chapter  8
36 Pages

CAPITAL MAINTENANCE AND DISTRIBUTIONS

Example 1: A company with virtually no share capital Company A Ltd is registered with a share capital of £1 made up of 1 × £1 ordinary shares, fully paid-up. Company A Ltd borrows £1,000 from B, repayable in 12 months. Company A Ltd has assets of £1,001. This is stated in its balance sheet as follows:

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Balance sheet of Company A Ltd as at 1 January 2013

£ Assets Cash at bank 1,001 Liabilities Sum owed to B 1,000 Net assets 1 Capital Share capital 1 (number of issued shares × nominal value)

The basic balance sheet equation, or accounting equation, is:

Assets = Liabilities + Capital

‘Capital’ is made up of a number of components; the main ones are:

Capital = share capital + share premium + reserves (accumulated profits and losses)

The only component of capital in the above balance sheet is share capital. ‘Net assets’ is also an important concept:

Assets – Liabilities = net assets

£1,001 – £1,000 = £1

Net assets is also equal to Capital. In this balance sheet, net assets is equal to the share capital because share capital is equal to the Capital but net assets will not always equal the share capital. Indeed, the moment the company has profits or losses its net assets will diverge from its share capital, as the following 1 January 2014 balance sheet of Company A Ltd shows. Company A Ltd trades for 12 months and incurs trading losses of £500. It then has £501. B demands repayment of the £1,000 owed and due to it from Company A Ltd. Even if B sues Company A Ltd, the most it can receive is £501 because that is all the money Company A Ltd has. The balance sheet now looks as follows:

Balance sheet of Company A Ltd as at 1 January 2014 £ Assets Cash at bank 501 Liabilities Sum owed to B 1,000 Net assets (499) Capital Share capital 1 (number of issued shares × nominal value)

Profit and loss (500) (accumulated profits and losses)

Brackets around a number indicate that it is a negative number. Note that the share capital amount remains the same. It reflects the number of shares in issue and their nominal value. It does not change unless more shares are issued (a share capital increase) or issued shares are cancelled (a share capital reduction). In this balance sheet, net assets is:

Assets – Liabilities

£501 – £1,000 = (£499)

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S This is not equal to the share capital of £1 because there are two components to Capital: share capital and accumulated profits and losses. The accumulated profits and loss here is a loss of £500, so Capital is:

share capital + profit and loss (accumulated profits and losses)

£1 + (500) = (£499)

The shareholders cannot receive their share capital back from Company A Ltd whilst the company is a going concern. The company cannot pay a dividend to shareholders because it has no profits available for the purpose (it has made a loss). B is entitled to all the assets of the company. Even if he receives them he remains only partly repaid. He has borne all but £1 of the trading risk of the company; he has absorbed all but £1 of the trading losses.