Financial Accounting Textbook

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Abridged table of contents
Chapter 1 Accounting in context
Chapter 2 The purpose of accounting
Chapter 3 The practice of accounting
Chapter 4 The conceptual framework
Chapter 5 Adjustments
Chapter 6 Inventory
Chapter 7 Value added tax (VAT)
Chapter 8 Bank reconciliation statements
Chapter 9 Introducing credit: Trade payables
Chapter 10 The other side of credit: Trade receivables and working
capital management
Chapter 11 Property, plant and equipment
Chapter 12 Companies
Chapter 13 Partnerships, and a brief note on close corporations
(CCs)
Chapter 14 Statement of cash flows
Chapter 15 Financial analysis
Chapter 16 Non-profit organisations and club accounting
Chapter 17 Incomplete records and other accounting issues
PART A: INCOMPLETE RECORDS
PART B: OTHER ACCOUNTING ISSUES
Contents
About the authors and contributors
Preface
1 Accounting in context
Learning objectives
1.1 De nition of accounting
1.2 First: A bit of history
1.2.1 The rst accounting records
1.2.2 Who was responsible for the creation of the double
entry system?
1.2.3 What is this book about?
1.3 Demystifying the jargon
1.4 The environment of accounting
1.4.1 The purpose of an economic system
1.4.2 Money as a unit of exchange
1.4.3 The nancial system
1.5 Business organisations
1.5.1 Classi cation of business by activity
1.5.2 Setting up a business
1.5.3 Operating a business
1.6 The purpose of accounting
1.6.1 Why is it necessary to create a record of transactions
in a business?
1.6.2 Who are the economic decision-makers, and what
decisions do they need to make?
1.6.3 What information will assist people in making
economic decisions?
1.6.4 How is nancial information communicated?
What have we learnt in this chapter?
What’s next?
2 The purpose of accounting

Learning objectives
2.1 Key nancial decisions
2.1.1 Financing decisions
2.1.2 Investing decisions
2.1.3 Operating decisions
2.1.4 Distribution decisions
2.2 Understanding the statement of nancial position
2.2.1 Understanding more about assets
2.2.2 Understanding more about liabilities
2.2.3 Understanding more about equity
2.3 Understanding pro t or loss and comprehensive
income
2.3.1 Income and expenses
2.3.2 Understanding accrual
2.3.3 Understanding pro t
2.4 An introduction to statement of changes in equity
2.5 Understand the statement of cash ows
What’s next?
Questions
3 The practice of accounting

Learning objectives
3.1 The accounting equation in more detail
3.2 The double entry principle
3.3 What are source documents?
3.3.1 Deposit slip
3.3.2 Loan application
3.3.3 Cheques
3.3.4 Internet banking
3.3.5 Cash receipt
3.3.6 Credit sales/credit purchases invoice
3.4 Journal entry
3.5 Recording information in the general ledger
3.5.1 What is the general ledger?
3.6 Extracting a trial balance
3.7 Closing entries
3.8 Reviewing the accounting cycle
3.8.1 Source documents
3.8.2 Journal entries
3.8.3 General ledger
3.8.4 Trial balance
3.8.5 Financial statements
3.9 How do specialised journals form part of the
accounting cycle?
3.9.1 Cash Receipts journal
3.9.2 Cash Payments journal
3.9.3 Purchases journal
3.9.4 Sales journal
3.10 Pulling it all together
What’s next?
Questions
4 The conceptual framework

Learning objectives
4.1 Generally accepted accounting practice
4.2 The objective of nancial reporting
4.2.1 Who are the primary users of nancial statements?
4.2.2 Who else would be interested in the nancial
statements?
4.2.2.1 Customers
4.2.2.2 South African Revenue Services (SARS)
4.2.2.3 Employees
4.3 The going concern assumption
4.4 Qualitative characteristics of useful nancial
information
4.4.1 Fundamental qualitative characteristics
4.4.1.1 Relevance
4.4.1.2 Faithful representation
4.4.2 Enhancing qualitative characteristics
4.4.2.1 Comparability
4.4.2.2 Timeliness
4.4.2.3 Veri ability
4.4.2.4 Understandability
4.4.3 Will nancial information always have all of the
enhancing qualitative characteristics?
4.5 Elements of the nancial statements
4.5.1 Assets
4.5.2 Liabilities
4.5.3 Equity
4.6 Recognition criteria for the elements
4.7 Derecognition of assets and liabilities
4.8 Measurement bases
4.8.1 Historical cost measurement
4.8.2 Current value measurement
4.8.2.1 Fair value
4.8.2.2 Value in use (assets) and ful llment values
(liabilities)
4.8.2.3 Current cost
4.8.3 Deciding which measurement base to use when
initially recognising an asset
4.8.4 Subsequent measurement
4.9 The accrual concept
What’s next?
Questions
5 Adjustments
Learning objectives
5.1 Processing adjusting entries
5.1.1 The accounting process
5.2 Closing entries
5.3 Understanding adjusting entries
5.3.1 Accrued expenses
5.3.2 Prepaid expenses
5.3.3 Income accrued
5.3.4 Income received in advance
5.3.5 Depreciation
5.3.6 Bad debts
5.3.7 Allowance for doubtful debts
5.4 Let’s pull it all together
5.5 Reversal of adjusting journal entries
5.5.1 Reversals for prepaid expenses
5.5.2 Reversals for accrued expenses
5.5.3 Reversals for income received in advance and
accrued interest
What’s next?
Questions
6 Inventory
Learning objectives
6.1 What is inventory?
6.1.1 De nition of inventory
6.1.2 Why is inventory an asset?
6.1.3 When is inventory recognised as an asset?
6.2 Calculating the cost at initial recognition
6.2.1 De nition of “cost of inventory”
6.2.2 So what is included in the cost of inventory?
6.2.3 The impact of trade discount and settlement
discount on the cost of inventory
6.3 Recording inventory in the general ledger
6.3.1 Inventory recording systems: perpetual versus
periodic
6.3.2 Recording inventory transactions in the general
ledger
6.4 Cost allocation methods − subsequent measurement
of inventory
6.4.1 The FIFO cost allocation method
6.4.2 The weighted average cost allocation method
6.4.3 Cost allocation methods − sales returns
6.4.4 Cost allocation methods − purchase returns
6.5 De-recognition of inventory
6.6 Disclosure of inventory in the nancial statements
6.7 Selling price and cost price in more detail
6.7.1 Understanding the difference between the stated
mark-up and the actual gross pro t
6.7.2 Determining the selling price
What’s next?
Questions
7 Value added tax (VAT)

Learning objectives
7.1 What is VAT?
7.1.1 Tax invoice
7.2 When does a business register as a VAT vendor?
7.3 How is VAT calculated?
7.4 How does the VAT system work?
7.5 Is VAT another tax that my business must pay?
7.6 How does VAT affect the records of a business?
7.7 Recording VAT
7.7.1 The general journal
7.7.2 The general ledger
7.7.3 The trial balance
7.7.4 Statement of comprehensive income for the year
ended 31 January X1
7.7.5 Statement of nancial position as at 31 January X1
7.8 VAT and inventory
7.8.1 VAT and the perpetual system
7.8.2 VAT and the periodic system
What’s next?
Useful web sites
Questions
8 Bank reconciliation statements

Learning objectives
8.1 Understanding the bank statement
8.1.1 What is the bank statement, and what does it look
like?
8.1.2 An example of how transactions are recorded in the
general ledger and on the bank statement
8.2 Understanding the bank reconciliation process
8.2.1 Timing (reconciling) and adjusting differences
8.2.2 Identifying reconciling and adjusting items, and
understanding why these differences occur
8.2.3 Preparing a bank reconciliation
8.3 What is the purpose of doing a bank reconciliation?
8.4 Another example
What’s next?
Questions
9 Introducing credit: Trade payables

Learning objectives
9.1 Looking at credit purchases
9.1.1 How do we record credit transactions?
9.1.2 Recording credit purchases in the general ledger
9.2 Why would a business purchase on credit?
9.3 Source documents relating to credit sales
9.4 How do we record credit transactions?
9.4.1 Why would Jason want information about individual
creditors?
9.4.2 Recording credit transactions in specialised journals
9.4.3 Creditors or trade payables subsidiary ledger
9.4.4 A worked example: Journals, ledger and subsidiary
ledger
9.4.5 What about VAT?
9.4.6 Summarising the transaction ow
9.5 Controlling trade payables
9.5.1 Trade payables subsidiary ledger
9.6 Creditor reconciliation
9.6.1 The creditors’ reconciliation process
9.6.2 How do we prepare a creditors’ reconciliation
statement?
9.6.3 Preparing a remittance advice
What’s next?
Questions
10 The other side of credit: Trade receivables and working capital

management
Learning objectives
10.1 Looking at credit sales
10.2 Why would a business sell on credit?
10.4 Recording credit sales
10.4.1 Why would Jason want information about individual
debtors?
10.4.2 Recording credit transactions in specialised journals
10.4.3 A worked example
10.4.4 Trade receivables subsidiary ledger
10.4.6 Summarising the transaction ow
10.5 Working capital management
10.5.1 What is working capital?
10.5.2 Why is working capital management important?
10.5.3 The nancing of working capital
10.5.4 Managing the various components of net working
capital
What’s next?
Questions
11 Property, plant and equipment

Learning objectives
11.1 What does the term “property, plant and equipment”
mean?
11.1.1 Uses of property, plant and equipment
11.1.2 Classifying assets as inventory or property, plant and
equipment
11.2 Initial recognition of property, plant and equipment
11.2.1 When is property, plant and equipment recognised?
11.2.2 At what amount do we initially recognise property,
plant and equipment?
11.2.3 Record the purchase of property, plant and
equipment?
11.3 Decrease in the carrying value of property, plant and
equipment owing to use of the asset
11.3.1 Depreciation
11.4 Treatment of subsequent expenditure on property,
plant and equipment
11.4.1 When subsequent expenditure is an expense
11.4.2 Recognising subsequent expenditure as an asset
(capitalised)
11.5 How to measure property, plant and equipment
11.5.1 Impairment of property, plant and equipment
11.5.2 Increases in value of property, plant and equipment
after acquisition
11.6 Integrated examples
11.6.1 Combining the concepts of revaluation, impairment,
subsequent expenditure and depreciation
11.6.2 Combining revaluation and depreciation
11.6.3 Depreciable amount and carrying value
11.7 Disposing of an item of property, plant and
equipment
11.7.1 Pro t or loss on sale
11.7.2 Recording a disposal of property, plant and
equipment
11.8 Disclosure requirements for property, plant and
equipment
11.8.1 Depreciation methods and rates
11.8.2 How property, plant and equipment is measured
11.8.3 The breakdown of the carrying value
11.8.4 Reconciliation of the carrying value at the beginning
of the year to the carrying value at the end of the
year
11.8.5 Additional information for the revaluation model
11.8.6 Impairment expense
11.8.7 Non-current asset
11.8.8 Final word on disclosure requirements
11.9 Change in estimate
11.9.1 Depreciation calculation for a change in estimate
11.9.2 Disclosure requirements for a change in estimate
11.10 Control of property, plant and equipment
11.11 Investment property
What’s next?
Questions
12 Companies
Learning objectives
12.1 Expanding the business
12.2 What is a company?
12.2.1 A company is a separate legal person from its
shareholders
12.3 Companies and the law
12.3.1 Who administers the Companies Act?
12.3.2 Incorporation of a company
12.4 Different types of pro t companies
12.4.1 Private company
12.4.2 Public company
12.4.3 Comparison of private and public companies
12.4.4 A personal liability company
12.4.5 State-owned company
12.5 Legal requirements for the formation of a company
12.5.1 Setting up a new company
12.5.2 Legal powers of a company
12.6 Share capital of a company
12.6.1 Raising equity
12.6.2 Rights of shareholders
12.6.3 Shares and share certi cates
12.6.4 Recording a share issue
12.6.5 Share issues other than to the general public
12.7 Dividends
12.7.1 Dividends − what are they?
12.7.2 Right to a dividend
12.7.3 Dividend policy and the capital structure
12.7.4 Recording a Class A dividend in the general ledger
12.7.5 Capitalisation shares − issued as payment of a
dividend
12.8 Shares with a xed dividend (preference shares)
12.8.1 Recording the issue of shares with a xed
distribution
12.8.2 Recording a xed dividend in the general ledger
12.8.3 What type of rights could shares with a xed
distribution rate have?
12.9 Company taxes
12.9.1 Normal tax
12.9.2 Dividend tax
12.9.3 VAT
12.9.4 Capital gains tax
12.10 Reserves
12.11 Capital maintenance
12.11.1 Reduction of share capital − share buy-backs
12.11.2 Why would a company buy back shares?
12.12 Statement of changes in equity
12.13 Financial statements for a public company
12.14 Debt and gearing
12.14.1 Debentures
12.14.2 Recording the issue of debentures
12.15 Requirements for annual nancial statements (AFS)
12.15.1 Objective of nancial reporting
12.15.2 Bene ts of good nancial reporting
12.15.3 Need for differential reporting
12.15.4 Types of reporting frameworks
12.15.5 Legal requirements for preparation and audit of
nancial statements
12.16 Corporate governance
12.16.1 What is King IV?
12.16.2 What is integrated reporting?
12.16.3 What is integrated thinking?
What’s next?
Questions
13 Partnerships, and a brief note on close corporations (CCs)

