MONASH

BUSINESS
SCHOOL

ACX5903 Accounting for Business

Week 5
Introduction to limited companies &
Regulatory framework for companies
Dr. Jin Zhang

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 Learning objectives
1. The main features of company
2. Corporate governance
3. Shares: ordinary and preference shares
4. Reserves
5. Distribution /Borrowing
6. Dividend
The Main Features of Companies

Legal nature

Unlimited (perpetual) life

Limited liability

Legal safeguards
 The Main Features of Companies

Public and proprietary (private) companies

• Public company can offer shares to the general public. Shares

can be traded on a public stock exchange.
– No maximum number of shareholders required for public companies,
so ownership could be widely spread.

– Shareholders can sell their shares at the going market price.

– Rigorously regulated.
 The Main Features of Companies

Small proprietary companies

• A proprietary company is deemed to be small and exempted

from reporting requirements if it satisfies two of the
following:

o It has consolidated gross revenue of less than

$50 million

o Its consolidated gross assets at the end of the financial year

are less than $25 million

o It employs fewer than 50 employees at the end of the financial

year
 Compare public and private firms
• Public firms:
– Face regulation to limit private communication
– Meet the info demand from investors/ creditors
– Have incentive to manipulate earnings
• Capital market pressures
• Equity-based compensation packages
– Disclosure is not without cost
• Private firms:
– Lower demand for financial information
– Fund limited
– Avoid hostile takeover
 The Main Features of Companies
Transferring share ownership
• Shares in companies may be transferred from one owner to
another
• A formal market for these transfers is called a stock exchange
• The purchase and sell prices are determined by the law of
supply and demand.
• Supply and demand are themselves determined by
investors’ perceptions of the future economic prospects
of the company.
• Major exchange markets
• NYSE
• TSE
• LSE
• HKSE
• SSE
 The Main Features of Companies

Separation of ownership and management

• Shareholders elect directors (by law there must be
at least one director) to manage the company on a
day-to-day basis on their behalf
• In small companies, directors may be the only level
of management, made up of shareholders
• Larger companies may have 10 or so directors
forming a ‘Board of Directors’
 The Main Features of Companies

Extensive regulation
• Companies are subject to much stricter regulation than
partnerships and sole proprietorships, due to ‘limited liability’
status and separation of shareholders/management

• Company regulation includes (unless exempted):

o company registration requirements before a company is granted a
certificate of incorporation
o the requirement to submit annual accounts
o the requirement to have accounts audited by registered auditors
o reporting and other obligations imposed on the company
management (directors), e.g. in relation to Corporate Governance
Advantages & Disadvantages of the
Company Entity Structure

Advantages Disadvantages
• the separation of ownership and • more expensive to establish
management
• more regulatory requirements
• perpetual existence
• less management flexibility
• separate legal entity
• control by the original owners
• limited liability may be lost
• greater access to ownership • greater scrutiny
funding
• greater pressure to perform
• potentially greater access to
• potential taxation disadvantages
debt funding
• potential taxation advantages
• access to stock exchange
 Many examples about professional judgement
• Not limit to:
• Judgement and evaluation of goodwill/ intangible assets
• Decision on bank-loan funding v. equity funding
• Decision on capital contribution, drawing and dividend
payment
• Decision on depreciation methods, evaluation of residual
value, and decision on assets replacement
• Decision on inventory cost record
• Doubtful and bad debt judgment
• The timing on dividend proposal, approval and payment
• ……
 Corporate Governance

• Corporate governance: The system by which corporations

are directed and controlled

• Most competitive market economies have a framework of

rules to help monitor and control the behaviour of directors.
Those include:

o disclosure

o accountability

o fairness

(to/towards shareholders)
 Corporate Governance

Activities would include identifying:

• the role, composition and background of the board
• the role of the chairperson
• the role of the CEO and executive team
• the role of the non-executive and independent directors
• details of executive compensation
• details of internal controls
• the role of the internal audit
• The quality of external independent auditor
• risk assessment and management procedures
• corporate culture and ethical issues.
Equity & Borrowings in a Company Context

• The difference between assets and external claims on the

business represents wealth of the business

• In a public company, more complicated, including:

o shares (original investment)

o reserves (profits and gains made, including ‘retained earnings’)

• Financing through equity or debt?

