Investors Report

Michelle_Michy

Chapter3_FMDMLimitedLiabilitiesCompanies1.pdf

Home >Education homework help >Investors Report

enu-fmd-bk-en-GB January 6, 2015 - 15:22 37

Chapter

Chapter 3

Limited Liability Companies

3.1 Introduction 33 3.2 Types of Business Entities 33 3.3 Financial Statements of Limited Liability Companies 35 3.4 Statement of Changes in Equity 40 3.5 Regulatory Framework 40 3.6 International Accounting Standards 43 3.7 Consolidated Financial Statements 43 3.8 Summary 45

Learning Objectives

After completing this unit of study you should be able to:

• distinguish between different types of business enterprise

• prepare the financial statements of a limited liability company

• appreciate the regulatory framework that surrounds the preparation of financial state- ments for a limited liability company

• recognise that companies eventually become part of a group.

3.1 Introduction

There are three main categories of business entity:

• sole traders

• partnerships

• limited liability companies.

In Chapter 2, when we looked at the preparation of accounts, it was the sole trader’s finan- cial statements that we focused on. This unit extends those statements to incorporate the requirements for a limited liability company and considers the environment within which such an entity operates. But before we do that, let’s consider each of the business entities noted above.

3.2 Types of Business Entities

3.2.1 Sole Trader

The sole trader business is one which is owned and financed by one individual. It often starts because the sole trader comes up with a good idea which he or she thinks might generate a profit. The individual has complete flexibility in the way in which the business is conducted because he or she is the sole decision-maker.

Unlike limited companies, a sole trader does not have to file a formal report and accounts each year with a government bureau. However, accounting information will still have to be prepared because the tax authorities will require annual accounts for tax purposes. Additionally, the

enu-fmd-bk-en-GB January 6, 2015 - 15:22 38

Chapter

Finance for Management Decision-Making

banks may need such information if a sole trader is seeking additional finance to expand the business.

Although many businesses start out as sole traders, it is often hard to expand this type of business because the individual can have difficulty arranging the necessary finance. The main problem, however, is that legally a sole trader is not separate from the business. Therefore, if the business is not successful, the sole trader must make good any losses, either from selling the assets in the business or from selling personal possessions like the family home. Being a sole trader can, therefore, be risky because you do not have the limited liability protection to which shareholders of a company are often entitled.

3.2.2 Partnerships

Partnerships are very similar to sole traders except that the ownership of the business is in the hands of two or more people. Now we have at least two bodies to help finance the entity and, very likely, a pooling of business skills to operate more efficiently than a sole trader. Generally, partnerships are run in accordance with a formal partnership agreement, setting out responsibilities, profit-sharing splits and how much capital each partner should input to the business.

In law, partners have ‘joint and several’ liability, effectively meaning that the creditors of a partnership can call on any one partner (through business or private means) to settle the debts of the partnership. It would then be up to that partner to seek redress from the other partners.

For accounting purposes, the partnership is seen as a separate economic entity requiring annual accounts to be prepared for the banks and the tax authorities.

3.2.3 Limited Companies

The big risk of being a sole trader or a partner in a partnership is that you stand to lose your personal possessions if the business fails. That risk alone is enough to deter people from starting or expanding a business. It became apparent in the 19th century in the UK, as the country moved from an agricultural to an industrial economy, that industrial companies would require large investments of capital to develop their entities. This investment could be raised only if the owners of the business were protected from personal financial risk. The solution was to provide the owners with limited liability so that although the business might fail and the owners might lose the monies they invested in the business, their personal wealth was safe.

A limited company is, therefore, a legal entity separate from the owners of the business. The entity may be a private limited company, which is prohibited by law from offering its shares to the public. This is most often appropriate to family controlled businesses. Alternatively, the entity may be a public limited company, which is permitted to offer its shares to the public. In both types of entity, the owners are called shareholders because they share the ownership of the business, whether it is sharing the profits in the good times or the losses in the bad times.

