Movements in Reserves and Provisions Including the Effects of Taxation

Movements in reserves and provisions including the effects of taxation

Contents

Key to resources

Introduction

Income tax and net profit after tax

Reserves

Dividends

Summary of items affecting the retained earnings or accumulated losses account

Feedback to questions

This learning guide is based on the following resource:
Textbook
Woodford WL and Mills AD (2005) Company Accounting, LexisNexis Butterworths, Chatswood, NSW

Key to resources

Resource / Textbook
1 / Chapter 5:

Overview, p60
pro-forma entries, pp60–61
example 1, p62

2 / Chapter 5, self-test questions 5A and 5B, pp64–65
Feedback is provided at the end of the textbook.
3 / Chapter 5, question 5.6, p64
Feedback is provided at the end of this learning guide.
4 / Chapter 5, Reserves, p67
5 / Chapter 5, questions 5.15 and 5.16, p70
For feedback, go back to where you were in this learning guide.
6 / Chapter 5:

example 2, p69
question 5.17, p70

Feedback is provided at the end of this learning guide.
7 / Chapter 5, Requirements of an accounting standard, p68
8 / Chapter 5, question 5.19, p70
For feedback, go back to where you were in this learning guide.
9 / Chapter 5:

self-assessment question 5C
(Feedback is provided at the back of the textbook.)
question 5.23
(Feedback is provided at the end of this learning guide.)

10 / Chapter 5:

Dividends, pp72–74
example 3, p74

11 / Chapter 5:

question 5.27, p76
question 5.28, p76

(Feedback is provided at the end of this learning guide.)
12 / Chapter 5:

Dividend reinvestment schemes, p74
example 4, p75

13 / Chapter 5:

question 5.29, p76
question 5.31, p77
self-assessment question 5D, p78

14 / Chapter 5:

question 5.34, p79
question 5.35, p79
question 5.37, p80
question 5.38, p80
question 5.39, p80

(Note: Feedback is provided at the end of this learning guide.)

Introduction

The material under this heading introduces a new account—the ‘retained earnings’ account; sometimes called the ‘retained earnings/accumulated losses’ account.

This account is similar to the profit and loss appropriation account met in previous studies of partnership accounting. The retained earnings account will receive the profits (losses) of the company and any distribution or transfer of those profits will also be recorded. The retained earnings account is part of shareholders’ equity.

A summary of the possible items contained in a retained earnings account appears at the end of this document.

Income tax and net profit after tax

Other studies of a sole trader and partnerships may not include the calculation of any income tax payable. Income tax is considered to be a personal expense of the sole trader or partner and not an expense of the business.

Companies, however, pay income tax. Income tax expense will need to be recorded in the books of account. It is important to note that our study purposes in this area are limited to the tax payable method of calculating income tax. It is assumed that all items in the profit and loss account are either assessable or deductible.

Laterstudies will introduce tax effect accounting which will vary the amount of income tax expense.

Under the tax payable method, when the amount of income tax to be paid is known, the accounting entry is:

Debit Income tax expense / xxxx
Credit Tax payable / xxxx

The entry when the income tax is paid is:

Debit Tax payable / xxxx
Credit Bank / xxxx

The entry at the end of the financial year when income tax expense is transferred to profit and loss account is:

Debit Profit and loss account / xxxx
Credit Income tax expense / xxxx
/ Now go to Resource 1

In example 1, take particular note of these entries:

the transfer of income tax expense of $15000 to profit and loss account:

Debit Profit and loss account / 15 000
Credit Income tax expense / 15 000

the transfer of profit after tax of $35000 from profit and loss account to an account called ‘retained earnings’:

Debit Profit and loss account / 35 000
Credit Retained earnings / 35 000

Note in example 1 the under-provision of income tax of $400.

Any under-provision or over-provision of income tax is found after the end of the financial year and it is too late to adjust the transfer of profit after tax to retained earnings. Under- and over-provisions of tax are carried forward and written off to profit and loss account in the next financial year.

/ Now go to Resource 2
/ Now go to Resource 3

Reserves

/ Now go to Resource 4

Note the following:

Reserves are part of shareholders’ equity.
Reserves are created as a result of:

–prudent management practice

–the requirements of an accounting standard.

Prudent management practice

Note the accounting entries to create a reserve and to transfer profits from a reserve back to retained earnings.

/ Now go to Resource 5
This will help you to check your understanding.

Feedback to question 5.15

General journal

Details / Debit / Credit
$ / $
Retained earnings / 40000
General reserve / 40000
Amount set aside out of profit

Solution (above) is from Company Accounting, Woodford & Mills, LexisNexis Butterworths, 2005. Reproduced with permission.

Feedback to question 5.16

General journal

Details / Debit / Credit
$ / $
Dividend equalisation reserve / 60000
Retained earnings / 60000
Transfer of earnings

Solution (above) is from Company Accounting, Woodford & Mills, LexisNexis Butterworths, 2005. Reproduced with permission.

