📌 Prerequisites: Lesson 3 (Limited Companies — Share Capital)
must be completed first. You need to understand ordinary shares, preference shares,
debentures and the equity section of the SFP. This lesson focuses on how a company
records its profit — and how that profit is then distributed or retained.
1. How a Company's Income Statement Differs from a Sole Trader's
9706 / 3.2
The basic structure of a company's Income Statement is the same as a
sole trader's — Revenue minus Expenses equals Profit. However, three
additional items appear that are unique to limited companies:
1. Debenture Interest
A finance cost — charged as an expense in the
Income Statement before profit is calculated. Reduces profit for tax
purposes. Not an appropriation.
2. Corporation Tax
Tax on company profits — charged after operating profit
but before appropriation. A legal obligation — reduces profit
available to shareholders.
3. Appropriation of Profit
After tax, profit is distributed — dividends to shareholders
and transfers to reserves. The remainder is retained
earnings carried forward.
📌 The Critical Sequence: Revenue → Gross Profit →
Operating Profit → Less Debenture Interest → Profit Before Tax →
Less Corporation Tax → Profit After Tax → Appropriation
(Dividends + Transfers to Reserves + Retained Earnings).
This sequence must be followed exactly — Cambridge mark schemes
award marks for correct positioning of each item.
2. Full Format — Company Income Statement
Must Know
The proforma below shows the complete structure. Every company Income
Statement must follow this format. Learn the order — Cambridge examiners
deduct marks for items placed in the wrong position.
Income Statement — [Company Name]
for the year ended [Date]
TRADING SECTION$
Revenue (Sales)X
Less: Cost of Sales(X)
Gross ProfitX
OPERATING EXPENSES$
Distribution costs(X)
Administrative expenses(X)
Other operating expenses(X)
Operating ProfitX
FINANCE COSTS$
Debenture interest(X)
Profit Before TaxX
Corporation Tax(X)
Profit After Tax (Profit for the year)X
💡 Proforma ends here for the Income Statement.
The appropriation of profit (dividends, transfers to reserves, retained
earnings) is shown separately — either as a continuation called the
Statement of Changes in Equity or as a note. Cambridge questions
often ask you to prepare the appropriation section separately.
3. Corporation Tax
9706 / 3.2
Corporation tax is the tax a company pays on its profits. At A Level
you are given the tax figure — you do not need to calculate it yourself.
You simply need to know where it goes and how it is recorded.
Corporation Tax Treatment:
Charged in the Income Statement as an expense — after
operating profit and debenture interest
Creates a current liability in the SFP —
"Corporation Tax Payable" — until it is paid
When paid: DR Corporation Tax Payable | CR Bank
Unlike debenture interest, corporation tax is not
a finance cost — it is a separate line between profit before tax
and profit after tax
⚠️ Common Mistake: Students often place corporation tax
in the appropriation section after profit after tax. This is wrong.
Corporation tax is deducted before arriving at profit
after tax — it is not an appropriation of profit. It is a legal
obligation to the government, not a distribution to owners.
4. Appropriation of Profit
Core Topic
After corporation tax, the remaining profit after tax
is appropriated — divided between:
Profit After TaxStarting point
→
Preference DividendFixed % — paid first
→
Ordinary DividendVariable — directors decide
→
Transfer to ReserveOptional — General Reserve
→
Retained EarningsCarried forward
The Appropriation Section — Format
Appropriation of Profit — [Company Name] — Year ended [Date]
Ordinary dividend — final (proposed, not yet paid)(X)
Transfer to General Reserve(X)
Retained earnings carried forwardX
Interim vs Final Dividend:
An interim dividend is paid partway through the year —
it has already been paid in cash, so it is a debit to retained earnings
and credit to bank when paid. A final dividend is
proposed at the year end — it has NOT yet been paid, so it creates a
current liability (Dividends Payable) in the SFP
until paid.
5. Reserves — Types and Treatment
9706 / 3.2
A reserve is a portion of profits or other gains set
aside within the company. Understanding the difference between types of
reserve is essential for both Paper 1 and Paper 3.
Reserve
Source
Distributable?
Can be used for
Retained Earnings
Cumulative undistributed profits from trading
✅ Yes — can pay dividends
Dividends, bonus issue, general use
General Reserve
Transfer from retained earnings by directors' decision
✅ Yes — can pay dividends
Dividends, bonus issue, stability buffer
Share Premium
Excess received above nominal value on share issue
📌 The Key Rule: Only distributable reserves
(retained earnings and general reserve) can be used to pay dividends.