Because limited liability is a great privilege for the owners, companies are subject to much more onerous regulations than sole trader and partnership businesses.

Although the precise detail may differ from country to country, there is likely to be a national legal requirement governing accounting in general and the specific accounting records that companies must maintain. Additionally, companies will be asked to comply with national and international financial reporting standards, which seek to harmonise financial reporting across the globe. Section 3.6 will cover these and other regulations in more detail.

For accounting purposes, the requirements for private and public limited companies are exactly the same. The companies must produce annual accounts that are filed with a government bureau and are, therefore, made available to the public.

enu-fmd-bk-en-GB January 6, 2015 - 15:22 39

Chapter

Limited Liability Companies

3.3 Financial Statements of Limited Liability Companies Before we look at the income statement and the balance sheet of a limited liability company, we need to consider how a company is financed by its owners. In the sole trader’s financial statements that we looked at in Chapter 2, the investment by the owner was known as capital.

The capital of a company, however, is called share capital because the capital needed to finance companies is divided into shares of a nominal or par value. The company will determine the maximum share capital that it is ever likely to need to raise and this is called its authorised share capital. The amount of shares actually in issue at any point in time will be set at a level to meet its requirements in the foreseeable future. These shares are called the issued share capital. The number of issued shares multiplied by the nominal value of the share will represent the value of the share capital on the balance sheet.

However, the nominal value of a share is only likely to be the same as the market value of a share when the company is newly established. If new shares are issued once a company has started trading then they are likely to be issued at a price above the nominal value. The difference between the market price and the nominal value of a share represents the share premium (see section 3.3.14).

The two main categories of share capital are:

• ordinary shares

• preference shares.

3.3.1 Ordinary Shares

These are the equity shares in the business and the most common type of share capital. It is the ordinary shareholders who exercise control over the company’s affairs because it is the ordinary shares that are the voting shares. However, these are also the risk-taking shares because it is the ordinary shareholders who are last in line when it comes to receiving a return on their investment. Ordinary shareholders are entitled to all the profits in the business but only after interest has been given to lenders, tax has been given to the tax authorities and preference dividends have been set aside for the preference shareholders. Clearly, if the business has a successful year then the ordinary shareholders stand to gain the most, but if the company fails then they risk losing everything.

3.3.2 Preference Shares

Preference shares are usually non-voting shares, but, as their name suggests, they have priority treatment over the ordinary shareholders in terms of receiving a dividend and with the repayment of capital in the winding-up of a company.

Preference shares are generally regarded as a safe investment because you know exactly the annual return that you are going to receive. The dividend is based on the capital you invested rather than the performance of the company over the trading period, for example, if you bought 10,000 (5%) £1 preference shares then your annual dividend would be £500 (10,000 shares × 5p per share).

3.3.3 Income Statement

Legislation prescribes two main formats which companies may use to prepare their income statements. The format chosen depends on how the company wishes to show its expenses. Format 1 shows expenditure by function while format 2 shows expenditure by type.

As format 1 is the more popular format, this is the format that we will use throughout the module.

enu-fmd-bk-en-GB January 6, 2015 - 15:22 40

Chapter

Finance for Management Decision-Making

Specimen plc − Format 1

Income statement for year ended 31 March 20x6

£000 £000

Revenue 1,000

Cost of sales 400

Gross profit 600

Distribution costs 120

Administration costs 70 190

410

Other operating income 20

Operating profit 430

Interest payable 30

Profit before tax 400

Taxation 120

Profit for the period 280

3.3.4 Expenses

Format 1, particularly popular with manufacturing companies, classifies expenses by function. Effectively, all the expenses of running the business are categorised under one of four headings, making the income statement a bit more user-friendly.

The headings are:

• cost of sales which deals with all the production-related costs associated with manufac- turing the product, for example raw materials, machinery depreciation

• distribution costs which deal with all the selling and distribution costs involved in getting the product to the customer, for example advertising, sales commission, depreciation on distribution vehicles

• administration costs which cover the general costs of running the business, for example stationery, telephone, photocopying, audit fee

• interest payable which refers to the annual cost of servicing borrowed monies used to finance the business.