Learning objectives
13.1 Partnerships
13.1.1 Some important terms in respect of partnerships
13.1.2 Advantages and disadvantages of partnerships
13.1.3 Formation of a partnership
13.1.4 Accounting principles for partnerships
13.1.5 Differences that occur when recording information for
a partnership
13.2 Close corporations
13.2.1 Accounting for transactions in a close corporation
What’s next?
Questions
14 Statement of cash flows
Learning objectives
14.1 An introduction to the statement of cash ows
14.1.1 Pro t calculation versus cash ow
14.1.2 The difference between accrual and cash
transactions
14.2 What is a statement of cash ows?
14.3 When should a statement of cash ows be
prepared?
14.4 The purpose of the statement of cash ows
14.5 What information does a statement of cash ows
present?
14.6 How is the information presented in the statement of
cash ows?
14.6.1 Operating activities
14.6.2 Investing activities
14.6.3 Financing activities
14.6.4 Direct and indirect methods of reporting cash ows
14.7 What does the statement of cash ows look like?
14.7.1 The direct method
14.7.2 The indirect method
14.8 Preparing the statement of cash ows
14.8.1 How do we go about identifying cash ows that
occurred during the year?
14.8.2 A simple worked example
14.8.3 Cash from operations on the direct and indirect
method
14.8.4 Cash ows from operating activities, investing
activities and nancing activities
14.8.5 Cash from operating activities in more detail
14.8.6 Cash from investing activities in more detail
14.8.7 Cash from nancing activities in more detail
What’s next?
Useful web links
Diagram summarising the statement of cash ows
Questions
15 Financial analysis
Learning objectives
15.1 What is nancial analysis?
15.2 The purpose of nancial analysis
15.3 Who uses nancial analysis?
15.4 Understanding a bit about risk
15.4.1 So what do we mean by the term “risk”?
15.4.2 Some of the risks affecting business operations
15.5 Using nancial analysis to evaluate the business
15.5.1 Comparability
15.6 Financial ratios
15.6.1 Do you know how to express a ratio?
15.6.2 Liquidity
15.6.3 Asset management
15.6.4 Debt management
15.6.5 Pro tability
15.6.6 Du Pont analysis
15.6.7 Market ratios
15.7 Conducting the analysis
15.7.1 Liquidity
15.7.2 Asset management (ef ciency) ratios
15.7.3 Debt ratios ( nancial leverage)
15.7.4 Pro tability ratios
15.7.6 Summary of ratios
15.7.7 What do the ratios reveal?
15.8 The bene ts of nancial analysis
15.8.1 Internal evaluation
15.8.2 External evaluation
15.9 Limitations of nancial analysis
What’s next?
Questions
16 Non-profit organisations and club accounting

Learning objectives
16.1 What are non-pro t organisations?
16.2 How are non-pro t organisations regulated?
16.3 What accounting rules govern non-pro t
organisations?
16.4 What rules govern the formation of non-pro t
organisations?
16.5 Accounting for non-pro t organisations
16.5.1 What nancial activities should be performed in the
business?
16.5.2 What reports do non-pro t organisations compile?
16.5.3 What do these reports look like?
16.5.4 Discussion of new terminology
16.5.5 Accounting for subscriptions
16.5.6 Accounting for income-producing activities
16.5.7 Accounting for sponsorships, grants and donations
16.6 Preparing the nancial statements for a club
16.7 Summary of special funds
16.8 Considering coupons
16.8.1 What are coupons?
16.8.2 How are coupons managed?
16.8.3 Accounting for coupons
What’s next?
Questions
17 Incomplete records and other accounting issues

Learning objectives (Part A)
17.1 Why do some businesses have incomplete records?
17.2 A case study with incomplete records
17.3 Approach to an incomplete records problem
17.4 Applying the approach
17.4.1 Items on the statement of comprehensive income
17.4.2 Items on the statement of nancial position

Learning objectives (Part B)
17.5 Business plans
17.6 Internal controls
17.6.1 Internal control techniques
17.6.2 Risks of the business: choosing and using internal
controls
17.7 Computerisation of the accounting records of a small
business
17.8 Budgeting
17.8.1 Functions of the budget
17.8.2 Budgeting process
17.8.3 Advantages of budgeting
17.8.4 Weaknesses of the budgeting system
17.8.5 Budgeting in different organisations
17.9 Management accounting
17.9.1 Information needs of management
Questions
Key concepts
Index
Jacqui Kew is an associate professor in the College of Accounting at
the University of Cape Town, where she co-ordinates the first-year
accounting course. She also lectures at the University of Cape
Town’s Graduate School of Business, where she specialises in
finance for non-financial managers and small business development.
She is a member of the South African Global Entrepreneurship
Monitor team and in this capacity is actively involved in small
business research. She is also the co-author of Tracking
Entrepreneurship in South Africa: A GEM Perspective.
Alex Watson, the original content editor, is a professor in the College

of Accounting at the University of Cape Town. She is a former
chairperson of the Accounting Practices Committee of SAICA and a
former member of the Accounting Practices Board. She is an
independent director of Coronation Funds Managers Ltd.
Carla Fourie is a senior lecturer in the College of Accounting at the
University of Cape Town.
The authors would like to thank all the contributors to the previous
editions of Financial Accounting: An Introduction for their
contribution: Carmen Mettler, Tracey Walker, Stefan Bezuidenhout,
Riley Carpenter and Birte Schneider.

Preface
South Africa is an exciting, developing economy that needs
informed business people within corporate businesses, in
government and as entrepreneurs. In order to shape informed
people, literacy (and more specifically, financial literacy) is of
fundamental importance. The first step in becoming financially
literate is to develop an understanding of the language of business.
Through work done with numerous small businesses and in
conversations with successful and not-as-successful business
owners, a common trend tends to emerge. Many individuals have
indicated that within South Africa there is a widespread lack of basic
business and accounting knowledge. As educationalists and
business advisors, we believe that making this knowledge accessible
and non-threatening to first-time accounting students is vital –
regardless of whether these students are at school or university, or
embarking on their first business venture.
Accounting is the language of business, and the first edition of
Financial Accounting: An Introduction developed from the belief that
learning to understand the language of accounting empowers
business owners, managers and individuals to take control of their
own financial destiny. By understanding accounting you will be able
to understand the story it tells about a business. This understanding
will enable you to identify what business owners and managers are
doing correctly and pick up warning signals regarding those areas in
the business where things could be going wrong. As a financially
literate citizen you will be able to participate more fully in the

economy and be more active in ensuring that you are financially
secure.
Learning is a journey of discovery and comes from doing, from
identifying and solving problems, and from making and learning
from mistakes. Every journey starts with the first step and we hope
that this fifth edition of Financial Accounting: An Introduction is the
first of many steps that you will take in your journey to becoming
financially literate. Join us as we take you on this journey into the
world of accounting. We trust that you will learn, question and enjoy
the experience as your knowledge of accounting improves.
The Authors
November 2018
How to use the “Something to Watch”
feature
The LearnAccounting website offers a suite of 100 concept-based
videos. Each concept selected is a concept that students struggle to
grasp and that can prevent them from progressing in their studies.
Students are able to watch, and re-watch, each video until they feel
confident that they understand the concept. Carefully selected
graphics serve to reinforce concepts while also assisting those who
learn best from visual images.
All the videos are in English. To assist students whose mother
tongue is not English, 68 videos focusing on concepts generally
introduced within the first 2 years of a commerce degree are
currently available in isiXhosa, isiZulu, Xitsonga and Sesotho.
Watching a video in both English and a students’ mother tongue
allows students the opportunity to develop a deeper understanding
of the concept as they can listen to the content without the
distraction of the nuances inherent in the English language acting as
a distraction.
The videos are available at http://learnaccounting.uct.ac.za. Once
students have registered (for free), videos on Financial Reporting,
Management Accounting, Financial Management, Taxation,
Corporate Governance/Auditing and Financial Skills are available
and within each subject area Basic, Intermediate and Advanced
videos are available. Basic videos refer to concepts covered in first
year studies; Intermediate in second year studies and Advanced
refers to concepts covered in the third and fourth year of studies.

Each video has a short description that highlights the key concept or
principle covered in that video.
The authors of Financial Accounting: An Introduction, co-ordinated
the LearnAccounting project and have integrated the videos into the
book on a chapter-by-chapter basis.
Something to watch 2
www.learnaccounting.uct.ac.za
Go and watch The Accounting Equation–Part 2: This video explains the
relationship between assets, equity and liabilities, with a focus on equity.
The videos supplement the explanations in the textbook and offer
students an additional resource to assist them in their accounting
journey.
1 Accounting in
context
Learning objectives
By the end of this chapter, you will be able to:
• Demonstrate an understanding of the general business and accounting
environment
• Identify different business entities
• Identify the need for and objective of accounting.
Have a look at the following images. What messages do you get
from them? Write down the thoughts that come to you as you
look at each one, noting similarities and differences in what the
illustrations are trying to communicate.
[All logos and visuals used with the permission of Pick n Pay.]
Integrated Reporting
The integrated annual report is our primary report to stakeholders. It is principally
aimed at the providers of financial capital, being our shareholders and debt
providers, however, it considers the information needs of our broad and diverse
range of stakeholders, including customers, suppliers, franchise partners,
employees and wider community groups. We believe this report provides our
stakeholders with an improved understanding of our business, including how the
Group creates value, and insight into how our strategy is focused on sustainable
value creation in the short, medium and long term.
We have adopted the International Integrated Reporting <IR> Framework (the
framework) of the International Integrated Reporting Council (IIRC) which provides
an international standard for integrated reporting that enables companies globally
to demonstrate, in a comparable manner, how they create value. We have also
applied the principles outlined in the King Code of Governance Principles (King Ill)
in South Africa. The group is in full support of the voluntary principles and leading
practices of King IV, which become effective for the Group during the 2019
financial period.
Summarised financial statements from the 2017 Annual Report for
Pick n Pay Stores Limited (now Pick n Pay) and its subsidiaries
appear on pages 3–6.

Source: Excerpts from Pick n Pay Stores Annual Report 2016 used with
the permission of Pick n Pay.

The annual financial statements communicate a message about a
business to someone interested in receiving the message, in this case,
you.
What do the financial statements communicate?
• How well the business has done
• The current financial position of the business

• The financial prospects of the business
• The cash used and generated in the business
• The profit earned in the business
• The value of assets, liabilities and equity at a point in time
• Performance.
This book is going to help you understand the information
communicated by the financial reports of a business. In order to
understand the financial reports of a business, you will need to
know something about accounting.
1.1 Definition of accounting

Accounting is a system that communicates the financial effects of all
the decisions made by a business. Business decisions result in the
production of something of a product, such as a can of cooldrink, or
a service, such as a haircut for someone who wants it. Accounting
places a financial measurement on the decisions which is transmitted
through the financial report to interested parties who use the
financial information to make economic decisions. The users of
financial reports could be anyone who has an interest in the effects
of decisions made in the business.
This book looks at a particular business to help you understand
how events, called transactions, are transformed through the
accounting process into a meaningful message. This is the story of
accounting.

1.2.1 The first accounting records
In Suhag province in Egypt, clay tablets were recently unearthed
from the tomb of an Egyptian king, Scorpion I, and reveal what is
believed to be the oldest discovered evidence of writing. German
archaeologists have placed the origin of the tablets at somewhere
between 3300 BCE and 3200 BCE. More than two thirds of the
translated hieroglyphic writing is tax accounting records.
Most of the writings were accounts of linen and oil delivered to
King Scorpion I in taxes, short notes, numbers, and lists of kings’
names and institutions.
So, five thousand years before the appearance of the double entry
system, which is an organised system for recording accounting
transactions, civilisations were flourishing in the Mesopotamian
Valley, and producing some of the oldest known records of
commerce.
The Mesopotamian equivalent of today’s accountant was the
scribe. His duties were similar, but even more extensive. In addition
to writing up the transaction, he ensured that the agreements
complied with the detailed code requirements for commercial
transactions. The temples, palaces and private firms employed
hundreds of scribes, and it was considered a prestigious profession.
Governments and individuals with large stored wealth needed to
keep detailed records of receipts and payments for taxes and for
assets managed on behalf of the wealthy individuals. The job of the
ancient accountants was extraordinarily difficult, because they
worked in societies where nearly all the people were illiterate,
writing materials were costly, and working with numbers was
tedious and difficult. A transaction had to be very important to
justify keeping an accounting record.
What led to the creation of accounting as an organised system of

recording events?
The rise of the double entry system of recording was the result of the
following key elements:
• Private property: the power to change ownership
• Capital: wealth productively employed
• Commerce: the widespread interchange of goods
• Credit: having the use of something immediately, but paying for it
later
• Writing: a mechanism for making a permanent record in a
common language, given the limits of human memory
• Money: the “medium” for exchanges that enabled transactions to
be reduced to a set of monetary values, and
• Arithmetic: a means of computing the monetary effects of
transactions.
Who were the first people to use the accounting system that is still
currently in use?
The Italians of the Renaissance (14th to 16th centuries) are called the
fathers of modern accounting. They revitalised trade and commerce
and actively sought better ways of keeping financial records.
The Italians were the first to track business accounts and kept
extensive business records as the use of capital and credit expanded.
1.2.2 Who was responsible for the creation of the

double entry system?
Luca Pacioli, born 1445, wrote a book on accounting called Summa de
Arithmetica, a book that earned him the title of “Father of
Accounting”. In his book he applied mathematics to trade in
Renaissance society. The method he created was an application of
Arabic algebra, and this new number system made a lot more
recording possible, and became known as the Venetian method. It is

now known as the double entry system. Pacioli was the first person
to write about the new system that had been evolving for almost two
centuries, and was widely used by Venetian business people
(merchants).
This work by Pacioli is now the universal standard for accounting
in the Western world. Known as the double entry system, it has been
used to record almost every commercial transaction in the last 500
years. It is amazing that this simple system for recording and
summarising transactions has been around for more than 500 years
and that it still works!