 Ordinary Shares

• Shares represent the basic units of ownership of the business

(equities)

• Ordinary shares are the main risk-bearing shares issued by

companies

• Ordinary shareholders’ returns come from distributions of

profit, called dividends
 Raising Share Capital

A company may decide to raise additional funds by making

further issues of new shares:

• Rights issues – issues made to existing shareholders

• Public issues – issues made to the general investing public

• Private placing – issues made to selected individuals or

institutions (PE)
Setting the price for issued shares

Example:
Suppose a balance sheet excerpt is as follows:
Net assets $1,500,000
Shareholder Equity
Capital (1 million shares issued @ $1) $1,000,000
Retained profits 500,000
$1,500,000
Assuming ‘market value’ = ‘book value’ ( a big assumption):
Share price = $1,500,000 (total market value) ÷ 1,000,000 shares =
$1.50 per share
 Preference Shares

• Some companies issue preference shares

• The reward is different compared with ordinary shares

• These shares have a fixed rate of dividend that must be paid

before any ordinary dividend can be paid

• Profit in excess of the preference dividend is the entitlement

of ordinary shareholders

• Ordinary shareholders are primary risk-takers

 Reserves

• Reserves are profits and gains that have been made by the
company and that still form part of the shareholders’ claim

• Retained profits represent the largest sources of new finance

in the company

• Reserve is cash or not?

 Restrictions:
Drawings or Reductions of capital

Restrictions on the rights of shareholders to make drawings or

reductions of capital

• Limited companies must distinguish equity that can be

distributed as cash dividends (retained profits) and other
part of equity that is non-distributable.

• To protect prospective creditors, companies must disclose

the extent of non-distributable and distributable equity
 Borrowings

• Most companies borrow to supplement the funds raised

from share issues and retained profit
• Borrowings may be in the form of:
o Long-term loans (usually secured on assets of the
company)
o Loan notes (also called ‘loan stock’, ‘debentures’ or
‘corporate bonds’)
 Dividend Decisions
• Dividends represent drawings by the shareholders of the
company

• In deciding whether, and what amount, to pay as a dividend,

directors would normally consider:

