Distinctions of companies
 Separate legal entity
 Separation of ownership and management
 Ownership through shares
 Limited liability is usual. It is the liability of the
shareholders that is limited. It is limited to the
amount paid for their shares.
 Profits are distributed as “dividends”.
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Requirements
 Legislative requirements for companies
contained in:
• Companies Act 1993
• Financial Reporting Act 1993
• Financial Reporting Amendment Act 2006
 Constitution – document established by the
company to govern its operations.
 Companies are not required to have their own
constitution. If they do not they are governed by
the provisions of the Companies Act 1993.
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Equity
 The capital in a company is called ‘equity’
 Equity is made up of:
 Paid-in capital/issued capital – ordinary or preference
shares
 Retained Earnings – built up from retained profits
 Reserves – such as revaluation surplus, foreign
currency translation or general reserves
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Classes of Shares
 Ordinary shares
 Provide a claim against the entity that ranks behind
the claims of creditors and some preference
shareholders
 Confers voting rights on shareholders
 Entitles their owners to distribution of profits in the
form of dividends – however there is no guarantee of a
dividend payout
 Dividends not paid in one year do not accrue
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 Preference Shares
 Subject to preferential treatment, often with receipt of
dividends or order of ranking for asset distributions
 Voting rights vary - some have voting rights, others
don’t and some have voting rights only if dividends
remain unpaid
 Shares can be participating, convertible or redeemable
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Types of Preference Shares
 Participating – may, after receiving a preference
dividend at a fixed rate, participate with ordinary
shareholders in further profits distributed
 Convertible – right of conversion to ordinary
shares
 Redeemable – ability to redeem shares for cash
at a later date
Note that some have the characteristics of equity
and others the characteristics of debt
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Dividends
 The most common form of distribution to
shareholders is in the form of dividends
 Dividends are authorised by the directors and
can be paid at any time in the year
 Interim dividends are paid in anticipation of the
current year’s profit
 Final dividends are authorised and paid after
balance date once the financial statements have
been completed
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Dividend Issue
Date
Payment
Date
Balance
Date
Dr
XX
Dividends paid
Cash
Record distribution of dividends
Cr
XX
Equity
XX
Dividends paid
XX
Record dividends paid closed to equity
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Solvency test
 In order to make a distribution (such as pay a
dividend) a company must satisfy the solvency
test.
 The solvency test is defined in s 4 Companies
Act 1993.
 Two limbs – liquidity (or cash flow test) and
balance sheet test
 Both parts of the solvency test must be satisfied
immediately after a distribution is made.
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The tests…
1. Liquidity
 The company is able to pay its debts as they become
due in the normal course of business.
 Look at the cash forecasts – these are essential in
establishing future cash availability.
2. Balance Sheet
 The value of the company’s assets is greater than the
value of the liabilities – including contingent liabilities.
 The directors must have regard to the most recent
financial statements.
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