The aim of this book is to make you understand the double entry
system and how it works, by recording the day-to-day transactions
of a particular business. You will learn how to use the system to tell
the accounting story of a business. The book will also look at how
information is reported, so that the information is useful in making
economic decisions.

Accounting, like any subject, uses terminology that distinguishes its
principles and practice from that of other disciplines. Once you
understand the language of accounting and finance, you can use it as
a tool for understanding and communicating economic events.
However, before you begin to understand accounting, you need
to understand the world within which accounting is used. Once you
have an understanding of this environment, you will be able to
identify the need for an accounting system and the information
required by the accounting system.

Let us begin by listing some of the new words that you may
encounter in your exposure to the environment of commerce:
economy finance
market cost
business accounting
risk disclosure
profit
How would you begin to explain each of the words listed above?
Here are some of the tools you could use:
• Your own experience
• An English or business dictionary
• The Internet
• A professional who has studied finance or accounting
• The owner or manager of a business
• A textbook about finance or accounting.
We will use each of these tools to discover the meaning of the words
listed above. Before you read the results of our inquiry, write down
what you think each word means. If you have access to any of the
sources mentioned above, use them to help you develop your own
definitions.
This is what our sources say about them:
Economy
• English dictionary: “community’s system of wealth creation”
• Business dictionary: doesn’t list “economy”!
• Internet: “a set of interrelated economic production and
consumption activities”
• Director of a professional services company: “the sum of all business,
markets and trade embarked on by government and individuals
in a country”
• Textbook on finance: “the environment within which economic
activity takes place”.
Market
• English dictionary: “gathering for sale of commodities, livestock,
etc./demand for commodity/place or group providing such
demand/conditions for buying and selling/stock market”
• Business dictionary: “the arena in which buyers and sellers meet to
exchange items of value”
• Internet: “1. Typically refers to the equity market where stocks are
traded, but can also refer to the bond, options, or commodity
market. 2. People with the desire and ability to buy a specific
product”
• Director of a professional services company: a place where goods and
services are traded on an arm’s-length basis”
• Textbook on finance: system in which companies operate”.
Business
• English dictionary: “one’s occupation or profession/buying and
selling”
• Business dictionary: “the activities of an entity”
• Internet: “A firm, occupation, trade or profession. Any of the
various operations or details of trade, or industry”
• Director of a professional services company: “an entity that uses
resources, whether natural or human, to create value and in so
doing, make a profit”
• Textbook on finance: “activity classified as service, merchandising,
extractive or manufacturing”.
Risk
• English dictionary: “chance of danger, injury, loss/exposure to
this”
• Business dictionary: “the possibility of suffering some loss or
damage”
• Internet: “The chance that an investment’s actual return will be
different from what is expected. This includes the possibility of
losing some or all of the original investment. Usually measured
using historical returns or average returns.”
• Director of a professional services company: “the chance that
something may go wrong”
• Textbook on finance: “a potential hazard or the possibility of an
unfortunate outcome resulting from a given action”.
Profit
• English dictionary: “advantage, benefit/financial gain; excess of
returns over outlays”
• Business dictionary: “for a single transaction, the excess of the
selling price of the article or service being sold over the costs of
providing it; for a period of trading, the surplus of net assets at
the end of a period over the net assets at the start of that period”
• Internet: “the same as net income, the company’s total earnings,
calculated by subtracting expenses, interest, taxes, and
depreciation from revenues”
• Director of a professional services company: “income less expenditure,
not cash”
• Textbook on finance: “income less expenditure for a given period”.
Finance
• English dictionary: “management of money/monetary support for
enterprise/money resources”
Business dictionary: “the process of managing money/the capital
•
involved in a project”
• Internet: “the science that describes the management of money,
banking, credit, investments, and assets”
• Director of a professional services company: “Funding, whether
external or internal, which is beneficial only if the return created
by the business as a result of the funding is greater than the cost
of the finance”
• Textbook on finance: “funds raised for investment purposes”.
Cost
• English dictionary: “price, loss, sacrifice”
• Business dictionary: “an expenditure, usually of money, for the
purchase of goods or services or the amount incurred in achieving
a goal”
• Internet: “an expense that reflects the cost of the product or goods
that generate revenue for a company”
• Director of a professional services company: “the inputs to a process”
• Textbook on finance: “incurred or contracted amount”.
Accounting
• English dictionary: “keeping or verifying of financial accounts”
• Business dictionary: “verification of financial accounts”
• Internet: “Providing a record such as funds paid or received for a
person or business. Accounting provides this information in
reports and statements for the firm itself and outside parties”
• Director of a professional services company: “recording financial
transactions in a uniform, generally accepted manner”
• Textbook on finance: “supply of standardised financial information
to the public”.
Disclosure
• English dictionary: “exposure, revelation”
• Business dictionary: “the obligation, in company law, for a
company to disclose all relevant information and results of
trading to its shareholders”
• Internet: “the publishing of financial information for the guidance
and education of the public, including issuers, auditors, and users
of financial information”
• Director of a professional services company: “explaining and
elaborating on financial results to make them more meaningful,
comparable and user-friendly”
• Textbook on finance: “information made public”.
The definitions of the words we have looked at may seem quite
difficult to understand, and financial jargon will be difficult to grasp
to start with, but as you read more articles about business, the words
will begin to make sense and understanding will follow.
Something to do 1
Read the business section of a newspaper and highlight any words you don’t
understand. Then, using the same process we have used in our exercise, try to
develop your own definitions for each of the words you have identified.
Let’s develop definitions for the words we have reviewed.
Economy
Economy is the system that enables resources to be moved to satisfy
individual material desires. In an economic system, goods and
services are produced from the scarce resources available within the
system. Examples of resources are land (e.g. minerals), labour,

entrepreneurial skill and capital (e.g. equipment). The goods and
services are produced to meet the needs and wants of consumers.
All individuals within this system are assumed to choose
products and services that bring them the greatest benefit.
Production, exchange and consumption in an economy therefore
occur with the intention of maximising benefit and minimising the
cost of achieving that benefit.
Market
A market is any channel that enables transactions between buyers
and sellers. The market for shares consists of buyers and sellers
wishing to exchange ownership in shares. Shares are rights of
ownership in business entities called companies. The prices of these
shares are determined by the demand and supply of shares in the
market. The demand and supply of shares depends on the
perceptions of buyers and sellers in the market.
Business
A business is an organisation that uses resources, such as land,
labour or equipment, to produce goods or services, usually with the
intention of generating a surplus from this activity, after paying all
costs.
Risk
Risk is the probability that an action will produce an unpleasant
outcome, not in line with expectations.
Profit
Profit is what is earned after the total expenses of a business have
been deducted from the total revenue.
Finance
Finance is the funding for a business, which is essential to enable the
business to operate and which must be managed very carefully.
Cost
This is a sacrifice, or opportunity given up, to receive something of
value. This sacrifice can be quantified in monetary terms as the
amount paid to purchase or produce goods and/or services.
Accounting
Accounting is a communication system designed to keep a record of
the financial effect of transactions arising from the activities of the
business. Transactions are processed in a systematic way and the
output from the process is communicated in the form of financial

reports.
It is important that this information is made available so that no
business activities can be hidden from the owners of the business,
the banks who lend money to the business, and any other person
who may have a valid interest in the activities of the business.
Disclosure
In the accounting context, disclosure is the presentation of relevant
and reliable information relating to the activities of a business. This
information is presented to those parties with an interest in the
outcome of business operations. Some disclosure is legislated, which
means that some business entities, for example, companies, are
obliged by law to reveal certain information about the business to
shareholders (the owners of the company).
Here are a few guidelines to help you in your initiation into the
financial world:
• Read the business section of newspapers daily to keep informed
about trading conditions in the global economy.
• Listen to the business news on television.
• Subscribe to a business magazine which analyses and reviews
global economic and business trends.
• Visit websites specifically related to finance and accounting, such
as:
www.businessday.com
www.accountingeducation.com
www.allacademic.com
www.onlinenewspapers.com
www.thecorporatelibrary.com
www.periodicals.net.
• Study textbooks on finance and accounting.
• Attend courses or join forums on financial topics.
Our focus so far has been on accounting terminology. It is important
that you master the concepts explained here as they will be used
throughout the rest of the book, and occur constantly in the world of
finance and business.
Before you can understand accounting, you need to understand
what it is that accounting is trying to measure and describe.
Let’s start by looking at the environment in which accounting is
used.

Within any society there are individuals desiring goods and services
and there are resources which can be used to meet individual
desires. People want an unlimited amount of goods and services.
People include individuals, businesses, and governments.
If you’re not convinced about this suggestion, imagine that you
had an infinite supply of money, make a list of everything you
would choose to acquire or do. Now, imagine that you had only R1
000 a month to spend. Make a list of what you would choose within
the given constraint. Not so easy, is it? Your consumption pattern is
different when you have limited resources.
You have just experienced the two fundamentals of economics:

1. People have unlimited wants.
2. There are limited resources to produce what people want.
The diagram below summarises the major categories of resources:
Something to do 2
1. What do all the resources listed above have in common,
apart from the fact that they are in limited supply?
2. When a specific investment choice is made, what is lost as a
result?
3. What do we call the total market value of all goods and
services produced within an economy?
Check your answers
1. All of the resources are involved in production. Resources such as

time and money may facilitate the flow of resources, but do not in
essence produce any output.
2. The choice that was not made is lost. There is a cost attached to
this lost alternative. This is known as opportunity cost, the
opportunity forgone when an economic decision is made.
3. This is known as the gross domestic product or GDP.
Because the resources that produce goods and services are in limited
supply, choices need to be made between alternative sources and uses
of resources. This involves analysing the costs and benefits of different
options. The basic premise of economics is that the purpose of
economic activity is to make the most efficient use of available
resources in order to achieve maximum benefit for the individual and for
society.
More resources could mean greater production capacity and
consequent increases in the production of goods and services, if the
resources are efficiently allocated. This is what brings about economic
development or economic growth.
How are resources employed to create products that meet consumer
needs? Consider the following processes that create outputs.
What are the common features of all the inputs? They are all factors
of production or resources.
•
What are the common features of all the outputs? They are all items
that satisfy needs or wants.
•
What are the common features of all the activities? They represent
work that needs to be done to transform inputs into outputs.
•
What facilitates the flow of the resources (input) into productive

output? Processes, time, money.
•
Think about this 1

Does money have any real value?
Check your answer
You must have heard it said many times that “money makes the world
go around”. In economic systems, individuals supply their labour and
ideas to businesses in return for compensation in the form of money,
and businesses in turn supply goods and services to individuals in
return for payment in the form of money. The flow of economic activity
happens simultaneously with the flow of money. This dynamic is
illustrated in the diagram on the next page:
Think about this 2

Can you think of another participant in the economic system which receives
and pays money?
Check your answer
Besides businesses and individuals, the government receives money in

the form of taxes and pays out money to build infrastructure such as
roads and provide services such as health care.
Without the provision of essential services that the private sector is
not willing to provide, businesses would not be able to operate efficiently
and produce wealth for the country.
In the diagram above, money flows from the buyers to the sellers of
the goods and services. This money flows continuously between
businesses, individuals and the government (which has not been
included in the diagram for the sake of simplicity).
Money is the means of payment for the goods and services, which is
why it flows in the opposite direction to the flow of the goods and
services. The question is whether money has any real value of its own.
The answer lies in the function money serves in an economy. If the
government decided tomorrow that all transactions concluded between
buyers and sellers were to be compensated by the exchange of acorns,
and nothing but acorns, would the coins and notes in your wallet have
any value?
The answer is clearly no, because acorns would become the accepted
method of payment for all exchanges in the economy. The more acorns
you owned, the richer you would be, and you would have to decide how
best to allocate your store of acorns.
If acorns were the accepted currency, all goods and services would
be measured in terms of acorns. Acorns could also be stored instead of
spent, and their value would be a measure of what you could buy with
them.
1.4.3 The financial system

In the economic system, goods and services are exchanged for
money. Some of this money is not spent immediately but saved for a
future date. This stored money represents an excess supply to
whoever holds it.
At any point in time there are people who have excess money at
their disposal. Think of them as the savers.
There are other people, by contrast, who do not have sufficient
money to meet their needs. Think of them as the borrowers.
Think about this 3

Can you think of any surplus or deficit units in the South African economy?
Examples of savers
• Businesses that have generated more cash revenue from their
operations than they will have to pay out in costs

• Individuals who have saved or inherited money, and so have
generated a surplus of cash in excess of their needs.
Examples of borrowers
• Businesses needing money to expand operations
• Individuals needing money to buy new homes or cars or
consumable goods
• The government needing money to develop infrastructure and
provide social benefits for the population.
Surplus money is handed over to financial institutions and in return,

interest is received on the amount invested.
Because people do not need the money they have deposited all at
once, the financial institutions only keep a percentage of total
deposits as a reserve to meet the withdrawal requirements of savers.

The rest of the money is lent to borrowers, or invested in
incomeearning investments. The borrowers will be required to pay
interest on the amounts borrowed for the time they are outstanding.
These relationships are illustrated in the diagram below:
Notice that the financial institutions pay interest to the savers in
return for their money and receive interest from the borrowers in
return.
The financial needs of both the savers and the borrowers are met
by the financial system. This process of matching savers to
borrowers units is called intermediation.

The financial institutions, called intermediaries, also earn income
from the costs charged on borrowings and from the fees levied for
their services to both savers and borrowers.
Money flows from savers to borrowers through different markets.
There is the money market, in which short-term money is traded,
and the capital market, in which long-term money is traded.
We’ll now turn our attention to the business organisations
operating in the financial system to understand what they are and
how they are formed.

