How limited companies differ from sole traders

Once you are comfortable with sole-trader accounts, limited companies are the next step. The double entry is the same. But the ownership structure changes the capital section, adds an appropriation of profit, and brings new terms: shares, reserves, debentures and dividends.

Knowing why the accounts differ makes the layout easier to learn. It is not a fresh subject.

Ownership is divided into shares

A sole trader owns the whole business, and one capital account records their stake. A limited company is owned by shareholders, so its ownership is divided into shares.

Instead of one capital figure, the company shows share capital, the nominal value of the shares issued, as the base of its equity. Most other differences follow from this.

Keep two ideas apart. The nominal (or par) value is the fixed face value of each share, and it is what appears in the share capital line.

The market price is what an investor is willing to pay, which can be far higher. Anything paid above the nominal value goes into a separate reserve called share premium.

Separate legal identity and limited liability

A company is a separate legal person from its owners. Shareholders’ liability is limited to what they agreed to pay for their shares. A sole trader is not legally separate from the business and takes profit as drawings whenever they wish.

Because the company owns its profit, profit cannot leave informally. There are no drawings for a shareholder.

Any return to owners must be a declared dividend, decided by the directors and recorded in the appropriation of profit. The formality of company accounts mirrors the legal structure.

Ordinary and preference shares

Companies can issue more than one kind of share. Ordinary shareholders carry the main risk and reward. Their dividend varies with how well the company does, and it is paid only after other claims.

Preference shareholders usually receive a fixed rate of dividend, paid before ordinary shareholders. Both are owners, so both dividends are appropriations of profit, not expenses. This is easy to get wrong, because a fixed preference dividend can look like the fixed interest on a loan.

Profit is appropriated, not drawn

A company first calculates profit for the year, then appropriates it: some may go to reserves, some is paid as dividends, and the rest is retained.

Dividends are the company’s return to owners. They are an appropriation of profit, not an expense. This appropriation stage is new compared with a sole trader.

A worked mini-illustration

These figures are invented to show the shape of the appropriation. A company earns a profit for the year of RM90,000.

The directors transfer RM20,000 to a general reserve, pay a preference dividend of RM5,000 and an ordinary dividend of RM15,000, and retain the rest. Profit for the year RM90,000, less transfer to general reserve RM20,000, less dividends RM20,000, leaves RM50,000 added to retained earnings.

If retained earnings opened the year at RM30,000, they close at RM80,000. Nothing here changes the income statement.

The RM90,000 profit was settled before the appropriation began. The exercise decides where earned profit goes.

Reserves and retained earnings

Companies build up reserves.

• Retained earnings: accumulated profits kept in the business.
• General reserve: profit set aside at the directors’ discretion.
• Share premium: the amount received for shares above nominal value. It is a capital reserve and cannot be paid out as an ordinary dividend.

A sole trader has none of this. Their retained profit sits within capital.

Revenue reserves, such as retained earnings and the general reserve, come from trading profit and can fund dividends. Capital reserves, such as share premium, come from dealings with owners, not trading, and are protected from distribution as ordinary dividends. Questions often test which reserve can fund a dividend.

Borrowing through debentures

Companies often raise long-term finance by issuing debentures: loans that pay a fixed rate of interest. Debenture interest is an expense, charged before profit for the year, because debenture holders are lenders, not owners.

Dividends to shareholders come after profit. Keeping the two apart is a common exam test.

Ask of every payment: is this person an owner or a lender? A lender is owed interest whether or not the company makes a profit, so interest is an expense.

An owner receives a dividend only when profit exists and the directors declare one. A fixed preference dividend still belongs with the owners’ appropriations, because a preference shareholder is an owner.

The equity section of the statement of financial position

A sole trader’s capital section ends in closing capital. A company lists share capital, share premium, general reserve and retained earnings under shareholders’ equity.

Debentures appear separately as a non-current liability. Assets and other liabilities look much the same.

What stays exactly the same

The trading section, expenses, depreciation, accruals, prepayments and double entry are identical. A company’s income statement down to profit for the year works like a sole trader’s. Only the appropriation and the equity section are new.

How to learn it

Prepare a company income statement with its appropriation, then its statement of financial position, and compare them with a sole trader’s. Spend most of your effort on the appropriation and the equity section, where the real differences lie.

When you check an answer, run down the equity section and ask where each figure came from. This quickly exposes any confusion between reserves, dividends and interest.

If company accounts feel like a big jump, one of our teachers can bridge from sole-trader accounts to companies, focusing on the appropriation and equity sections. Book a trial class to get started.

Syllabus reference: Cambridge 0452 and 0985, syllabus for 2027 to 2029, sub-topic 5.3 Limited companies (page 16).