In the sole trader’s income statement, once expenses have been deducted from the revenue, the resultant profit belongs to the owner and is added to the capital in the balance sheet. For companies, the income statement needs to be extended to explain how much of the profit is distributed to the tax authorities and how much is retained to plough back into the business for future growth.

3.3.5 Company Tax

Companies, as separate legal entities, are responsible for their own tax. This differs from sole traders and partnerships where the liability rests with the individual owners and partners. In

enu-fmd-bk-en-GB January 6, 2015 - 15:22 41

Chapter

Limited Liability Companies

nearly all countries, companies are taxed on the basis of their trading income. In some coun- tries, this may be called corporation or corporate tax but the terminology of the international accounting standard on taxation (IAS 12) calls it corporate income tax.

Companies pay corporate income tax (currently around 26% in the UK for a medium- to large-sized company) on their taxable profits for the year. Taxable profits essentially comprise the net profit before dividends, adjusted for certain items where the tax treatment may differ from the accounting treatment.

For example, in the UK, depreciation is the most common example of an expense that the tax authorities do not consider to be tax deductible. However, to counter depreciation being a disallowable expense, companies are given capital allowances when capital investment is made in the business.

The amount of tax to which an enterprise is assessed on its profit for an accounting period is often referred to as its tax liability. For many countries, the payment date for corporate income tax is after the end of the accounting period to which the tax relates; for example, in the UK, corporation tax is paid nine months after the end of the relevant trading period. Therefore, as well as the tax being a charge in the income statement for the period, the tax figure will also appear as a liability in the year-end balance sheet because it is effectively an accrued expense.

3.3.6 Profit for the Period

The profit after tax is the increase in the wealth of the company and, therefore, belongs to the shareholders.

3.3.7 Dividends

If the company has preference shareholders then they, of course, have a fixed right to a slice of this profit after tax because they are entitled to their preference dividend. Ordinary shareholders will usually be paid a dividend, but the level of the dividend is likely to depend on the profits achieved during the period. The directors, who run the business on behalf of the shareholders, now have a tricky decision to make. How much of the profit for the period should be distributed to the ordinary shareholders in dividends and how much should be held as retained earnings to be reinvested in the future operations of the business?

It is generally the practice that ‘blue-chip’ companies will pay out between 30% to 40% of their profits in the form of dividends. This leaves sufficient in the business for development but at the same time gives the company a cushion should profits not reach similar levels in the future. Shareholders are most displeased when the dividend offered in one year is less than the dividend they got the previous year. By not paying all the profits out in dividends in any one year, the business is keeping some profit in reserve, which could be used to pay dividends in future years.

Dividends tend to be paid twice a year. An interim dividend, usually a fairly small amount, is paid during the year. This interim dividend is effectively a charge against the company’s profit and may be shown either on the face of the income statement or in the statement of changes in equity, which is discussed in section 3.4. Because this interim dividend has been paid during the year there will also be a reduction in the cash balance. Once the directors have an idea of the financial results for the trading period, a final dividend is then proposed at the end of the year, subject to confirmation at the company’s AGM. This proposed final dividend, under international accounting standards, cannot appear in the company’s financial statements until it has been approved and will most likely therefore be a deduction from the profit in the following year’s statement of changes in equity.

enu-fmd-bk-en-GB January 6, 2015 - 15:22 42

Chapter

Finance for Management Decision-Making

3.3.8 Retained Profits

The retained profit for the year is what is left after deducting dividends for the year. These are profits ploughed back into the business for future growth. Because they belong to the ordinary shareholders, they form part of the equity of the company and are added to the share capital in the balance sheet.

3.3.9 Balance Sheet

A typical format for a company’s balance sheet is similar to the vertical layout used for the sole trader. However, there are a few differences to note. See the example shown below.