In our discussion of economic and financial systems, the participants
in the flow of goods and services were introduced. These are the
economic decision-makers, who use resources to produce goods and

services or consume the outputs of production. They are individuals,
businesses and governments. The economy can be divided into
sectors based on the roles of the participants in that sector. The
private sector consists of households (individuals) and businesses,
while the public sector is government.
Households (individuals) are the greatest suppliers of resources
to the economy. In return for their services, they receive income in
the form of wages, rent, interest, salaries, and a share of profits,
among others.
Businesses exist to supply goods and services (products) to
satisfy the demands of consumers (their customers). Businesses are
formed by individuals, who employ resources (human and
otherwise), to produce goods and services to generate a surplus from
the operating activities. This surplus is withdrawn by the owners or
reinvested into operations to make the business grow.
The interaction of a business with its customers is shown below:

There are many different types of businesses in the economy offering
their customers a huge diversity of goods and services. These
business entities may be classified either according to the activity
undertaken by them or by their ownership structure and legal form.
1.5.1 Classification of business by activity

The following classifications broadly divide business activity into
four major areas: retail, manufacturing, extractive and services.
Merchandising and retail activities involve the buying and selling

activities of wholesalers and retailers of goods. A wholesaler is a
business that supplies goods to other businesses, known as retailers,
who sell goods to individuals.
Manufacturing activities are those activities that convert raw
materials, such as natural resources, into a product.
Extractive activities are those activities that extract natural
resources from the earth, such as mining.
Service activities are those activities that deliver services ranging
from professional advice to installation and maintenance services.

Something to do 3
Make a list of all the businesses you know in your area. Group similar businesses
together and then notice the types of goods and services they produce. Is it
possible to divide these businesses into groups based on what they do?
Here is an example of what such a study might produce:
A list of 10 businesses in Wynberg, a suburb of Cape Town
Name of business What it does

Chelsea Health and Beauty Clinic Provides health therapy to clients
Shoprite Sells groceries
Precision Tec CC Manufactures typewriter ribbon
Isolla Bella Trattoria Italian restaurant
Freddy’s Blinds Manufactures a variety of blinds
Keith Lombard Plumbers Provides plumbing services
Joshua Doore Sells furniture
Lindol Environmental Services Provides pest control service
Wynberg Cellular Sells cell phones and instruments
Natural Gardens CC Landscaping and irrigation
Businesses can be classified as follows:
Type of business Examples

Service Chelsea Health and Beauty Clinic
Isolla Bella Trattoria
Keith Lombard Plumbers
Lindol Environmental Services
Retail Natural Gardens CC
Shoprite
Joshua Doore
Wynberg Cellular
Manufacturing Precision Tec CC
Freddy’s Blinds
Think about this 4

There are many decisions that are made before a business can
commence operating.
Some of these are highlighted below:
Location: Where are the activities and operations going to be
positioned?
•
Capital requirement: How much money is required to start the

business and what are the expected daily operating costs?
•
Sources of finance: Where is the capital required for the initial

investment going to come from?
•
Capital structure: How much capital will be borrowed and how

much is going to be contributed by the owner(s)?
•
Staff: How many people need to be employed in the business, and

what skills are required?
•
Legal requirements: What legal obligations must be fulfilled before

the business can start operating? If the business is a company,
•
the company name will have to be registered with the Registrar of

Companies in Pretoria. Certain documents detailing the nature
and structure of the company will also have to be lodged with the
Registrar. Registration with the labour department and SARS (the
South African Revenue Service) may be required.
Service provision: What services, such as water, electricity and
telephone, will have to be applied for and from which service
•
providers?
Income division: How is the income generated from operations
going to be distributed? How much will be retained in the business
•
for future investment and how much will be distributed to the

owners and in what proportions?
Financial reporting: Are manual or computerised accounting
systems going to be used to process transactions? How extensive
should this accounting system be? For example, could all
•
transactions be summarised in a cashbook only? What are the

reporting requirements for the business entity? In the case of a
company, a published financial report needs to be presented to
shareholders at the end of each financial year.
Once the business is in operation, events will occur which have a
financial effect. These are called transactions.

Examples of these events are:
• Buying goods from suppliers
• Paying employees
• Selling goods to customers
• Delivering a service to clients
• Paying rates and water
• Paying the telephone account.
By recording these transactions, the owner will be able to determine
whether the business is doing well or not.
The process of presenting financial information in a format that is
useful for making economic decisions is known as accounting.

1.6.1 Why is it necessary to create a record of
transactions in a business?
We said earlier that records of transactions and reports of the results
of business operations provide information, which is useful for
making economic decisions.
1.6.2 Who are the economic decision-makers, and

what decisions do they need to make?
The business owners/shareholders
The owner of the business has made a capital investment in the
business and is interested in the profit the business makes. If the
owner could earn more income from an alternative investment (for
example leaving the money in the bank), then it would make sense
to invest the money in the better opportunity.
In the case of a new business, the owner would probably be
willing to sacrifice shortterm gains on his/her investment, because
of the expectation that the business will grow and generate greater
profits than other investments in the long term.
Creditors and lenders

Suppliers of short- and long-term finance to the business will want
to evaluate the credit-worthiness of a business before deciding to
lend money. The creditworthiness of a business depends on the
probability of the borrower being able to meet the interest and
capital repayments in the future. Should the business fail to make
the payments required, the lenders will have a claim on the business
assets and will be entitled to sell the assets of the business (or of the
owner, where the business is not a separate legal entity).
Management
When the owners and managers are different individuals, they will
need different information to help them make decisions. Managers

are responsible for running the business on behalf of the owners.
They must make sure that their actions result in the highest possible
profit for the business.
Employees
Employees supply the majority of resources used by businesses,
whether in the form of labour or ideas. In return for their services
they are paid according to market rates. Employees need to decide
whether they are being paid enough and whether the business in
which they are employed is able to continue paying them for their
services.
SARS (South African Revenue Service)

The government is interested in the financial activities of individuals
and business entities that generate income because this income is
subject to taxation. Individuals are taxed at different taxation rates
depending on their level of income, and business entities having a
particular legal status are taxed separately from individuals. The
government must assess the activities of individuals and businesses
in order to determine the amount of tax collectable from these
entities.
Financial analysts, investors, financial institutions and others

Other parties interested in the financial information generated by
business entities include financial institutions or investors who have
shares in the business and need to decide whether to retain or
withdraw their investment in the business. Financial analysts are
research analysts who evaluate the outcome of business operations
and make predictions about the future of the business. Institutions
requiring information about businesses usually employ analysts so
that they can make investments in those businesses expected to
generate high future returns.

economic decisions?
Depending on their role in the company, people will require
different types of information.
Business owners/shareholders need information about:
• How well the business is doing (is the business making a profit,
and how large is that profit when compared to the investment in
the business made by the owner?)
• What resources are controlled by the business
• What the business owes
• How much money is in the bank
• What the money has been spent on
• What activities generated the most cash flow.
Managers need information about:
• What resources have been purchased
• How successfully these resources have been managed to earn a
profit (how much profit has been generated?)
• The cost of borrowing money
• How much money needs to be borrowed in the future
• What resources need to be purchased in the future
• What it costs to run the business
• The timing of cash flows.
Employees need information about:
• What profit has been generated by the business
• What the total expenses of the business are
• What percentage of the total expenses the salary and wage bill
makes up
• How much cash is available in the business.
Creditors and lenders need information about:
• What profit has been generated by the business
• What other loans the business has to pay back
• How large the total interest expense is in relation to the income
earned
• How much is available in the business after paying all the costs of
running the business.
SARS needs information about:
• How much income has been earned
• The expenses incurred in order to earn that income.
Financial analysts, investors, financial advisors, and financial
institutions need information about:
• How much cash has flowed into and out of the business
• How much profit has been generated
• The total value of all resources controlled by the business.
1.6.4 How is financial information communicated?

Now that we know who uses what financial information, we’ll look
at how this information is presented. In the next few chapters you
will have an opportunity to learn how to record and report this
information in the required format.

• Accounting is a system that communicates a message about the
financial effects of all decisions made in a business in the past.

Accounting is a financial measure of the decisions taken by the
• business.
• We know something about the history of accounting.
• We have learnt how the business and accounting environment
works.
• We have discovered what businesses are and how they are
formed.
• We know how businesses are classified according to their
function.
• We know who needs accounting information and what
information is needed.
What’s next?
In the next chapter you will learn more about the purpose of
accounting and you will start learning how to present accounting
information.
2 The purpose of
accounting
Judy Abrahams has owned a stall at Greenmarket Square in Cape
Town for the past four years. She sells leather handbags to tourists
and feels her business has become really successful during this
time. In conversation with you she mentioned that she always has
more money coming into the business than she has going out of
the business.
Judy has been offered a small kiosk at the V&A Waterfront
from which to operate and has decided to take up the offer and
move her business. “The rainy weather in winter really affects my
business so it will be an advantage to be inside,” she said. She
approached the bank to take out a loan of R50 000 to help
finance the move, and the bank manager asked her for her
financial statements.
Judy has never kept any financial records other than making a
note of money coming in and money going out, as she is the only
person working with the money at the stall. She has been using
her own bank account for depositing her cash. Judy has always
been satisfied if she has more money at the end of the week than
she had at the start.
For the past month, since talking to the bank manager, Judy
has kept track of what has been happening in the business. She
decided to open a separate bank account in the name of the
business and called it “Handbags for Africa”. She deposited R8
000 of her own money into the business bank account. Judy did
not have any leather handbags on hand on 1 January X1 as she
had sold them all on a special holiday season sale on 31
December X0.
On the next page, you will find the records she kept of her
transactions for the month of January.
Judy presented a copy of these records to the bank manager and
was a little upset with his response. “He asked me to give him my
financial statements and that is what I thought I had given him!
Now he tells me that he needs a profit or loss calculation, a
statement of financial position, and a statement of cash flows for
my business. I don't even know what those things are!”
Learning objectives
• Understand the key types of decisions a business owner needs to make to enable a
business to be successful
• Understand how a business makes the owner wealthier
• Understand what information is communicated in the financial reports of a
business
• Identify assets and liabilities
• Identify income and expenses
• Prepare basic financial reports.
Understanding Judy's problem

What do you think has upset Judy?
• She has less money at the end of the month than she had at the
beginning.
• She does not know if her business has made her wealthier during
the period she has been operating.
• Her bank manager has rejected her application for a loan because
she has not presented him with the information he requires.
• She doesn’t know what financial statements are, but she needs to
present the bank with a statement of financial position, a profit or
loss calculation, and a statement of cash flows.
Why did this problem occur?

Judy hasn’t had any formal financial or accounting training. Many
businesses are started by individuals who have an idea about what
need in the market could be fulfilled by their business, but when
they start operating, they have little knowledge of how to record the
events that take place.
Regardless of why people start a business, it is important that the
business is able to make the owner wealthier, that the owner is in a
better financial position at the end of a business year than he or she

was at the start of a business year. However, if business owners do
not have sufficient financial skills, the businesses they own could in
fact be making them poorer and they may lose money or incur even
more debt.
How are we going to help Judy to solve her problem?

1. By understanding how the business makes the owner wealthier.
2. By understanding what information is presented in the
statement of financial position, statement of comprehensive
income, also referred to as the statement of profit or loss and
other comprehensive income or SPLOCI, and statement of cash
flows.
3. By using the information in Judy’s records to prepare the
financial statements of her business.
2.1 Key financial decisions

The main objective to starting a business is for the owner to become
wealthier. What do we mean by wealthier? The owner would be
wealthier if he or she had more assets or had fewer obligations
(owed less).
There are four key types of decisions that business owners will
need to make throughout the life of the business. If these decisions
are made well, the business is more likely to be successful, which
means that the owner will become wealthier.
Let's look at these four decisions.

In order to start a business, and at various times during the life of
the business, the business will require funds. These funds can come
from one of two sources. The owner can contribute the funds him- or
herself, or the business can borrow funds from someone else, for
example the bank or a family member.
The funds to start a business are generally contributed in the form of
cash, i.e. cash contributed by the owner or a loan taken by the
business. However, they can be in the form of any asset.

The business will use these funds, i.e. the cash currently in the
business’ bank account, to purchase additional assets that the
business requires, such as vehicles, equipment, stationery, raw
materials, or inventory. The total assets the business has at any given
time is equal to the amount of funding used to acquire the assets.
ASSETS = EQUITY + LIABILITIES

The assets of the business will be used to produce a product or
provide a service. If the business generates more assets (i.e. earns)
more from providing the service or product (income) than it costs

(the amount of assets used up) to provide the service or product
(expenses), the business will make a profit.
PROFIT = INCOME − EXPENSES
If the income earned (assets generated) by the business is less than
the cost (assets used) of providing that service or product, the
business will make a loss.
LOSS = EXPENSES − INCOME

The owner can leave the profit in the business, or the profit can be
withdrawn from the business to use in his or her personal life.
If the business makes a profit, the owner becomes wealthier:
• The owner has invested more funding in the business (the profit
has been left in the business).
• The owner has more funds to spend in his or her personal life (the
profit has been taken out of the business).
Let’s look at a few of Judy’s transactions to understand the effect of
the decisions she is making. We are going to identify which
transactions have made her wealthier.

At this point it is important to note that all accounting transactions
are recorded from the point of view of the business. In other words,
for the first transaction the business has acquired an asset or a
resource (cash in the bank) and will also recognise who the funding
came from, i.e. who provided the resources, in this case, the owner.
1. Financing decision
The business (Handbags for Africa) has an asset (bank) amounting to
R8 000. The owner (Judy) has a claim on the assets of the business
amounting to R8 000.
Has this transaction made Judy wealthier?