Non-distributable reserves protect creditors — they cannot be paid out
to shareholders. This is a heavily tested distinction in Paper 1.
💡 Transfer to General Reserve: When directors transfer
profit to the General Reserve, they are not spending money — they are
simply ringfencing part of the profit to prevent it from being paid
as a dividend in the near future. The General Reserve still belongs to
shareholders and can be used for dividends later.
6. Full Worked Example
Cambridge Style
📋 Example 1 — Complete Company Income Statement and Appropriation
The following information relates to Lahore Textile Plc
for the year ended 31 December 2026:
Cambridge sometimes asks you to prepare the Retained Earnings
Account (also called the Profit and Loss Account) as a T-account
rather than as an appropriation statement. The format is:
Retained Earnings Account
DR — Deductions
CR — Additions
Details
$
Preference dividend
X
Interim ordinary dividend
X
Final ordinary dividend
X
Transfer to General Reserve
X
Balance c/d (retained earnings c/f)
X
Total
X
Details
$
Balance b/d (retained earnings b/f)
X
Profit after tax
X
Total
X
💡 Interim vs Final Dividend — Timing matters:
The interim dividend was paid during the year — it was
debited to Retained Earnings and credited to Bank when paid. So it
appears on the DR side of the Retained Earnings Account.
The final dividend proposed at year end — debited to
Retained Earnings and credited to Dividends Payable (current
liability) — it has not yet left the bank. Both appear on the DR side
of Retained Earnings but the final dividend creates a liability, not
a bank payment yet.
8. Earnings Per Share (EPS)
Higher Level
Earnings Per Share (EPS) measures the profit attributable
to each ordinary share. It is one of the most widely used investor ratios
for evaluating company performance.
EPS Formula
EPS = Profit After Tax − Preference Dividend ÷ Number of Ordinary Shares in IssueResult expressed in cents per share (or pence, or the relevant currency unit)
📋 Example 2: EPS Calculation
Using Lahore Textile Plc from Example 1:
Profit after tax = $158,000
Less: Preference dividend = $40,000 Profit attributable to ordinary shareholders = $118,000
Ordinary shares in issue = 2,000,000 shares (assume)
EPS = $118,000 ÷ 2,000,000 = $0.059 per share = 5.9 cents per share
💡 Why deduct preference dividend?
Preference shareholders have a prior claim on profits — their fixed
dividend must be paid before ordinary shareholders benefit. EPS
measures what is available specifically to ordinary shareholders,
so preference dividends must be deducted first.
9. Memory Aids & Common Mistakes
🧠 Memory Aid — Company Income Statement Order
"GOFDPT — Appropriation" Gross Profit Operating Profit (after expenses) Finance costs (debenture interest) Dividend? No — Profit Before Tax Tax (corporation tax)
Then → Profit After Tax → Appropriation
🧠 Memory Aid — Distributable vs Non-Distributable
CAN pay dividends from: Retained Earnings · General Reserve CANNOT pay dividends from: Share Premium · Revaluation Reserve · Capital Redemption Reserve Shortcut: if it came from profits → distributable. If it came from a capital transaction → non-distributable.
⚠️ Mistake 1 — Debenture interest treated as appropriation:
Debenture interest is a finance cost — an expense in the
Income Statement. It reduces profit before tax. It is never placed in the
appropriation section after profit after tax. Dividends are appropriations —
debenture interest is not.
⚠️ Mistake 2 — Corporation tax placed after appropriation:
Corporation tax is deducted before arriving at profit
after tax. The appropriation section starts with profit after tax — by
that point, tax has already been deducted. Never show tax as a deduction
in the appropriation section.
⚠️ Mistake 3 — Final dividend shown as expense not liability:
A proposed final dividend that has not yet been paid is a
current liability in the SFP. It is debited to Retained
Earnings and credited to Dividends Payable. It is not debited to Bank
until it is actually paid.
⚠️ Mistake 4 — Including interim dividend in current liabilities:
The interim dividend was already paid during the year —
it has already left the bank. It appears in the appropriation section
reducing retained earnings but does not appear as a
current liability in the SFP. Only unpaid (proposed) dividends are liabilities.