By transferring funds out of retained earnings, management may be providing for some unknown future contingency. The removal of the funds out of retained earnings may imply that those funds are not available for distribution to shareholders by way of dividends (see next section) and therefore the cash assets of the company are protected. Note, however, that the creation of a reserve does not mean that equivalent cash assets are available.

/ Now go to Resource 6

In example 2, note the effect of the entries on the retained earnings account and the shareholders’ equity.

Reserves created as a result of the requirements of an accounting standard

/ Now go to Resource 7

Our studies are limited to the revaluation of an asset and the possible future issue of bonus shares. Bonus shares are shares issued to existing shareholders free of charge. The issue will be based on the number of shares held,for example one bonus share for every five (one for five) already held. Be aware of the issue price of the share.

/ Now go to Resource 8
This will help you to check your progress.

Feedback to question 5.19

Generaljournal

Details / Debit / Credit
$ / $
Land and buildings / 1200000
Asset revaluation reserve / 1200000
Revaluation of land and buildings
Asset revaluation reserve / 500000
Share capital / 500000
Bonus issue of shares

Solution (above) is from Company Accounting, Woodford & Mills, LexisNexis Butterworths, 2005. Reproduced with permission.

/ Now go to Resource 9

Dividends

/ Now go to Resource 10

Note that usually (but not always) a company will pay two dividends a year: an interim dividend half-way through the company’s financial year and a final dividend after the end of the financial year.

Note that:

Dividends on ordinary shares are usually declared at so many cents per share. Some types of preference shares are paid at a fixed percentagerate.
The final dividend is proposed in one financial year and paid in the next financial year.
Dividends payable (sometimes called proposed final dividend) is a current liability in the balance sheet.
Both the interim dividend and the dividend payable are debited to retained earnings.

/ Now go to Resource 11

Dividend reinvestment schemes

/ Now go to Resource 12

Note the journal entries in the example.

Dividend reinvestment schemes are popular with some small shareholders as it allows them to build up their shareholding in a company without incurring brokerage charges. Instead of receiving cash for their dividends the shareholders receive additional shares.

/ Now go to Resource 13

Summary of items affecting the retained earnings or accumulated losses account

Retained earnings/Accumulated losses

Balance / xxxxxx / (a) / Balance / xxxxxx / (a)
Profit & loss
(Net loss-after tax) / xxxx / (b) / Profit & loss
(Net profit-after tax) / xxxx / (b)
Interim dividend / xxxx / Transfer from a reserve / xxxx
Dividend payable / xxxx
Transfer to a reserve / xxxx

Note:

(a)Balance brought down would be eithera debit or credit—not both.

(b)Net profit or loss after tax from the profit and loss account—not both.

/ Now go to Resource 14

Feedback to questions

The following solutions in this feedback section are from Company Accounting, Woodford & Mills, LexisNexis Butterworths, 2005. Reproduced with permission.

Question 5.6feedback

Details / Debit
$ / Credit
$
(a) / Tax payable / 700
Income tax expense / 700
(b) / Profit and loss / 48000
Income tax expense / 48000
(c) / Profit and loss / 112000
Retained earnings / 112000
(d) / Tax payable / 900
Overprovision of income tax / 900

Question 5.17feedback

(a)

General journal

Details / Debit / Credit
$ / $
Retained earnings / 200000
Dividend equalisation reserve / 200000
Amount transferred
General reserve / 100000
Retained earnings / 100000
Amount transferred

(b)

Retained earnings

Dividend equalisation reserve / 200000 / Balance b/d / 600000
Balance c/d / 500000 / General reserve / 100000
700000 / 700000
Balance b/d / 500000

(c)

Statement of shareholders’ equity

$
1000000 fully paid ordinary shares with an issue price of $1 / 1000000
General reserve / 100000
Dividend equalisation reserve / 200000
Retained earnings / 500000
Shareholders’ equity / 1800000

Question 5.23feedback

(a)

General journal

Details / Debit / Credit
$ / $
Accumulated depreciation – buildings / 40000
Land and buildings / 40000
Balance transferred prior to revaluation
Land and buildings / 240000
Asset revaluation reserve / 240000
Revaluation of land and buildings
Asset revaluation reserve / 80000
Share capital / 80000
1 for 5 bonus issue

(b)

(i)

Land and buildings

Balance / 400000 / Accumulated depreciation – buildings / 40000
Asset revaluation reserve / 240000 / Balance c/d / 600000
640000 / 640000
Balance b/d / 600000

(ii)

Asset revaluation reserve

Share capital / 80000 / Land and buildings / 240000
Balance c/d / 160000
240000 / 240000
Balance b/d / 160000