Judy’s personal funds have decreased by R8 000 (the amount she
invested in the business). Judy’s claim (the equity amount) on the
business amounts to R8 000. All she has done is change the type of
investment she has (cash in a personal bank account to a claim on a

business). Judy has therefore not become wealthier because of this
transaction.
The assets of the business have increased by R2 000 (the cash
received by the business from Judy’s sister). The increase in assets
was funded by Judy’s sister so the business will indicate who the
resources were received from, i.e. the liabilities will also increase by
R2 000.
Has this transaction made Judy wealthier?

The assets of the business have increased by R2 000, but these assets
have been funded by Judy’s sister. This means that Judy’s sister has
a claim on the assets of R2 000 and the owner’s claim (also referred
to as the net asset value of the business) is still R8 000. Judy is not
wealthier, as her claim on the assets of the business remains at R8
000.
2. Investing decisions
Handbags for Africa has purchased a cellphone and a trestle table to
use in the business. The business used the cash in its bank account to
purchase other assets. These assets will be used for a period of more
than one year and are referred to as non-current assets. In this
transaction, the business swapped cash (an asset) for other assets
(the cellphone and furniture). The business has cash in the bank
amounting to R7 850 and has a cellphone that cost R1 200 and
furniture that cost R950. The total amount of assets remains at R10
000. Judy’s sister still has a claim on the assets amounting to R2 000
and the owner’s claim still amounts to R8 000. Judy has not become
wealthier due to this transaction.
Handbags for Africa has also purchased 30 briefcases (to sell). The
business swapped cash for inventory. These assets will be used in
the business over a period of less than one year and are referred to as
current assets. The business has cash in the bank amounting to R4
250, a cellphone that cost R1 200, furniture that cost R950 and has
inventory that cost R3 600. The total amount of assets has not
changed. Judy’s sister still has a claim on the assets amounting to R2
000 and the owner’s claim still amounts to R8 000. Judy has not
become wealthier due to this transaction.

Handbags for Africa purchased 20 handbags (to sell). Although the
business has received the handbags (the assets, inventory has
increased by R600), no payment has been made as yet (the handbags
have been purchased on credit). Until they have been paid for, the
supplier will have a claim of R600 on the assets of the business. The
liabilities of the business have therefore increased by R600. When
inventory is purchased on credit, we refer to this liability as trade
payables. The total assets of the business have increased to R10 600.
The claim that the liabilities have on the business amounts to R2 600,
and the owner’s claim still amounts to R8 000. Judy has not become
wealthier.
3. Operating decisions
Handbags for Africa sells 2 briefcases at R300 each [R600/2] and 1
handbag at R60. Does the business make a profit on this transaction?
What do we mean by the term profit?

A business earns a profit when the income earned (increase in asset)
as a result of the transaction is higher than what it cost us to provide
the product or service (decrease in asset):
What is the cost price of each briefcase and handbag?

Purchased 30 briefcases for R3 600, so each briefcase cost R120 [R3
600/30].
Purchased 20 handbags for R600, so each handbag cost R30
[R600/20].
So the expense recognised when the briefcases and handbag is sold
amounts to 3 × 120 + 1 × 30 = R270. We refer to this expense as cost

of sales expense.
Handbags for Africa sold 2 briefcases and 1 handbag and earned
R660 (2 × R300 + 1 × R60). The cost of sales expense is the cost of the
2 briefcases and 1 handbag used (sold). The business still has 28
briefcases and 19 handbags left (28 × R120 + 19 × R30 = R3 930). The
unsold briefcases and handbags are still an asset to the business as

they can be used (i.e. sold) in the future. The unsold briefcases and
handbags are recognised as inventory.
The total assets of the business amount to R10 990 (R4 910 in the
bank, cellphone costing R1 200, furniture costing R950, and
inventory of R3 930). The assets have increased not due to a
transaction with Judy (the owner).
Although the assets of the business have increased, the claim the
liabilities have on the assets of the business still amounts to R2 600.
Judy’s claim on the assets has, therefore, increased to R8 390. Once
the liabilities have been repaid, the remaining assets will be available
for Judy. Judy’s direct contribution into the business (referred to as
capital) still amounts to R8 000 and the profit that has been
generated and left in the business amounts to R390 (referred to as
accumulated profit or retained income). This transaction has made
Judy wealthier.
Handbags for Africa sold 4 briefcases and 3 handbags and earned R1
380 (4 × R300 + 3 × R60).
What cost of sales expense will be recognised for this transaction?
4 × R120 + 3 × R30 = R570

The inventory has been sold on credit. The customer has been given
the briefcases and handbags, so we will no longer show these items
as inventory. The business cannot increase the bank as we have not,
as yet, received any money. The business will recognise an asset
called trade receivables, amounting to R1 380 (the amount owed to
Handbags for Africa by the customer). Inventory decreased by R570
and trade receivables increased by R1 380. In other words total assets
increased by R810 (R1 380 − R570). There has been no change in
liabilities (i.e. their claim still amounts to R2 000). The claim the
owner has on the assets will increase. This is because the profit
generated by the business belongs to the owner.
When should we recognise the sales income, cost of sales expense

and the profit?
A business recognises the sale (income) when an asset (in this case
trade receivables) increases which causes equity to increase, not due
to a transaction with the owner. So sales income is reported even if
payment has not been received from the customer.
An expense is recognised when an asset decreases (i.e. inventory).
The expense is recognised even if the supplier has not been paid for
the inventory.
The business will recognise sales income of R1 380 and cost of
sales expense of R570. The business has made a profit of R810 [R1
380–570]. This transaction has made Judy wealthier.
Accrual basis
The following financial statements (statement of financial
position, statement of profit or loss and other comprehensive
income and statement of changes in equity) are prepared on the
accrual basis of accounting. The statement of cash flows is
prepared on the cash-basis. Under the accrual basis, transactions

are recorded when they actually happen (i.e., when the
assets/liabilities are recognised) and not only when cash is paid
or received for the transaction.
4. Distribution decision
Judy takes cash out of the business to use in her personal capacity.
The assets of the business decrease because R300 cash has been taken
out of the bank by Judy as a distribution. The R300 paid to Judy is
not considered an expense as it is a transaction with the owner.
Once the distribution of R300 has been paid to Judy, her claim on
the business decreases, as she has withdrawn part of the assets she
had a claim on.
Let's review the terms we have used.
ASSETS = EQUITY + LIABILITIES
Equity and liabilities refer to the sources of funding for the business.
Assets are resources used during the operations of the business. If
the business is able to generate more assets during operations than it
has consumed, the business will make a profit. If the business makes
a profit, the owner will become wealthier, irrespective of whether or
not the profits are distributed to the owner or left in the business.
So decisions are made – financing, investing, operating and
distribution decisions. These decisions result in business events
known as transactions. The financial statements, namely the
statement of financial position, the statement of profit or loss and
other comprehensive income, the statement of cash flows and the
statement of changes in equity, provide a summary of the various
business transactions. The financial statements are used to make
economic decisions about the business.
2.2 Understanding the statement of

financial position
The statement of financial position is prepared at a point in time.
The business will need to prepare the statement at least once a year
at the reporting date. The reporting date is the end of the business’
financial year end, i.e. the date the business will prepare financial
statements. The statement of financial position indicates all the
assets the business recognises at that date, as well as how these
assets have been funded (the equity and liabilities).
Statement of financial position of AB Traders as at 30 December

2017 (date the statement of financial position is prepared)
Let’s look at the elements on the statement of financial position in a
bit more detail.

2.2.1.1 What is an asset?
An asset is a present economic resource controlled by the business
as a result of past events. An economic resource is a right that has
the potential to produce economic benefit. We will look at
understanding assets in more detail in Chapter 4. Assets can be
tangible (things we can see and touch), such as vehicles, land and
buildings, equipment and handbags. Assets also include claims on
other people, such as trade receivables and intangible assets (an
example would be patents).

When the business no longer controls all or a part of the asset, for
example inventory is sold (i.e. the inventory leaves the business),
assets decrease (inventory). This decrease in assets is recognised as
an expense and remaining inventory is shown as an asset.
2.2.1.2 Assets/expenses/income
1. The business purchases prepaid airtime vouchers. Because it has
the right to use the vouchers we recognise an asset. As the
vouchers are used we derecognise the asset. This decrease in
assets is recognised as an expense to the business.
2. The business purchases briefcases, handbags and purses that are
sold to customers. The briefcases, handbags and purses are
assets to the business (inventory). The business has the right to
sell the inventory. Once the inventory is sold we derecognise the
asset, the decrease in assets is recognised as an expense (cost of
sales expense). The increase in assets (cash received or increase
in trade receivables) is recognised as income.
3. Remember that the business may also use non-current assets.
Judy’s business uses the furniture and a cellphone in order to
run the business. These assets have a limited useful life. This
means is that the business intends to use the asset only for a
limited time, after which the asset will be replaced. The business
paid R1 200 to purchase the cellphone on 1 January X1. The
business intends to use the cellphone for two years, after which
it will give it away to a charity. Assume the business uses the
cellphone evenly over the two years. The cost of using the
cellphone for a year is R600 [R1 200/2] and will be recognised as
an EXPENSE. This expense is referred to as DEPRECIATION.
Depreciation will be covered in more detail in Chapter 5.

2.2.2.1 What is a liability?
A liability is a present obligation of the business to transfer an
economic resource as a result of past events. An obligation is a duty
or responsibility that the entity has no practical ability to avoid. We
will look at understanding this definition in greater detail in Chapter
4. Examples are amounts payable to someone who has lent you
money, for example, long- or short-term loans, bank overdraft and
mortgage bonds. Where a business has received goods (such as
inventory) or services (such as using electricity) and has not paid for
it. A payment has to be made in the future for something from
which the business has already benefited.
15 Received an order for 10 handbags. Received a deposit of 20%. 120

80% (R480) still to be paid on 1/2/X1, when the bags are to be
selected and collected.
Liabilities are often settled in cash (repaying the loan or paying for
the inventory bought on credit). However, liabilities can also be
settled by providing someone with a service, for example, Judy’s
business received a deposit of R120 on 15 January X1 for a handbag
that will be selected and collected on 1 February X1. Until the
handbags have been selected and collected, Judy will have an
obligation to the customer to offer the handbags or to refund the
deposit. Although the business has received the R120 cash, it will not
record the R120 as sales income until the business has provided the
client with the service, which involves selecting and collecting the
bags. Until the service is provided, the R120 will appear as a liability.
We could call the liability unearned income, as when the sale is
earned in the future, it will be recognised as income.

ASSETS LIABILITIES
Bank + R120 Unearned income +R120
In February X1, once the handbags have been selected and collected
(the service has been provided), the business will no longer have an
obligation to the customer. The liability will decrease by R120, and
the sales income earned by the business will increase by R120. The
business will recognise the income in February X1, even though the
cash was received in January X1.

2.2.3.1 What is equity?
The owner can fund the business through a direct contribution,
referred to as a capital contribution, and by leaving profit that the
business has generated in the business, which is referred to as
accumulated profit (retained earnings).

Equity is the amount that is left after liabilities have been
deducted from assets. It is therefore often referred to as the residual
amount. It is the amount representing the owner’s claim on the
business.
Equity refers to the funding provided by the owner. Equity is also
referred to as the net asset value, which means the assets of the
business less the liabilities, or the residual value of a business. It is
referred to as the residual value because the liability holders would
have preference over the assets if the business closed down. The
assets would be liquidated (converted into cash) and the liability
claims settled. Whatever is left would belong to the owner − it is a
residual claim.
Understanding a bit more about net asset
2.2.3.2
value
An individual buys a house for R100 000. He has R60 000 in his
personal bank account, which he uses in part payment for the house.
He takes out a loan of R40 000 from the bank to pay the balance.
How much did the house cost? R100 000
How much of the owner’s own money was used to pay for the house? R60
000
How much money is still owed on the house? R40 000
Do you think that the owner has become wealthier (in financial terms) by
buying the house?
Is he worth R100 000, because he now owns a house worth R100 000?
Check your answer
No, the owner is not wealthier, because although he has a house costing R100 000, he
still owes the bank the R40 000.
If we subtract the amount of the loan from the cost of the house, we will be able to
measure the claim the owner has on the house or the owner's funding.
We can represent this information in the form of an equation:
R100 000 (house) − R40 000 (loan) = R60 000 (owner's money)
Think about this 1

If the owner were to sell his house for R100 000 a month later, how much
cash would the owner keep from the sale?
Check your answer
If he sold the house for R100 000, he would have to use R40 000 of the amount to
pay back the loan, and he would keep the balance of R60 000. The R60 000 is the
owner's claim on the house. The R40 000 is the claim that the bank has against the
house.
Now let's translate the example above into accounting language.
The house (costing R100 000) would be called an asset − assets are items which we
control.
The loan from the bank (R40 000) would be called a liability − liabilities are
amounts which we owe to others.
The net asset value of the owner is the difference between the assets and
liabilities.
NET ASSET VALUE = ASSETS LESS LIABILITIES
What is the net asset value of the owner in the example above?
Net asset value = R100 000 (ASSET) − R40 000 (LIABILITY) = R60 000
The net asset value of R60 000 is equal to the amount that the owner invested in the
house. This is sometimes also expressed as the owner having a R60 000 equity
interest in the house.
Let’s summarise what we’ve learnt.
The house (an asset) is funded from two sources:
• The owner’s money (this funding is called EQUITY)
• The loan from the bank (this funding is called a
LIABILITY)
We can represent the transaction in the form of an
equation:
R100 000 (asset) = R60 000 (own funds) + R40 000 (loan)
Does the statement of financial position of the business tell us

anything about Judy's personal net asset value?
No. The statement of financial position tells us what the financial
position of Judy’s business is. It does not reflect any of Judy’s
personal information, such as her personal bank account balance or
money that she spends on herself.
The fact that the records of the owner and the records of the
business are separate is called the entity concept.
Something to do 1
In the information provided at the start of the chapter, we can see that Judy
deposited R8 000 into the business as funding to start the business. She also
used business funding to purchase clothing for herself from the stall next door
for R420.
How do we show the contributions and withdrawals made by Judy during
January?
Check your answer
When transactions are recorded, they are recorded from the point of view of the
business. The money deposited by Judy into the business bank account will be
recognised as an asset of the business, and the claim Judy has on the business will be
recognised as equity. The money withdrawn from the business to buy clothing for
herself will be recognised by the business as a distribution, in other words, a decrease
in the business assets and a decrease in the claim that Judy has on the assets of the
business.
What if Judy used money from her personal bank account to buy clothing from the
stall next door? No entry would be made in the business records. This is not a
transaction between Judy and the business but a personal transaction.
In accounting, we call the contributions made by the owner to the business capital
and the withdrawals made by the owner from the business drawings or a dividend.
Let’s look at the following internationally acceptable format for a
statement of financial position which Judy can use to present the
financial position of the business at 1 January X1 (after all the
transactions on 1 January have been recorded).
This is the financial position after the first DAY of Judy's business.
Statement of financial position as at 1 January X1

Assets
Non-current assets
Furniture and equipment 950
Cellphone 1 200
Current assets
Inventory 3 600
Bank balance 4 250
Total assets 10 000
Equity and liabilities

Capital 8 000
Non-current liabilities
Loan 2 000
Current liabilities
Total equity and liabilities 10 000
What do you notice?

