Appropriation of Earnings in Limited Companies

As part of our 'Bookkeeping in Practice' series, ICB's Director of Learning Peter Stewart explains the options and treatment of profits in a limited company.

Introduction

Bookkeepers are particularly skilled in recording transactions and making adjustments to nominal ledger accounts to arrive at closing balances for assets, liabilities, revenues and expenses, calculating, among other things, profits.

This article aims to explain the options and treatment of profits in a limited company, so that bookkeepers understand the full picture in finalising the financial statements.

In limited companies, there is a subtle distinction between profits and earnings. Profits result from trading activities, any investment income and profits or losses on disposal of fixed assets. Before making any decision on what to do with those profits, the company will have an obligation to pay interest on any loans it has borrowed. After allowing for those payments and corporation tax, the remainder is known as “Earnings” available to the owners of the business, i.e. the shareholders.

The term “appropriation” refers to how those earnings are used.

There are, broadly, two ways to deal with the earnings:

1. Transferring to reserves, and
2. Distribution as payments to shareholders (dividends)

The company can decide to do any combination of the two but, if nothing else is decided upon, the default position is that all earnings will be transferred to reserves.

Transfers to Reserves

Transferring a portion of profits to reserves is a prudent practice that helps companies maintain a buffer for future needs and improve financial stability.

Types of Reserves

1. Revenue Reserves:
• These accumulate gradually each year the company makes profits, which are not otherwise appropriated.
• Used to reinforce working capital, invest in expansion, or offset future losses.
• Can be distributed as dividends
2. Capital Reserves:
• Created from non-operating activities such as premium on share issues.
• The company can add to the capital reserves by transferring amounts from revenue reserves, so that those reserves can be ring-fenced for a specific purpose.
• Cannot be distributed as dividends.

Dividends

Dividends are distributions of a company's earnings to its shareholders and come in two main types: ordinary and preference shares.

Ordinary Shares

• Ordinary shareholders are the equity owners of the company.
• Dividends paid on ordinary shares are not fixed and depend on the company’s profitability and discretion of the board of directors. They are usually declared after considering the company’s financial health and future investment needs. Shareholders will vote to approve the level of dividends being paid.
• Dividends declared are deducted from the company’s reserves in the balance sheet and reported as an appropriation of profit.
• Although dividend payments are usually linked to that year’s post-tax profits, they may be higher than the profits if there are sufficient revenue reserves. Indeed, dividends may be paid if the company has made a loss.

Preference Shares

• Preference shareholders have a higher claim on assets and earnings than ordinary shareholders but often without voting rights.
• Dividends on preference shares are usually fixed and must be paid before ordinary share dividends. They can be cumulative (carried forward if not paid in a given year).
• Preference dividends are treated as an expense in the P&L account after corporation tax and reduce the net profit available for distribution to ordinary shareholders or transfer to reserves.

Distribution of earnings

To summarise the above, a company that has made earnings in the year (Profit After Taxation) will distribute or ‘appropriate’ them in the following order:

1. Account for any preference dividend
   This is a simple calculation. For example, if the balance sheet shows £50,000 of 4% Preference Shares, there will be a dividend of £2,000.
   The double entry is straightforward:
   Debit P&L Account
   Credit Preference Dividend Payable (as not paid at the balance sheet date).
2. Decide on how much of the earnings after preference dividends (and previously retained earnings*) will be distributed to ordinary shareholders.
   When this dividend is ‘declared’, the journal required is:
   Debit P&L Account
   Credit Ordinary Dividend Payable (a liability)
3. Transfer remainder of P&L Account (if any) to Retained Earnings, a Revenue Reserve, which involves the following double entry journal:
   Debit P&L Account
   Credit Retained Earnings
4. If required, transfer an agreed amount to a Capital Reserve. This can be done at any point in time, it does not need to be a year-end adjustment.
   Debit Retained Earnings
   Credit Capital Reserves

* Should a declared dividend be larger than the retained earnings for the year, the double entry will be:

Debit P&L Account (full amount – making the balance £0)
Debit Revenue Reserves
Credit Dividends Payable

Conclusion

Dividends and transfers to reserves are key components that highlight how profits are utilised, offering insights into the company’s priorities and long-term objectives.

Bookkeepers who grasp these concepts will find themselves better equipped to provide valuable insights and support to the businesses they serve.