Madeup plc

Balance sheet as at March 20x7

Non-current assets £000 £000

Intangible assets 280

Tangible assets 1,300

Investments 297 1,877

Current assets

Inventory/Stocks 839

Debtors 669

Investments 70

Cash at bank 109 1,687

Total assets 3,564

Current liabilities

Trade payables 469

Current tax payable 365 834

Non-current liabilities

Long-term borrowings 861

Deferred tax 300 1,161

Total liabilities 1,995

Net assets 1,569

Equity

Ordinary share capital 500

Preference share capital 100

Share premium account 270

Revaluation reserve account 280

enu-fmd-bk-en-GB January 6, 2015 - 15:22 43

Chapter

Limited Liability Companies

Profit and loss account 419

Total equity 1,569

3.3.10 Non-current Assets

Most of the non-current assets used by a company will be the same as those used by a sole trader but, in addition, a company might have intangible assets and investments on their balance sheets.

Intangible assets are non-monetary in nature and without physical substance. Examples include goodwill, patents, trademarks and development expenditure.

Investments in the non-current assets section are assets held for the long term and for the following purposes:

• generating income through interest, dividends or royalties, for example loans to other companies, trade investments

• capital appreciation, for example investment properties

• trading relationships, for example investments in subsidiaries.

3.3.11 Current Assets

A company’s current assets are made up of the same main components as those of a sole trader but they might also include short-term trade investments.

3.3.12 Current Liabilities

Included in this section of the balance sheet for companies will be the corporate income tax payable.

3.3.13 Non-current Liabilities

Long-term loans, debentures and deferred tax are typical entries in the balance sheet of a company.

3.3.14 Equity

The share capital and reserves represent the book value of the business to the shareholders at any point in time. The share capital in the balance sheet represents the nominal value of the shares that have been issued to the preference and the ordinary shareholders.

The reserves are amounts, which add to the balance sheet value of shareholders’ wealth. They are unlikely to be held in the form of cash because normally reserves will have been reinvested in other assets.

A revaluation reserve occurs when a company revalues an asset. The amount of the revaluation will be shown as an increase in the asset value and the matching increase will be taken straight to a revaluation reserve account in the balance sheet. The revaluation gain does not go through the income statement because the gain has not yet been realised. It is only a book gain at this stage and is not, therefore, a part of the operating transactions of the business.

A share premium account arises when shares are issued at a price above the nominal value. The difference between the nominal value and the issue price is a premium, which has to be recorded separately in the company’s accounts as a share premium account. For example, if

enu-fmd-bk-en-GB January 6, 2015 - 15:22 44

Chapter

Finance for Management Decision-Making

the company issues 1,000 £1 ordinary shares at a premium price of £5, the accounting entries would be an increase in cash of £5,000, an increase in ordinary share capital of £1,000 (the nominal value of the shares) and an increase of £4,000 to the share premium account.

The profit and loss account reserves are the profits generated from running the business that have been reinvested in the company for future development.

3.4 Statement of Changes in Equity

In addition to the income statement and the balance sheet, IAS 1 requires that every year companies prepare a statement of changes in equity. This tells the shareholders and other user groups exactly how the components making up the equity figure have changed since the end of the previous financial period. Typical entries shown in the statement of changes in equity are:

• issue of additional share capital

• revaluation of assets

• profit for the period

• dividends paid.

The suggested format is as follows.