• Assets are classified as current or non-current assets. This
classification depends on how long they will be held by the
business. Generally assets purchased with the intention to hold
for more than a year are classified as non-current assets. Assets

that are in the form of cash, or will be converted into cash, or used
within one year, are classified as current assets, such as

inventory, which will be sold and for which cash will be received.
• Liabilities are classified as current or non-current liabilities.
Liabilities that are settled within one year are classified as current
liabilities, whereas liabilities that are settled over a period of more
than one year are classified as non-current liabilities. If a liability is
settled in instalments, like a mortgage bond, the portion
repayable within 12 months is generally classified as a current
liability.
• Assets equal equity plus liabilities.
By now you should have some understanding of: what information is
reported in the statement of financial position and how to prepare a
statement of financial position.
2.3 Understanding profit or loss and

comprehensive income
Income
Income is recognised as an increase in assets or a decrease in
liabilities that result in increases in equity, other than contributions
by owner.
Expense
An expense is a decrease in assets or an increase in liabilities that
results in a decrease in equity, other than distributions (drawings) to
owners.
Let's look at an example.

Judy sold inventory on credit for R1 380. The inventory had a cost
price of R570.
An asset (trade receivables) increased by R1 380. No other asset or
liability changed by R1 380.
The net asset value of the business increased by R1 380, and the
increase was not due to a transaction with the owner. The increase in
net asset value is recognised as sales income.
An asset (inventory) decreased by R570. No other asset or liability
changed by R570. The net asset value of the business decreased by
R570, and the decrease was not due to a transaction with the owner.
The decrease in net asset value is recognised as cost of sales

expense.

What is the accrual concept?
A transaction is reported when an asset or liability is recognised or
derecognised. Income + expense are recognised when
assets/liabilities change and this is not necessarily when cash is
received/paid.
Income and expenses will be discussed in detail in Chapters 3 and
4.
In the example above, Judy recorded the sale and the profit made
on the sale when she made the sale, and did not wait until she
received the money. If the customer did not pay her, she would
record the non-payment as a bad debt at a later stage (see Chapter 5
for more details). The rental of Judy’s stall is R1 000 per month. The
R1 000 for January’s rent is recognised as an expense for January,
irrespective of whether she paid the amount in December, January
or February.
As Judy’s business is still small and has simple transactions, she
will need to prepare only the profit or loss portion of the statement
of comprehensive income in order to calculate her profit or loss. We
will look at the remainder of the statement in Chapter 11.
It is necessary to ensure that all income earned for a period,
whether received or not, and all expenses incurred in earning that
income, whether paid or not, are included in calculating the profit
for a given period. This ensures that matching of expenses to income
is achieved, that is, that expenses incurred in order to generate the
income are shown in the period that the income was earned.
2.3.3 Understanding profit

2.3.3.1 How is profit for the year calculated?
Every business needs to calculate its profit or loss at the end of a
period of time (at least once a year but usually more often). One of
the subtotals that is usually presented in the calculation of profit is
“Gross profit”. Gross profit is the difference between the income
received from selling goods or providing a service less only those
expenses that are directly related to generating that income. This
expense is referred to as cost of sales and would include the cost of
the goods sold or the petrol costs if the business offered a delivery
service. General expenses like interest expense or rental expense
would not be included in the Cost of sales figure, which means they
would not affect the gross profit figure. These expenses would be
deducted from the gross profit figure to calculate the profit for the
year.
Profit for the year is all the income earned over the period less all
the expenses incurred over the same period. If expenses are greater
than income, then the business will show a loss for the period. The
profit or loss is the primary measure of financial performance and is
presented as a profit or loss statement or on the SPLOCI, which is
usually drawn up at the end of a twelve-month period (also known
as the financial period or financial year).
We have identified that the only decisions that change the
owner’s wealth are operating decisions. These are decisions that
increase (income) or decrease (expenses) the net asset value of the
business and are not transactions with the owner. The net effect of
the operating decisions, which is the profit or loss generated by the
business, needs to be disclosed.
As you pursue your accounting studies, you will learn that in
exceptional circumstances the term ‘‘other comprehensive income’’
is used and only for income or expenses arising from a change in the
current value of an asset or liability. You will learn more about an
example, revaluation gain in Chapter 11.

TOTAL COMPREHENSIVE INCOME
= PROFIT OR LOSS + OTHER COMPREHENSIVE INCOME
The performance of the company could be presented in either one or
two statements:
• A separate income statement showing the calculation of profit or
loss, with a second statement starting with the total of profit or
loss and then detailing other comprehensive income (in other
words, two separate statements: an income statement or profit or
loss statement, plus a statement of comprehensive income).
• A single statement starting with the calculation of profit (or loss),
then showing other comprehensive income, and ending with the
total comprehensive income amount. This single statement is
known as the statement of profit or loss and other comprehensive
income or SPLOCI.
Previously businesses had to produce only an income statement.
Details relating to other comprehensive income were difficult to find
in the financial statements and were easily missed by people
analysing the statements. A SPLOCI presents all the gains and loss,
as implied by the word ‘‘comprehensive’’.
2.3.3.2 What does the statement of profit or loss

and other comprehensive income look like if
a separate income statement is not
prepared? (One-statement format)
STATEMENT OF PROFIT OR LOSS AND OTHER
COMPREHENSIVE INCOME FOR THE PERIOD ENDED 31
JANUARY X1
SALES/TURNOVER
LESS COST OF SALES
GROSS PROFIT
ADD OTHER INCOME
Rent received
Interest received
LESS OPERATING EXPENSES
Rent
Electricity
Wages and salaries
Depreciation
Repairs
PROFIT BEFORE INTEREST
Finance costs (interest expense)
PROFIT FOR THE YEAR
OTHER COMPREHENSIVE INCOME
Revaluation gain
If the entity decided to use the two-statement approach, the
statements would be as follows:
INCOME STATEMENT FOR THE PERIOD ENDED 31 JANUARY
X1
SALES/TURNOVER
LESS COST OF SALES
GROSS PROFIT
ADD OTHER INCOME
Rent received
Interest received
LESS OPERATING EXPENSES
Rent
Electricity
Wages and salaries
Depreciation
Repairs
PROFIT BEFORE INTEREST
Finance costs (interest expense)
PROFIT FOR THE YEAR
STATEMENT OF COMPREHENSIVE INCOME FOR THE
PERIOD ENDED 31 JANUARY X1
PROFIT FOR THE YEAR (which is the closing balance from the
income statement)
OTHER COMPREHENSIVE INCOME
Revaluation gain
Exactly the same information is given, but in two different
statements. Profit for the year is the link between the two statements.
Something to do 2
Go back to the information provided at the start of the chapter, and answer
these questions:
1. What was the cost of the inventory purchased during the month?
2. What was the cost of the inventory that the business had at the end of
January?
3. Do you think that the R120 received on 15 January should be recognised
as sales income?
4. Should we recognise the R500 received from A. Browning on 16 January
as sales income?
5. Do you think that the invoice books and pens purchased on 12 January X1
are an asset on the statement of financial position at 31 January X1?
6. Read through Judy's financial reports and identify any expenses and
income that should be recognised in January X1.
7. Would we include the personal clothing Judy purchased in the calculation
of profit? Explain your answer.
Check your answers
1.
30 Briefcases (R120 each) R3 600
20 Handbags (R30 each) R600
30 Purses (R20 each) R600
Total cost of inventory purchased R4 800
2.
Cost of inventory on hand at the end of January X1 (10 × R120) + (8 × R30) + (21
× R20) = R1 860
3. The customer has not received the handbags; they are still under Judy's control.
The deposit received is a liability, as Judy will have to give it back if the customer
does not like the bags. If the bags had already been selected and Judy had put
them somewhere separate from the other bags, then the full amount would be
recognised as sales.
4. The R500 received on 16 January will not be recognised as sales income. The
sales income was recognised on 6 January − when the service was provided. On
16 January the business received cash R500 and the debtor (A. Browning) owed
the business R500 less.
5. If the invoice books and pens were unused (i.e. had not been derecognised) they
would still be recognised as an asset. If the invoice books and pens had been
used during the period, their cost would be shown as an expense.
6. Expenses:
Cost of sales expense R[(20 × R120) + (12 × R30) + (9 × R20)] R2 940
Rent expense R1 000
Wages expense R600
Talk-time expense R440
Stationery expense R200
Petrol expense R300
Depreciation expense [R1 200/2 × 1/12 + R950/5 × 1/12] R66
Income: 600 + 60 + 1 380 + 120 + 2 850 + 60 + 480 + 1 161 = R6 711

We would include the credit sales in the statement of profit or loss and other
comprehensive income because of the accrual concept. Although Judy has not
received the money for the handbags, she has provided the service. The
handbags are no longer controlled by her (she has sold the bags). The handbags
are no longer an asset − the cost of the bags is recognised as a cost of sales
expense, and the selling price of the bags will be recognised as income.
7. No, we would not include the personal clothing Judy bought in the calculation of
profit, as that includes only business expenses. We would record the fact that
business money had been utilised by the owner as drawings.
Let’s draw up the statement of comprehensive income for Judy’s
business, assuming that a separate statement has not been prepared.
Statement of profit or loss and other comprehensive income for

the period ended 31 January X1
Sales 6 711
Less Cost of sales (2 940)
Gross pro t 3 771
Less operating expenses (2 606)
Rent expense 1 000
Wages and salaries expense 600
Petrol expense 300
Stationery expense 200
Talk-time expense 440
Depreciation expense 66
Profit for the year 1 165
Depreciation:
= (R1 200/2 × 1/12) + (950/5 × 1/12)
= R50 + R16 [15.83 has been rounded up for convenience]
By now you should understand what information is reported in the
statement of profit or loss and other comprehensive income, what
concepts underlie the preparation of the statement of profit or loss
and other comprehensive income, and how to prepare a statement of
profit or loss and other comprehensive income.
2.4 An introduction to statement of

changes in equity
Let's look at the statement of changes in equity.
The owner or owners of a business will want to know whether and
why the equity of the business changes from year to year, because
this means that the net assets (the claim) of the company have
changed. To show why this has happened, the business prepares a

statement of changes in equity. This shows the user how each type of
equity account on the statement of financial position has changed
over the year.
Statement of financial position
20X2 20X1
Equity
Capital
Revaluation surplus
Retained pro t
The statement of changes in equity (see below) starts with the
balances of each equity account at the beginning of the year. All the
movements that have happened in each equity account (Capital,
Retained Earnings, Revaluation Surplus) during the year are shown.
The statement of changes in equity reconciles the balance of the
equity account at the beginning of the year and the balance of the
equity accounts at the end of the year (together with comparatives
for the prior year).
Handbags for Africa Ltd
Statement of changes in equity for the years ended 31 December

The statement of changes in equity will show the users of the
financial statements why the total equity changed by showing all
gains and losses and transactions with the owners, in their capacity
as an owner.
What do we notice?
1. The statement of changes in equity requires you to show:
a. All the gains and loss and show each type of OCI either on
the statement or in the notes
b. all transactions with owners in their capacity as owners i.e.
capital raised and drawings/dividends
2. The profit for the period and the revaluation gain are shown as
changes in total comprehensive income.
3. Retained profit will increase if the company generated a profit
during the year and will decrease if the company distributed
part of the profit to the shareholders.
4. The revaluation surplus will increase if the company revalued
assets during the year (increase in the fair value). The
revaluation surplus can decrease if the fair value of the asset
decreases. (This is discussed in more detail in the PPE chapter,
Chapter 11.)
2.5 Understanding the statement of
cash flows
The financial position of the business is reported in the statement of
financial position, the financial performance is reported in the
statement of profit or loss and other comprehensive income and the
change in net asset value is reported in the statement of changes in
equity. Let’s look at the statement that communicates how much
cash has been received and paid by the business. This will complete
the picture of Judy’s business for January.
Something to do 3
How much cash is in the business bank account at the end of January?
Check your answer

Total money received in January = R13 101
Total money paid out in January = R9 010
The difference between money received and money paid out amounts to R4 091.
Because the receipts are higher than the payments for January, Judy's bank balance is
positive. Does this mean that Judy has earned a profit of R4 091? No, the statement of
comprehensive income reported a profit for January of R1 165 and her bank balance
is R4 091.
Do you remember how we calculated the profit for January? We calculated the
difference between the income earned and expenses incurred during January, and
arrived at a profit of R1 165.
Why is the bank balance different from the profit?