o the availability of cash

o the needs of the business for finance for investment

o possibly a need for the directors to create good relations with

investors

• The dividends declared by the directors during the year but

still unpaid at the year end may appear as a liability in the
statement of financial position.
The directors’ duty to account—the role
of company law (Corporations Act) (1 of 3)
➢ It is not usually possible for all of the shareholders to be
involved in general management of companies.
➢ Directors must prepare financial statements that provide a fair
representation of the financial position and performance of
the business.
➢ Financial reporting is compulsory for:
▪ reporting entities
▪ disclosing entities.
➢ These financial statements must comply with accounting
standards and be checked by an auditor.
The directors’ duty to account—the role
of company law (Corporations Act) (2 of 3)
➢ Reporting entity
▪ An entity that is required, or chooses, to prepare financial
statements.
▪ It need not be a legal entity, and can be a single entity, a portion
of a larger entity, or be made up of more than one entity.
▪ Includes public companies and large proprietary companies.
➢ Disclosing entity
▪ An entity that issues securities that are quoted on a stock
exchange or made available to the public via a prospectus.
The directors’ duty to account—the role
of company law (Corporations Act) (3 of 3)
➢ Accounting standards
▪ Rules established by the professional or statutory accounting
bodies, which should be followed by preparers of the annual
accounts of companies.
➢ Auditors
▪ Professionals whose main duty is to make a report as to whether,
in their opinion, the accounting statements of a company show a
true and fair view, and comply with statutory and accounting
standard requirements.
▪ Auditors are appointed by, and report to, the shareholders.
Relationships between shareholders,
directors and auditors
Sources of rules and regulation
➢ Companies are subject to multiple sources of accounting rules
and regulations, including:
▪ International Financial Reporting Standards (IFRS), and/or local
equivalents
▪ ASX listing rules
▪ company law.
Corporate governance
➢ Corporate governance means the system by which
corporations are directed and controlled.
➢ ASX Corporate Governance Council establishes the Corporate
Governance Principles and Recommendations.
➢ ASX listed companies must disclose extent to which they have
met the principles and recommendations, and if not, why not.
Principle 1 Lay solid foundations for management and oversight
A listed entity should clearly delineate the respective roles and responsibilities of its board and management and regularly review
their performance.
Principle 2 Structure the board to be effective and add value
The board of a listed entity should be of an appropriate size and collectively have the skills, commitment and knowledge of the
entity and the industry in which it operates, to enable it to discharge its duties effectively and to add value.
Principle 3 Instil a culture of acting lawfully, ethically and responsibly
A listed entity should instil and continually reinforce a culture across the organisation of acting lawfully, ethically and responsibly.
Principle 4 Safeguard the integrity of corporate reports
A listed entity should have appropriate processes to verify the integrity of its corporate reports.
Principle 5 Make timely and balanced disclosure
A listed entity should make timely and balanced disclosure of all matters concerning it that a reasonable person would expect to
have a material effect on the price or value of its securities.
Principle 6 Respect the rights of security holders
A listed entity should provide its security holders with appropriate information and facilities to allow them to exercise those rights as
security holders effectively.
Principle 7 Recognise and manage risk
A listed company should establish a sound risk management framework and periodically review the effectiveness of that framework.

Principle 8 Remunerate fairly and responsibly

A listed entity should pay director remuneration sufficient to attract and retain high-quality directors and design its effective
remuneration to attract, retain and motivate high-quality senior executives and to align their interests with the creation of value for
security holders and with the entity’s values and risk appetite.

Table 5.1 The ASX Corporate Governance Principles

Presentation of published financial
statements
➢ Accounting Standard AASB 101: Presentation of Financial
Statements sets out requirements for disclosing and reporting
entities.
➢ AASB 101 includes minimum requirements for:
▪ statement of financial position
▪ statement of comprehensive income
▪ statement of changes in equity
▪ statement of cash flows
▪ notes to the financial statements.
Accounting for groups of companies (1 of 3)
➢ Many companies acquire shares in other companies to obtain
a controlling interest in these companies.
➢ Reasons for this might include:
▪ the elimination of, or at least reduction in, competition
▪ safeguarding of sources of supply or sales outlets
▪ risk reduction through diversification
▪ access to economies of scale.
Accounting for groups of companies (2 of 3)
➢ Control can normally be achieved by ownership of at least
50% of the ordinary share capital.
➢ The controlling company is known as the parent company (or
‘holding company’).
➢ The owned company is known as the subsidiary company.
➢ Many large companies control multiple subsidiaries.
Accounting for groups of companies (3 of 3)
➢ The parent company is required to prepare a set of group or
consolidated accounts.
➢ Group or consolidated accounts are an amalgamation of sets
of accounts for a group of companies where the group
accounts appear as if the entire group was one entity.
➢ Group accounts are complicated by several factors, including:
▪ goodwill arising on consolidation
▪ non-controlling (minority) interests
▪ intra-group transactions.
Example
5.4
Accounting for groups of companies
➢ Investment in shares of another company does not always
involve the acquisition of a controlling interest.
➢ An associate company is a company partly owned by another
company (typically between 20% and 50%), where the
investor company does not have control, but can exert
considerable influence.
➢ Consolidated accounts also need to show:
▪ the share of profits or losses of the associate company
▪ the share of tax attributable to the associate company
▪ the share of retained profit in the associate company.
Online resources
➢ ASX Corporate Governance Principles, ASX Corporate
Governance Council
➢ Illustrative Consolidated Financial Statements, PwC