Noreal plc

Statement of changes in equity for the year ended 31st December 21x1

Share capital

Share premium

Revaluation reserve

Retained earnings

Total

£m £m £m £m £m

Balance 31/12/x0 10 2 8 45 65

Profit for the period 12 12

Surplus on property

Revaluation 14 14

Issue of shares 6 3 9

Dividends paid (5) (5)

Balance 31/12/x1 16 5 22 52 95

3.5 Regulatory Framework

Prior to the 1970s, when accounting standards were first introduced, accountants had consid- erable freedom in recording, preparing and presenting financial information. However, because there was no formal legislation on how companies should prepare their accounts, a wide vari- ety of accounting practices were adopted. This led to a reduction in the usefulness of financial statements to the user because of the lack of comparability, with similar transactions being dealt with in entirely different ways by companies nationwide.

enu-fmd-bk-en-GB January 6, 2015 - 15:22 45

Chapter

Limited Liability Companies

Nowadays, accounting is regulated by:

• ‘local’ company law

• Stock Exchange requirements

• accounting standards.

However, the actual methods used to prepare accounts can still vary from country to country and the term ‘generally-accepted accounting practice’ (GAAP) refers to the whole regime of regulation used by a specific country. For example, the UK GAAP refers to UK Law (the Companies Act 2006 primarily), UK Financial Reporting Standards (FRS) and UK listing rules for companies whose shares are traded on the Stock Exchange. A flavour of the regulatory framework governing a UK company is given below.

3.5.1 UK Company Law

The Companies Act 1985, as amended by the Companies Act 1989 and 2006, deals with all the legal requirements which must be followed regarding the published accounts of companies. The key elements of this legislation are as follows.

• Limited companies are required by law to prepare an annual set of financial statements.

• Limited companies must lodge their financial statements with the Registrar of Companies for public inspection.

• There are prescribed formats to be followed by limited companies when they prepare profit and loss accounts and balance sheets.

• There are prescribed methods for valuing assets and liabilities when preparing the financial statements.

However, the overriding requirement arising from the Companies Act 2006 is that the financial statements of companies must present a true and fair view of the events from the last trading period.

3.5.2 European Union

As a member of the European Union, the United Kingdom is obliged to develop its laws in harmony with those of the other member countries. This process of harmonisation starts when ‘directives’, which set out the basic rules to be followed in the national laws of each member country, are issued by the European Commission.

The Companies Act 1985, and its amendments in 1989 and 2006, were primarily the result of the fourth and seventh directives issued by the European Union.

3.5.3 Stock Exchange

Companies whose shares are listed on the UK Stock Exchange must conform with all the Stock Exchange regulations. These regulations are contained in a publication called ‘The Listing Rules’ (often referred to as the Yellow Book) and they commit companies to certain procedures and standards which can be even more extensive than the Companies Act requirements. Failure to comply with the rules can lead to the Stock Exchange suspending a company’s listing.

3.5.4 External Auditors

As the majority of a company’s shareholders do not have day-to-day access to the accounting records of the entity, they need someone to act on their behalf to ensure that the directors

enu-fmd-bk-en-GB January 6, 2015 - 15:22 46

Chapter

Finance for Management Decision-Making

present a true and fair view of the results of the period. This reassurance comes from the appointment of a firm of auditors who, following their own code of practice, Auditing Standards, review the annual report and offer an opinion on the truth and fairness of the financial information presented. It is important to note that the auditors are not expected to be totally certain in their opinion, but are merely looking for ‘material’ errors.

3.5.5 Accounting Standards

Figure 3.1 Accounting bodies

The bodies shown in Figure 3.1 have been established to draft accounting policy, set accounting standards and monitor compliance with those standards and the provisions of the Companies Act.

3.5.6 Financial Reporting Council

The Financial Reporting Council (FRC) is in overall control of the process and comprises about 20 members drawn from the profession, the City, industry and academia. Its objectives are to:

• oversee the standard-setting process and the work of the ASB

• provide the finance needed to support the standard-setting process

• offer guidance to the ASB on work programme priorities

• advise the ASB on areas of public concern or controversy.

3.5.7 Accounting Standards Board

The Accounting Standards Board (ASB) has responsibility for developing, issuing and with- drawing accounting standards. Creating accounting standards is an ongoing attempt to tackle the diversity of treatment of items in the accounts and to continue to improve the current standards of financial accounting and reporting.

