Understanding Profit, Directors loan and Dividends
As a bookkeeper to limited companies I often find myself explaining what a directors loan is, and how it fits into accounts and bookkeeping. If a person has never had a limited company why would they know the directors loan exists?
Ultimately a limited company is a separate legal entity from the person who created and registered the company. Any revenue created and invoiced in that company’ name belongs to that company. The money does not belong to the director of that company.
With the above in mind, in order to ensure that there is transparency of what is owed or owing to the company by the director(s) a ‘Directors Loan account’ exists within the company. This ‘account’ if managed correctly will help business owners understand the distinction between them as individuals and the limited company.
If the director uses that money for any kind of personal use, or makes a withdrawal from the company, those amounts sit in the company balance sheet as an asset to the company, or ‘owing’ to the company. Alternatively a director may put a cash investment into the company and this will show as a liability to the company or ‘owing’ to the director.
Regardless of the balance sitting in balance sheet as an asset, or liability, this account is known generally as the directors loan
A point to note is that I usually guide clients to make a payment at the end of the month as a wage, from their business bank account, and process this amount through their PAYE scheme, any other amounts will be recorded into their directors loan accounts.
So this includes small amounts if a director has gone to the supermarket and paid for food shopping in the home, or filled their car with petrol. Any business expense has to be ‘A fundamental rule of tax law is that a person carrying on a trade can only claim a deduction for an expense that is incurred ‘wholly and exclusively‘ for the purposes of the trade.
If an outgoing transaction in the business accounts does not fit this rule, it should be posted to the directors loan. Of course any revenue or true business expenses will be recorded as such and reported in the Profit and Loss figures. A director may have used personal funds to pay for a business expense as well, this will be recorded in the directors loan legitimate business cost and be included in the P&L. I usually set up a separate bank account in my bookkeeping and call it personal, this is deducted from any amount the director has withdrawn.
So at the end of a reporting period for a company, whether that be monthly quarterly or annually, there will be a figure in the balance sheet showing the amount a director either owes to the company or is owed.
Another means of taking money from the company is via dividends, these are paid from profits after taxation.
The key point here, is that this is after tax, dividends paid over and above the profit after tax are known as ‘illegal dividends’, and effectively means that the company needs to be paid back this amount. Having an understanding of your limited company profit position either current or projected can help avoid this situation.
So as a guideline, its is good business practice to know how much profit you are making before you take any drawings. And where possible only use your business account for business, keep personal costs to your personal account. Keep everything simple! Know your numbers!