reserves

There are two types of reserves on a company’s Statement of Financial Position:

1. revenue reserves — revenue reserves are profits that have been retained in the business (ploughing back profit)

   1. The revenue reserve is the proprty of the ordinary shareholder and can be used by the company for the payment of dividends to ordinary shareholders

   2. Retained earnings are profits that have not been distributed to shareholders

   3. General reserves are profits that are unlikely to be distributed as dividends and will be used to fund future growth

2. capital reserves — company law could require a company to create a capital reserve. A capital reserve is created to offer protection to the creditors of the company. Capital reserves cannot be used to pay cash dividends. The following are capital reserves:

   1. Share Premium account — when shares are issued at a premium above the par value, then a share premium must be opened for the total amount of the premium

      1. a company could decide to issue shares at a premium if the issue is considered to be attractive to investors

      2. the investors will pay a price for the share that will include the par value plus the premium

      3. company law requires the amount taken on the premium to be credited to this capital reserve account

      4. the share premium account cannot be used to pay cash dividends BUT it can be used for the following:

         1. to issue bonus shares

         2. to write off expenses on a new issue of shares at a premium

         3. to write off any commission paid on a new issue of shares at a premium

   2. Revaluation Reserve — when land and buildings are revalued, then the amount of the revalutation must be entered in the revaluation account

      1. a comapny may show the land and buildings on the balance sheet at the historic cost. This is the amount the company paid for the land and buildings

      2. the company balance sheet will not show a ‘true and fair view’ of the value of the land and buildings because the market value will have increased over a period of time

      3. the company should have an independent valuation of the land and buildings at the fair market price so as to reflect a ‘true and fair view’ on the balance sheet

      4. the company will create this capital reserve and will be shown in the SOFP under the heading of reserves

      5. for the purpose of bonus issue of shares, the revaluation reserve is not to be used

Issues of Shares

Rights Issue

A rights issue is a share issue made by the company to existing shareholders. It will often be offered at a lower price. Rights issue of shares, much like ordinary share issues, can raise immediate finance for the company if needed.

Rights issues will increase a company’s equity and thus, increase their cash assets.

The shareholders do not have to subscribe to their right.

Example: The following Statement of Financial Position has been prepared at 28 February 2022:

On 28th February 2022, the company made a rights issue of 100,000 ordinary shares at a premium of $1 each.

1. the business has 900,000 shares

   1. ordinary shares of a dollar each = $900 000

2. at a premium of $1 each = price of share is $2

3. 100,000 shares * 2 = $200 000 debit to the bank (raised immediate finance for the business)

4. par value is $1 (Ordinary Shares of $1 each) but premium is $1

   1. $100 000 goes towards the Ordinary Share account

   2. $100 000 goes towards the Share Premium Reserve

The new equity section will look as follows:

Bonus Issue

A bonus issue of shares is made by the company to increase the value of the current shareholders’ shares. It raises no immediate finance for the business; it is done to keep shareholders satisfied.

Bonus issues will not make any changes to a company’s equity. It is only moving around cash from reserves.

Example: The following Statement of Financial Position are given:

A bonus issue is made on the basis of one new share for every share already held. It is the director’s policy to maintain reserves in their most flexible form.

Most flexible form: retained earnings is to be kept as much as possible; capital reserves are to be used first

1. Therefore, there are 4,000 ordinary shares

   1. $4 000, each share is a dollar each

   2. $1 is the par value

2. One new share for every share held = 4,000 new shares

3. 4,000 shares at a dollar = $4 000 new shares into Ordinary Share Capital

   1. bonus issues are always done at par value, never at a premium

4. Move $2 000 from Share Premium

5. Move $2 000 from Retained earnings

The new equity section will look as follows:

Summary Table