The ASB was formed in 1990 to replace the Accounting Standards Committee (ASC) which, primarily, had undertaken the same function between 1970 and 1990. Up to 1990, the account- ing standards were known as Statements of Standard Accounting Practice (SSAPs) and some of the 25 SSAPs that were introduced by the ASC are still in existence today. Accounting standards issued by the ASB are called Financial Reporting Standards (FRS) and more than 20 have been issued since its inception, covering such topics as cash flow statements, capital instruments and deferred taxation.

enu-fmd-bk-en-GB January 6, 2015 - 15:22 47

Chapter

Limited Liability Companies

The Board comprises nine members, including a full-time chairman and technical director, and requires a two-thirds majority to approve its standards. These standards have no legal effect but are simply a set of rules of professional conduct which the accounting bodies regard as binding on their members.

3.5.8 Urgent Issues Task Force

The ASB is responsible for the operation of the Urgent Issues Task Force (UITF), whose role is to issue abstracts where an accounting standard is in force but is not being appropriately interpreted. If a company fails to comply with a UITF abstract, it is required to give adequate disclosure of the fact in its financial statements.

3.5.9 Financial Reporting Review Panel

The Accounting Standards Committee’s standard-setting process lacked an effective mechan- ism for enforcing accounting standards to be adopted. The Financial Reporting Review Panel (FRRP) was set up as an independent body from the ASB and UITF and its remit is to review material departures from the accounting standards. If the FRRP feels that the accounting requirements of the Companies Act 2006, including the true and fair view requirement, have been breached, it has the power to ask companies to revise their accounts. Although it has the power to take companies to court in order to rectify matters, the FRRP prefers to deal with defects by agreement and so far has not found it necessary to resort to legal action.

However, in case you doubt its powers, consider the early case of Trafalgar House. Trafalgar House had reported profits of £122.5m for the year to 30 September 1991. The FRRP disagreed with the company’s treatment of writing-off the value of some properties and asked them to revise their accounts. The profit of £122.5m became a loss of £30m!

3.6 International Accounting Standards

It is the International Accounting Standards Board (IASB) that issues international accounting standards (IASs) and international financial reporting standards (IFRSs).

Before the development of international accounting standards, there were often significant differences in the approach taken by individual countries in treating specific items in the financial statements. One of the key aims of international accounting standards has been to try and harmonise these different accounting standards in order to provide one framework for financial reporting that can be adopted by every country.

In fact, many countries (the UK is a good example) have changed and adapted their national accounting standards in order to be more consistent with international accounting standards. Perhaps that was just as well because from 2005 onwards, it became mandatory for all listed companies within the European Union to publish consolidated financial statements in accordance with IASs and IFRSs. For that reason references made throughout this unit will be to the relevant IAS.

3.7 Consolidated Financial Statements

When we were reviewing the non-current assets that we might come across in the balance sheet of a limited liability company, one of the categories of non-current assets was investments. Long-term investment is likely to take one of the following four forms:

• trade investment, where one company buys shares in another company for the same reasons that we, as individuals, might invest in a company, namely to generate an annual return in the form of a dividend and, at the same time, hope the share price increases in the future so that the company can accrue a capital gain as well, should it ever choose

enu-fmd-bk-en-GB January 6, 2015 - 15:22 48

Chapter

Finance for Management Decision-Making

to sell the shares. The investor has no interest in getting involved in the running of the company and the investment is very likely to be for less than 20% of the voting shares

• investment in a subsidiary, where one company has bought a majority of the voting shares in another company or, in some other way, exercises a dominant influence over that company. The purpose of this type of investment is to establish control over the financial and operating policies of another undertaking with a view to gaining benefits from its activities

• investment in an associate, where one company has bought a participating interest in another company and can, therefore, exercise a significant influence, but not a dominant influence, over its operating and financial policies. This investment is usually between 20% to 50% of the voting shares

• investment in a joint venture, where, as a result of a contractual agreement, a number of companies together share control over an entity, but no one company can control the entity on its own.

