The balance sheet of a limited company is still constructed on the same principles as a balance sheet for a sole trader. If the balance sheet is for publication then there are certain formats and heading that must be present. However, if the balance sheet is for internal use only then most of the balance sheet will probably appear very similar to balance sheets that you are already familiar with - as in the case of a sole trader.
The main difference comes with the capital section of the balance sheet. In the case of a sole trader, the owner's capital figures was adjusted by the net profits and drawings to give the new capital figure, which would then be carried forward to the next year.
For a limited company, the share capital is kept separate and is not adjusted by any of the profits retained within the company. The section dealing with this is entitled capital and reserves.
Issued share capital is the amount of shares actually sold to investors and this is the amount that will appear in the capital and reserves section. Also, any reserves that have been generated - capital reserves or revenue reserves - will also appear in this section.
These reserves are created out of trading profits earned by the firm over a period of time. Once tax has been deducted, the firm can choose to allocate the remainder as dividends, or to retain this within the firm. The retained profit is known as the profit and loss account balance (this is a revenue reserves). However, the firm may also decide to transfer money to another designated reserve. This would then appear as a deduction in the profit and loss appropriation account.
The names of these revenue reserves are not necessarily an indicator of why the profits have been transferred into this reserve. For example, if the firm transfers profits into a reserve called the fixed asset replacement reserve, then this may mean that the firm would like to use some of its profits to replace the fixed assets. However, this is not necessarily the case. Profits are earned over a period of time and therefore they may be tied up in other assets, in stocks or in other investments. The name of the revenue reserve does not commit the firm to any type of actions. As a result, most revenue reserves are simply known as a general reserve.
Summary of revenue reserves
Capital reserves do not arise out of trading profits, which means that they cannot be used for distribution as dividends. They arise, largely out of changes to the balance sheet of the firm. There are two main capital reserves that you are likely to come across; the revaluation reserve and the share premium account (still a reserve)
It is a requirement of company law that all fixed assets (with the exception of freehold land) should be depreciated. Although property does eventually wear out, it is possible that its value will increase significantly over a period of time. If the value of any of the fixed assets becomes significantly greater than the balance sheet value then it is allowable for a firm to increase - revalue - this asset. This requires a simple upwards adjustment to the asset's value on the balance sheet.
However, if we increase the value of any fixed asset then the balance sheet would no longer balance. To remedy this, we simply create a 'revaluation reserve' (or add to one if one already exists) by adding the amount equal to the increase in the value of the asset (i.e. both sections of the balance sheet increase by the same amount - thus permitting the balance sheet to balance).
Share premium account
When limited companies issue shares, they may not always issue them all in one go. They may issue their shares in a number of stages. If this is the case, the shares issued later will still have to be issued at the same face (nominal) value of the shares that were originally issued. However, if the firm has well established, the market value of the firm's shares is likely to be higher than the face value of the shares.
The firm will probably issue these later shares at a premium. This means that the price paid for these shares will be closer to their current market value. However, the face value of these shares will still be as originally set out in the memorandum of association. This means that the firm will received more in cash than is indicated by the increase in the share capital (the value of the share capital is always based on the face value of the shares). This surplus money that is being received will be entered into the share premium account, which is a capital reserve.