Question 5.27feedback

General journal

Date / Details / Debit / Credit
$ / $
20x4
Nov 30 / Interim dividend / 40000
Interim dividends payable / 40000
Interim dividend declared of $0.08 per share on500000 issued shares
20x5
Feb 15 / Interim dividends payable / 40000
Bank / 40000
Payment of dividend
Jun 30 / Retained earnings / 60000
Dividends payable / 60000
Proposed final dividend of $0.12 per share on500000 issued shares
Retained earnings / 40000
Interim dividend / 40000
Balance transferred
Aug 15 / Dividends payable / 60000
Bank / 60000
Payment of dividend

Question 5.28feedback

General journal

Date / Details / Debit / Credit
$ / $
20x8
Dec 15 / Interim preference dividend / 80000
Interim preference dividends payable / 80000
Interim dividend declared 4% × 2000000 as per directors’ resolution
20x9
Jan 1 / Interim preference dividend payable / 80000
Bank / 80000
Payment of interim dividend
Jun 30 / Retained earnings / 100000
Preference dividend payable / 100000
Proposed final dividend of 5% on 2000000 preference shares
Retained earnings / 80000
Interim preference dividend / 80000
Balance transferred
Aug 15 / Preference dividend payable / 100000
Bank / 100000
Payment of final dividend

Question 5.29feedback

General journal

Date / Details / Debit / Credit
$ / $
20x2
Jun 30 / Retained earnings / 60000
Dividends payable / 60000
Recommendation of 15 cents per share on400000 shares as per directors’ minute book
Aug 20 / Dividends payable / 60000
Share capital / 18000
Bank / 42000
Payment of dividend

Question 5.31feedback

(a)

General journal

Details / Debit / Credit
$ / $
Dividends payable / 50000
Share capital / 10500
Bank / 39500
Payment of dividend

(b)

Adjusted trial balance

$ / $
Share capital –207000* ordinary shares fully paid / 310500
Retained earnings / 80000
Bank / 100500
Other assets / 290000
390500 / 390500

Question 5.34feedback

Retained earnings/Accumulated losses account

20x0
Interim dividends / 9000 / Jul 1 / Balance b/d / 48964
Dividends payable / 13500 / Profit and loss account / 28535
General reserve / 20000
20x1
Jun 30 / Balance c/d / 34999
77499 / 77499
20x1
Jul 1 / Balance b/d / 34999

Question 5.35feedback

Retained earnings/Accumulated losses account

20x1
Jul 1 / Balance b/d / 17960 / Dividend equalisation reserve / 45000
Profit and loss account / 8100
Dividends payable / 6000
20x2
Jun 30 / Balance c/d / 12940
45000 / 45000
20x2
Jul 1 / Balance b/d / 12940

Question 5.37feedback

Profit and loss account

Income tax expense / 156000 / Balance b/d (Profit before tax) / 520000
Under-provision of income tax / 5000
Retained earnings/accum losses (Profit after tax) / 359000
520000 / 520000

Retained earnings/Accumulated losses account

Interim dividend paid / 12000 / Balance 1.7.20x5 / 430000
Dividends payable / 24000 / Profit and loss account / 359000
General reserve / 30000
Dividend equalisation reserve / 15000
Balance 30.6.20x6 / 708000
789000 / 789000
Balance 1.7.20x6 / 708000

Question 5.38feedback

Profit and loss account

Income tax expense / 60000 / Balance b/d (Profit before tax) / 200000
Under-provision of income tax / 6000
Retained earnings/accum losses (Profit after tax) / 134000
200000 / 200000

Retained earnings/Accumulated losses account

Interim dividend paid / 10000 / Balance 1.7.20x5 / 20000
Dividends payable / 15000 / Profit and loss account / 134000
General reserve / 27000
Dividend equalisation reserve / 15 000
Balance 30.6.20x6 / 87000
154000 / 154000
Balance 1.7.20x6 / 87000

Question 5.39feedback

Details / Debit$ / Credit$
1 / Profit and loss account / 50000
Retained earnings account / 50000
2 / Profit and loss / 1000
Under-provision of taxation / 1000
3 / Retained earnings account / 45000
General reserve / 45000
4 / Land and buildings / 400000
Asset revaluation reserve / 400000
Asset revaluation reserve / 400000
Share capital – ordinary shares / 400000
5 / Contingencies reserve / 10000
Retained earnings / 10000
6 / Retained earnings / 20000
Dividends payable / 20000
Interim dividend / 15000
Interim dividend payable / 15000
7 / ON PAYMENT
Interim dividends payable / 15000
Bank / 15000
AT YEAR END
Retained earnings account / 15000
Interim dividend / 15000
8 / General reserve / 350000
Share capital – ordinary shares / 350000
9 / Retained earnings account / 150000
Dividend equalisation reserve / 150000
10 / Profit and loss / 31000
Income tax expense / 31000
11 / Dividends payable / 70000
Bank / 70000

Movements in reserves and provisions including the effects of taxation1