Profit is calculated according to the accrual concept and only
includes income and expense amounts in the calculation. The bank
balance is calculated by looking at the cash coming in and going out
of the business. The bank balance will be affected by the purchase of
assets such as the cellphone or inventory for cash. The profit will be
affected only if the inventory is sold (cost of sales expense) and the
cellphone and furniture has been used for one month (depreciation
expense).
Let's look at the transaction of 6 January.

On 6 January, the business sold 4 briefcases and 3 handbags for R1
380 on credit.
Why was this amount reported in the statement of comprehensive

income as income?
According to the accrual concept income is recognised when the
transaction occurs, i.e. when assets/liabilities change and not
necessarily when cash is received. Because Judy did not receive this
money in January, her bank balance would not reflect the cash
coming in. The calculation of profits, however, includes this amount
as income in January.
Now that we understand the difference between cash and profit, let
us prepare the statement of cash flow for Judy’s business for
January.
Statement of cash flows for January X1 (all amounts in rands)

Cash received
Cash received from customers 3 101
Loans raised 2 000
Capital contributed by Judy 8 000
13 101
Cash paid
Cash paid to suppliers (for goods) 3 600
Purchase of new assets 2 150
Operating costs 2 540
Drawings 720
9 010
Net cash received (13 101 − 9 010) R4 091
We can see that this amount is equal to Judy’s bank balance.
What do you notice?

• Cash received is shown separately from cash paid.
• Operating costs are the costs of running the business that have
been paid in cash, calculated as follows:
Rent R1 000
Wages R600
Talk-time R440
Petrol R300
Stationery R200
Total R2 540
• The money withdrawn by Judy is an outflow of cash.
• The statement of cash flow shows the cash inflows and outflows
during the reporting period (January), and the final cash figure
shown on the statement of cash flows is the same cash balance
that appears on the statement of financial position as at 31
January X1.
Think about this 2

What transactions appear on the statement of cash flows but and are not
included in the profit calculation?
Loans raised
Purchase of new assets
•
Cash purchases of inventory

•
Capital contributions by the owner

•
Drawings.
•
What transactions are taken into account in the profit calculation but are not
•
on the statement of cash flows?

Credit sales
Credit purchases
•
Cost of sales expense

•
Depreciation.
•
Below is an example of the kind of information reported in the
statement of cash flows of a business. We’ll look at statements of
cash flows in detail in Chapter 14.
STATEMENT OF CASH FLOWS
SOURCES OF CASH
Cash received from customers/clients
Proceeds from property, equipment or other assets sold
Interest or dividends received on investments
Loans raised
USES OF CASH
Cash paid to suppliers (for inventory)
Purchase of new assets
Operating costs
Interest paid on borrowed funds
Taxation paid
Loans repaid
By now you should understand what information is reported in the
statement of cash flow, why the bank balance or cash position is not
the same as profit, and how to prepare a simple cash flow statement.
Well done! If you have come this far, you should be able to
prepare basic financial statements for a business.
We still have one more task to complete. We must prepare the
statement of financial position of the business at 31 January X1.

Assets
Non-current assets 2 084
Furniture and equipment [950 − 16] 934
Cellphone [1 200 − 50] 1 150
Current assets 9 681

Inventory 1 860
Debtors [4 230 − 500] 3 730
Bank 4 091
Total assets 11 765

Equity 8 445
Capital 8 000
Retained earnings [1 165 − 720] 445
Loan 2 000
Current liabilities 1 320
Trade payables 1 200
Deposit for bags 120
What do you notice?

• The retained earnings amount is made up of:
Pro t earned for January R1 165

Less drawings R720
• The inventory balance shows the cost of goods not sold (closing
inventory) at 31 January.
• The bank balance is the amount of money in the bank account at
31 January (calculated in the statement of cash flows).
• The cellphone and trestle table are shown at the amounts paid
when the items were bought, less the depreciation.
• The loan is still R2 000 because no repayments have taken place.
Think about this 3

In Judy's example we have assumed that the talk-time for the cellphone has all
been used in January. What if there was still talk-time remaining? The unused
•
talk-time would be reflected as a current asset in the statement of financial

position, and only the portion used would be shown as an expense on the
statement of comprehensive income. This will be discussed in greater depth in
Chapter 6.
Now that we have prepared all the financial statements of Judy’s
business, she is in a position to present them to the bank. Good luck
with the application for a loan, Judy!

• We know how the accounting equation (assets = equity +
liabilities) is derived.
• We have learnt what information is presented in the statement of
financial position.
• We know what assets and liabilities are.
• We know how profit is calculated and how that calculation is
presented.
profit and loss and other comprehensive income.
cash flows.
• We know how to prepare basic financial statements.
What's next?
In the next chapter you will learn how to process the transactions
that took place in January.

QUESTIONS
QUESTION 2.1 (B)

(14 marks: 17 minutes)
On 1 June 20X0, Peter opened a toy shop in the Pavilion Shopping
Centre. During the month of June, the following transactions,
amongst others, took place:
1. On 1 June Peter deposited R150 000 cash into the business bank
account.
2. On 5 June Peter gave his motor car that he valued at R25 000 to
the business.
3. On 10 June the business purchased inventory on credit for R70
000 from a local wholesaler.
4. On 15 June the business sold inventory to a tourist for cash R6
500 (inventory cost R1 500).
5. On 18 June the business purchased R1 500 stationery on credit
from Walters stationery shop.
6. On 30 June the business had unused stationery of R1 000 on
hand.
Show how the above transactions affect the financial position of the
business as represented by A = E + L. You need to clearly indicate

whether the element has increased or decreased and provide the
relevant amount and account that would be affected.
QUESTION 2.2 (C)

Anand Singh moved to South Africa from India in November X3 to
pursue a two-year, part-time master’s degree in the History of Art at
University. Anand’s uncle owns a shop in India that makes and sells
leather jackets. Anand persuaded his uncle that there was a market
for the leather jackets in South Africa and together they decided to
open a shop called Hip in Leather on 1 January X4.

Each day you travel on the bus with Anand to University and
have become good friends. He has just been given the financial
statements of Hip in Leather for the year ended 31 December X4 and,

since you are studying Financial Accounting, has a few questions
that he would like to ask you. Anand gives you the following
information to review:
Hip in Leather
Extract from the statement of financial position as at 31
December X4
Total 435 000
Equity
Capital 200 000
Accumulated pro t (net of drawings of R60 000) 60 000
Non-current liabilities 105 000
Answer the following questions asked by your friend Anand about
his business Hip in Leather:

1. Anand stated, “I have become so wealthy over the year. After
being in business for one year, I own total assets amounting to
R435 000. Do you agree that if I decided to go back to India, I
could sell all the assets and use all the money to start my own
business over there?”
Provide Anand with an answer to his question and support your

answer with a brief explanation. (4 marks)
2. Anand was frowning as he spoke. “I don’t really understand
where the assets amounting to R435 000 came from.”
Explain to Anand how assets can be funded and how the

change in the assets came about for the year ended 31
December X4. (6 marks)
3. While looking at the statement of financial position Anand
made the comment, “I would have expected to see the drawings
of R60 000 in the statement of profit or loss and other
comprehensive income and not in the statement of financial
position.”
Explain to Anand the purpose of the statement of profit or loss

and other comprehensive income and whether he is correct in
recording drawings in the statement of profit or loss and other
comprehensive income. (5 marks)
4. Anand looked puzzled as he began to speak, “On 1 May X4,
ABSA bank granted the business a loan of R105 000. This
amount was deposited directly into the business bank account. I
know that the assets would have increased by R105 000, but I
cannot understand why the liabilities increased as well.”

Using and briefly explaining any definitions outlined in the
conceptual framework, explain to Anand whether and why the
liabilities of the business will increase. (7 marks)
5. Anand noticed that the headings to the statement of profit or
loss and other comprehensive income and statement of financial
position were not the same. “The headings to the statements are
different. Has the accountant made a mistake?”
The heading in the statement of profit or loss and other
comprehensive income reads “for the year ended 31 December
X4” whereas the heading for the statement of financial position
reads “as at 31 December X4”. Briefly explain to Anand why the

headings differ. (3 marks)
QUESTION 2.3 (A)

Mr and Mrs Dube started a small paint business, New Dube Traders,
on 1 July X0. During the month of July, the following transactions
took place:
1 Mr and Mrs Dube deposited R30 000 in a bank account in the
name of the business. Obtained a long-term loan of R15 000
from Mrs Dube’s rich aunt. Interest would be payable monthly
at the rate of 12% per annum. Repayment terms were not set.
3 Signed a three-year lease for office premises with an annual
rental of R12 000. Paid a deposit of R1 000 and three months’
rent in advance to secure the premises.
4 Employed an assistant, Helpful Goba, at an agreed salary of R1
500 per month to be paid on the 25th of each month.
5 Purchased paint for cash of R2 750 from Paint Wholesalers Ltd.
6 Bought office supplies (stationery etc) for R750 on account.

7 Bought paint on credit from Paint Galore Ltd for R6 200.
8 Purchased office furniture at an auction for R3 300 cash.
10 Sold paint for R800 cash to Ms Fix-it (cost New Dube Traders
R600).
15 Purchased a second-hand delivery vehicle from Trusty Motors
Ltd for R7 500 and paid R1 650 as deposit. The remainder of the
money is to be paid in 3 equal instalments over the next 3
months.
18 Made sales on credit to Hardy Ltd for R3 740 for paint that cost
R2 900.
20 Banked cash sales for the day of R2 800. Cost to New Dube
Traders R2 200. Paid motor vehicle expenses of R300 to a
university friend, Jabu Sithole, who gave the car a service.
25 Paid Helpful Goba his salary for the month.
29 Received the money due from Hardy Ltd.
30 Paid R4 000 to Paint Galore Ltd in part settlement of the amount
owing.
31 Paid the interest due to Mrs Dube’s aunt.
Record the above transactions under the accounting equation.

3 The practice of
accounting
Judy was pleased to learn how to present the financial information
of her business in an acceptable form. She was a little concerned
at how long it took her to go through all the transactions that had
already happened during the month. “It seems as if I am wasting
time! All of these transactions have taken place, but I have to sort
out what are assets, what is income and what are expenses. I am
worried that as the number of transactions that occur during a
month increases, I am going to be spending even longer trying to
sort things out at the end of the month. I am also concerned that I
may miss out certain transactions as I am lumping things
together. All I seem to be doing is dealing with each transaction
over and over again. First I write out cheques or receipts, and then
I record the details of each transaction in my cashbook. At the end
of the month I re-read everything and sort the information out so
that I can complete the financial statements. There must be a way
to keep a record of transactions without having to repeat the same
process over and over again. Isn't there an easier way to ensure
that the information at the end of the month is more useable?”
Learning objectives
• Understand the need for a processing system
• Process transactions
• Record transactions in the general ledger
• Balance ledger accounts
• Extract a trial balance at the end of the month
• Record information in the general journal
• Recognise source documents and understand what transaction is being reflected
on them
• Understand the need for specialised journals
• Record information in specialised journals.

Judy has realised that she needs to use the financial information
provided by her business to draw up financial statements. These
statements are generally completed at the end of a financial period,

but could be drawn up at any other time, if required. She has
realised that it takes time to look through the list of transactions in
order to classify the various transactions, so she is looking for a
better way to record the transactions of her business as they occur.
Why did this problem occur?

Judy does not have a systematic method of recording transactions.
All her transactions are recorded in one book and the only question
she asks is whether money has been received or paid before writing
up the information in one of the two columns she is using.
Let's look at what we have already learnt in Chapter 2.

We have learnt that the assets of a business are equal to the claims
(or contributions) of the funders of those assets: Assets = Equity +
Liabilities (this is referred to as the accounting equation). The
funders may be the owner(s) or outside lenders, for example a bank.
The owners’ contribution is referred to as equity and the outside
lenders’ contribution as liabilities. This equation is the foundation of
accounting and every financial event is processed and reported
using this equation, which interprets the financial effect of the
transaction. We also learnt that the amount of assets could never be
more or less than the amount of funding for these assets. This is
another way of saying that assets must always equal the sum of
equity and liabilities.
How are we going to help Judy solve her problem?