3.7.1 Subsidiaries

In terms of the impact that the above long-term investments might have on the financial statements, investment in a subsidiary is the most significant. Where companies invest funds by purchasing shares in other companies, the accounting entries are required to show the investment at its cost in the balance sheet and the return from the investment, the dividends, as investment income in the income statement. This form of accounting can prove to be inadequate when the investing company builds up a controlling interest in the shares of another company. Imagine, for example, that Company A, owns all the shares in Company B. Company A would be deemed the holding or parent company and Company B would be the subsidiary. As a shareholder in Company A, you would be entitled to receive a copy of their financial statements but apart from the two accounting entries mentioned above, you would have very little idea as to how successful or otherwise this investment in Company B has been.

To overcome this deficiency in the information provided, a new concept needs to be intro- duced. If one company can control another and a parent−subsidiary relationship is deemed to exist, then this relationship constitutes a group. The group will also include companies in which the parent’s subsidiaries themselves have invested, which means that a group can have a number of different layers. Legislation requires group accounts to be prepared for the holding company in addition to the accounts that are required to be prepared for each of the compan- ies in the group. Basically, group accounts are formed by aggregating the financial statements of each group member, a process known as consolidation. These ‘consolidated financial state- ments’ exclude all transactions between group members, for example inter-company trading, so that the final results presented reflect the performance of the group as if it had been an individual company trading with the outside world.

A lot of the major businesses around the world operate under a group structure, perhaps because they cover different markets or products, or simply as the result of a succession of takeovers or mergers. Their financial statements will feature:

• a group income statement

• a group and an individual parent company balance sheet

• a group cash flow statement.

3.7.2 Associates

Because a company can exercise significant influence over an associate, legislation considers the inclusion of dividend income only in the income statement to be insufficient to meet users’

enu-fmd-bk-en-GB January 6, 2015 - 15:22 49

Chapter

Limited Liability Companies

needs. The related accounting standard for associates (IAS 28), requires that the investor’s share of the associate’s results should be included in the group income statement and that the investment in the associate shown on the group balance sheet represents the investor’s share of the associate’s net assets. This is known as equity consolidation.

3.7.3 Joint Ventures

Joint ventures are dealt with very similarly to associates with IAS 31 stipulating the gross equity method of accounting. In addition to the disclosures noted above with associates, the investor’s share of the gross assets and gross liabilities of its joint venture need to be shown on the group balance sheet.

Note: For the purposes of this module, there is no requirement for you to know the detail behind the preparation of group financial statements.

3.8 Summary

This unit began by discussing the three main types of business enterprise:

• sole traders

• partnerships

• limited liability companies

and stressed that the major drawback for the sole trader and partnership businesses was that the owners had unlimited liability. The limited liability company therefore protects its investors because their liability is limited to the amount of capital that they have invested in the business.

However, there is a price to pay for this limited liability because the financial statements of a limited liability company are subject to much greater regulation. National and international laws and accounting standards determine the layout and the content of the financial statements. Perhaps with this regulation in place the consistency and quality of financial reporting will continue to improve and ultimately benefit the users of the financial statements.

In addition to the preparation of an income statement and a balance sheet, IAS 1 (Presentation of Financial Statements) requires companies to prepare a statement of changes in equity. This highlights to the users how the company’s equity has changed over the trading period. Was it, for example, because of profits generated through trading or simply because more shares were issued to the investors?

Finally, this unit highlighted how the financial statements that you review could well be group financial statements due to the parent company controlling a number of subsidiaries through its majority shareholding.

Where companies operate using a group structure, for accounting purposes the group as a whole is the economic entity for which financial statements are prepared. This process of combining all the financial statements of the companies within the group is called consolidation. Consolidation is a process that aggregates the total assets, the total liabilities and the total results of the holding company and all its subsidiaries. This ensures that the effects on the holding company’s financial performance and financial position, of its interests in its subsidiaries, are fully reflected in the financial statements.