⚠️ Mistake 5 — EPS calculated on total shares including preference:
EPS is calculated only on ordinary shares. The numerator
is profit after tax minus preference dividend. The
denominator is the number of ordinary shares in issue —
preference shares are never included in the EPS calculation.
📝 Exam Practice Questions
Question 1Knowledge — 2 marksPaper 1
Explain the difference between an interim dividend
and a final dividend, and state how each is treated
in the Statement of Financial Position at the year end.
An interim dividend is paid during the accounting
year — it has already been paid in cash by the year end. It therefore
does not appear as a liability in the SFP —
it has already reduced the bank balance and been debited to retained
earnings. (1 mark)
A final dividend is proposed by directors at the
end of the year but has not yet been paid. It is debited to retained
earnings and credited to Dividends Payable — a
current liability in the SFP — until it is paid
to shareholders. (1 mark)
Question 2Application — 8 marksPaper 3
The following information relates to Karachi Steel Plc
for the year ended 31 March 2026:
Item
$
Revenue
1,200,000
Cost of Sales
720,000
Distribution costs
95,000
Administrative expenses
65,000
10% Debentures $300,000
—
Corporation tax
62,000
6% Preference shares $400,000
—
Ordinary dividend — interim
18,000
Ordinary dividend — final (proposed)
32,000
Transfer to General Reserve
15,000
Retained earnings b/f
74,000
Prepare the Income Statement and
Appropriation of Profit for the year.
INCOME STATEMENT — Karachi Steel Plc
Year ended 31 March 2026
Revenue 1,200,000
Less: Cost of Sales (720,000)
Gross Profit 480,000
Distribution costs (95,000)
Administrative expenses (65,000)
Operating Profit 320,000
Debenture interest (10% × 300,000) (30,000)
Profit Before Tax 290,000
Corporation Tax (62,000) Profit After Tax 228,000
APPROPRIATION — Karachi Steel Plc
Profit after tax 228,000
Retained earnings b/f 74,000
Total available 302,000
Preference dividend (6% × 400,000) (24,000)
Ordinary dividend — interim (18,000)
Ordinary dividend — final (32,000)
Transfer to General Reserve (15,000) Retained earnings c/f 213,000
(4 marks Income Statement + 4 marks Appropriation)
Question 3Knowledge — 3 marksPaper 1
State three ways in which the Share Premium Account
may be used, and state whether it can be used to pay an ordinary dividend.
The Share Premium Account may be used for (any three — 1 mark each):
To fund a bonus issue of shares
(capitalising the reserve as share capital)
To write off share issue costs
(underwriting fees, legal costs of the share issue)
To write off preliminary expenses
(formation costs incurred when the company was incorporated)
To provide the premium on redemption
of preference shares
The Share Premium Account cannot be used to
pay an ordinary dividend — it is a non-distributable reserve.
Only distributable reserves (retained earnings and general reserve)
may be used to pay dividends.
Question 4Application — 3 marksPaper 1
Islamabad Holdings Plc has the following information for the year
ended 31 December 2026:
Profit after tax: $180,000
6% Preference shares of $1 each: $300,000 in issue
EPS:
$162,000 ÷ 4,000,000 = $0.0405 per share = 4.05 cents per share(1 mark)
Question 5Analysis — 4 marksPaper 3
Explain why corporation tax is treated as an
expense in the Income Statement rather than as an appropriation of
profit, and discuss one advantage and one disadvantage
of a company financing expansion through debentures
rather than a new share issue.
Corporation tax as expense: Corporation tax is
a legal obligation to the government — it must be paid regardless
of what the directors decide to do with the profit. It is not a
discretionary distribution to owners but a compulsory deduction.
An appropriation of profit implies a choice about how to use profit
— tax involves no such choice. Therefore it is treated as an expense,
reducing profit before the appropriation stage. (2 marks)
Advantage of debentures over share issue:
Debenture interest is a tax-deductible expense —
it reduces the company's taxable profit, giving an effective tax
saving. A dividend on new shares is not tax deductible. Additionally,
issuing debentures does not dilute the ownership or voting rights of
existing shareholders. (1 mark)
Disadvantage of debentures over share issue:
Debenture interest must be paid regardless of whether the company
makes a profit — it is a fixed commitment that increases financial
risk. In a poor trading year, a company with high debenture interest
may struggle to meet this obligation even when no dividend needs to
be paid to ordinary shareholders. (1 mark)