1. We are going to understand how the accounting equation can
be used to record the effect of each transaction on the assets,
2. We are going to learn how the bookkeeping system
systematically records all transactions.
3. We will learn how to process a journal entry, post to ledger
accounts and extract a trial balance.
4. We are going to see how the information in the trial balance is
used to prepare the financial statements of her business.
5. We will understand how using specialised journals will allow
Judy to summarise similar transactions before posting a single

amount to the general ledger.
3.1 The accounting equation in more

detail
Let’s look at the first two transactions that occurred in Judy’s
business.
1. Deposited R8 000 of her own money into a bank account in the
business’s name.
2. Borrowed R2 000 from her sister.
Transaction 1
The R8 000 is an ASSET (cash) of the business.
The R8 000 ALSO represents the claim that Judy has on the
business. Because Judy is the owner of the business this claim is
called the EQUITY of the business. So this transaction has
simultaneously lead to an asset and equity being recognised in the
business.
Let’s look at how transaction 1 would affect the accounting
equation.
Transaction 2
The R2 000 Judy’s business borrowed from her sister will be paid
into the bank account of the business. The extra R2 000 in the bank
account is an ASSET to the business.
The R2 000 also represents a claim that Judy’s sister has on the
business. Because Judy’s sister is an example of outside funding (she

is not an owner), her claim is a LIABILITY of the business.
The net effect of these transactions is an increase in the assets of the
business of R10 000, which is funded to the extent of R8 000 by
equity and R2 000 by debt.
relationship between the resources of a business and how these resources are
funded.
Something to do 1
Here are two transactions which occurred in Judy's business this month:
1. Purchased a cellphone and paid R1 200.
2. Purchased a trestle table and chair and paid R950.
Answer the following:
1. For each transaction, identify which element(s) of the accounting
equation will be affected.
2. Show each transaction under the accounting equation.
3. Has the net asset value of the business changed because of either
transaction?
Check your answers
Transaction 1
The cellphone is an asset, and the money from the business bank
account that is used to pay for the cellphone is an asset.
The net asset value (equity) of the business has not changed, as the
business is exchanging one asset (cash) for another asset (cellphone).
Transaction 2
The trestle table and chair and the money from the business bank
account that is used to pay for the furniture are both assets.
The net asset value of the business has not changed as the business is
exchanging one asset (cash) for another asset (trestle table and chair).

We can see from the above examples that every transaction affects at
least two items. This is known as the double entry principle. For
example, the asset acquired and a record of how it was acquired
(capital increases or bank decreases or a liability increases). For the
entry to be recorded the business indicates both that an asset was
acquired and whether the owner contributed it, it was purchased
using cash in the business or whether it was purchased on credit.
How can we use our understanding of the accounting equation
and the double entry principle to record the impact the transactions
have on the assets, equity and liabilities?

Let’s look at the following transactions of Handbags for Africa
that occurred during January X1:
1. Purchased 30 briefcases for R3 600
2. Sold 2 briefcases for R600
3. Judy withdrew R300 for personal use
4. Purchased petrol to be used during the month R300
5. Wages paid R150.
For each of the transactions we will:
1. Identify which element(s) of the accounting equation will be
affected.
2. Show each transaction under the accounting equation.
3. Consider whether the net asset value of the business increased
or reduced because of the transaction.
Transaction 1
Purchased 30 briefcases for R3 600
The inventory purchased is recorded as an asset when purchased
i.e. inventory increases, and the money paid from the business’ bank
account for the inventory is also an asset. i.e. bank decreases.
The net asset value of the business has not changed, as you are
exchanging one asset (cash) for another asset (inventory).
Transaction 2
Sold 2 briefcases for R600
The cash received for the sale increases the bank (an asset). Assets
(bank) increased by R600 and there is no change in any other assets,
no liability has changed. The net asset value (equity) of the business
has increased. The increase in net asset value is not due to a
transaction with the owner. This increase in net asset value is
recognised as INCOME. Sales income of R600 increases equity.
Inventory (an asset) has decreased by the cost of the 2 briefcases that
have been sold. The briefcases cost R120 each (R3 600/30).
Assets (inventory) decreased by R240. There is no change in any
other assets, and no liability has changed. The net asset value
(equity) of the business has decreased. The decrease in net asset
value is not due to a transaction with the owner. The decrease in net
asset value is recognised as an EXPENSE. Cost of sales of R240
decreases equity.
For a sale transaction the business records the sale at selling price
and the movement of inventory at cost price as two separate
entries.
relationship between assets, equity and liabilities, with a focus on equity.
What would we record if the inventory was sold on credit –
transaction on 6 January X1?
6 Sold 4 briefcases and 3 handbags − must still be paid R1 380 Nil
When would we record the sale transaction? Would we record the
sale when we received the money or when the transaction occurred,
in other words, when the customer took the briefcases and handbags
out of the store?
In Chapter 2 we looked at the accrual concept, which indicates
that income is recognised when the asset/liability changes and not
necessarily when the money is received, and expenses are
recognised when the asset/liability changes and not necessarily
when the money is paid.
Although the business has not received the money, the sales
transaction has occurred. Assets (trade receivables) increased by R1
380. There is no change in any other assets, and no liability has
changed. The net asset value (equity) of the business has increased
and the increase in net asset value is not due to a transaction with
the owner. The increase in net asset value is recognised as INCOME.
Sales income of R1 380 increases equity.
Assets (inventory) decreased by R570 [R120 x 4 + R30 x 3]. There is
no change in any other assets, and no liability has changed. The net
asset value (equity) of the business has decreased and the decrease
in net asset value is not due to a transaction with the owner. The
decrease in net asset value is recognised as an EXPENSE. Cost of
sales of R570 decreases equity.

Think about this 1
When the trade receivable settles the debt, would you record this as a further
sale? Explain your answer.
How would you record the settlement of the debt under the accounting
equation?
Check your answers
No. When the trade receivable settles the outstanding debt, the business is merely
exchanging one asset (trade receivables) for another asset (cash), so trade receivables
decrease and bank increases.
Transaction 3
Judy withdrew R300 for personal use.
Assets (bank) decreased by R300. There is no change in any other
assets, and no liability has changed. The net asset value (equity) of
the business has decreased. The decrease in net asset value is due to
a transaction with the owner. The decrease in net asset value is

therefore a distribution of assets to the owner and is referred to as
drawings. This distribution will NOT be recognised as an expense.
Transaction 4
Purchased petrol to be used during the month for R300.
The petrol was purchased at the start of the month. The business
has the right to use the petrol. The payment would be treated as an
asset, so petrol (asset) increases and bank (asset) decreases.
What if?
Assume the petrol had already been used, in this case assets (bank) would
decrease, as no other asset or liability changes, the net asset value would
decrease. This is not a transaction with the owner so a petrol expense would be
recognised, equity would decrease.
Transaction 5
Wages paid R150
The wages for the week have been paid on the 7th, the last day of
the week. Judy is paying her employees for the work that they have
already done. (The net asset value of the business decreased). Bank
(asset) decreased by R150, no other asset or liabilities changed). The
transaction is not with the owner, so an expense will be recognised.
Something to do 2
For each of the following transactions of Judy's business, answer the
questions below:
1. Identify which element(s) of the accounting equation will be affected.
2. Record each transaction under the accounting equation.
Check your answers

Calculations:
13. Amount owed by the tour operator = 10 x R300 = R3 000 ± 5% (R150) = R2 850
Cost of inventory sold = 10 x R120 = R1 200
28. Sale day = (3 x R300) + (5 x R30) + (4 x R60) = R1 290 ± R129 = R1 161
Cost of inventory sold = (3 x R120) + (5 x R20) + (4 x R30) = R580
Let's review some of the above transactions .
On the 5th Judy purchased inventory on credit .
The business supplying her with the goods is known as a trade payable. A trade
payable is someone to whom the business owes money.
At what point would Judy's business have the right to sell the inventory? When the
inventory is delivered to the business, or at the later date, when the inventory is
actually paid for?
The right to sell the inventory transfers on delivery. The inventory would be
recognised as an asset on delivery.
On the 15th Judy received R120 cash as a deposit received in
advance on inventory that was going to be purchased in February .
The handbags had not been selected so Judy could not say that the sale had
happened. She has received part of the money but has, as yet, not provided the
customer with any goods. The R120 she has received is a liability because the
business has an obligation to provide the handbags to the customer.
On the 16th Judy used business money to purchase clothing for
herself .
Should the money spent on clothing for Judy be recorded as a business expense?
No! The clothing should also not be recognised as inventory of the business, as it
was purchased for her personal use and not for resale by the business.
The business records will reflect only business transactions. Any personal
transactions that make use of business funds will reduce the claim that the owner has
against the business. These transactions are known as drawings.
On the 16th Judy received a cheque from A. Browning (trade
receivable) to settle part of their debt .
Should the R500 received from A. Browning be recognised as sales income on 16
January?
No! On 16 January an asset (bank) will increase by R500 and another asset (trade
receivables) will decrease by R500. There is no change in the net assets of the
business, so no income or expense will be recognised. No new sale occurred on 16
January. The debtor was paying for a sale that had already been recognised (on 6
January).
Something to do 3
At the end of the month Judy had used up the petrol, stationery and talk-time.
How would you record this under the accounting equation? She also paid the
rent for January.
Check your answer
When the petrol, stationery and talk-time were purchased they were recorded as
ASSETS. At the end of the month they have all been used. They will now be recorded as
expenses.
The asset (petrol asset) decreases. The net asset value (equity) of the business
decreases, and this is not due to a transaction with the owner. The decrease in net
asset value is recognised as an expense.
Think about this 2
How would you classify electricity? Do you think it should be recorded as an
asset or as an expense?
Check your answers
The answer lies in when electricity is used in relation to when the cash payment is
made.
Electricity used can be paid for at the end of the month after we have used the
electricity, or we can install a prepaid electricity meter and pay for the electricity before
we use it.
The payment made for electricity can therefore be recognised as either an expense
or an asset. It is extremely important to understand when we recognise an item as an
asset and when we recognise it as an expense.
It is important to question what has happened when we purchase or pay for
something. Does the payment lead to a decrease in equity that is not due to a
distribution to the owner? If so, recognise an expense. If the payment means that the
business has acquired a right that has the potential to produce economic benefit, an
asset is recognised.
When prepaid (or unused) electricity is purchased, the business acquires the right to
use the electricity. This has the potential to produce economic benefit, so an asset is
recognised.

It is important to realise that businesses need to have proof of the
transactions that occur. Every business transaction is initially
recorded on a source document.
A source document is the point of original entry of a transaction and

should provide the information necessary to record the transaction
accurately .
When you purchase items from a grocery store for cash the store
gives you a cash register slip. The cash register slip is an example of
a source document. It is proof that you purchased the items from
that particular store.
Something to do 4
Find a cash register slip (till slip). What information is provided on the cash
register slip?
Check your answer
The type of information provided on the till slip could vary depending on the actual
business you are dealing with. The information could include the following: the date of
the transaction, the name of the business where you purchased the items, the amount
of money spent on each item, the total amount of money spent, the value added tax
(VAT) paid on the transaction, and a description of what items were purchased.
Every transaction in Judy's business would have a source document as proof of the
transaction. Let's look at some of examples of the source documents that Judy would
use in her business.
3.3.1 Deposit slip

The start-up capital of R8 000 would have been paid into a bank
account. The source document Judy would use as proof of this
transaction would be a bank deposit slip.

The deposit slip is proof that on 1 January X1 Judy Abrahams
wrote out a personal cheque and paid R8 000 into the current
account (cheque account) of Handbags for Africa at SBS Bank.
Please ensure that your account number is correctly inserted as the
Bank cannot be held responsible for errors resulting from incorrect
information furnished.
Cheques, etc. handed in for collection will be available as cash only
when paid. While acting in good faith and exercising reasonable
care, the Bank will not accept responsibility for ensuring that
depositors/account holders have lawful title to cheques etc.
collected.

Judy borrowed money from her sister. This money will be used by
the business (Handbags for Africa) to purchase assets. Judy and her
sister agreed on the credit terms of the loan.

The credit terms include the following information:
• When will the loan be repaid? The loan could be repaid in full at a
later date or the loan could be repaid in instalments. If the loan is

repaid in instalments, it means that a portion of the loan is paid
back at a time; for example, the loan could be paid back in four
equal instalments of R500 each.
• What interest rate will be charged on the loan? The interest rate
that a business or individual will be offered by the bank will
depend on their creditworthiness. Banks will look at the risk-

profile of the client and the ability to repay the loan. The lower the
risk, the lower the interest rate will be that the bank offers. The
interest rate that is quoted is for a year. If the money is lent for a
shorter period the interest charged by the bank will be less. We
pay interest only on the amount of money we have borrowed, for
the period that we keep the money.

Judy Abrahams
Handbags for Africa
This is to confirm that Ms Pearl Abrahams of 30 Strubens Road,
Mowbray loaned R2 000 to Ms J. Abrahams of Handbags for Africa on
1 January X2. The loan shall be repaid in full on 1 April X1. Interest at
10 per cent per annum on the loan will be paid in arrears on 1 April
X1. Should the loan be repaid at a date later than 1 April X1, interest
of 15 per cent per annum will be charged for the entire duration of
the loan.
Signed at Cape Town on 1 January X1.
J. Abrahams __________________ P. Abrahams _________________
Witness ______________________
3.3.3 Cheques
On 1 January, Handbags for Africa purchased a cellphone. The
business has a current account that allows the business to make use
of a chequebook.
The following information appears on the cheque:
1. The account number. This will be the same number that appeared
on the bank deposit slip. The account number indicates the
current account that will be used to pay the cheque.
2. The cheque number. Each cheque has its own number and this
information is recorded in the books of the business. If there is a
query regarding a transaction, it is easy to identify the source
document (cheque) relating to the entry and confirm what the
transaction should have been.
3. The branch code. The Waterfront branch of SBS Bank has its own
branch code.
4. The date of the transaction.
5. The drawer. The drawer is the individual or business writing out

the cheque. In the example below, the drawer is Judy
Abrahams.
6. The payee. The payee is the individual or person that is receiving

the cheque. In the example below the payee is Vodacom.
7. The name of the bank that will act as an intermediary and make the
payment on behalf of the drawer to the payee.

Businesses can use internet banking facilities to pay suppliers, or to
receive payments from clients. A payment made through internet
banking is also referred to as an EFT payment (EFT = Electronic
Funds Transfer).
Judy could speak to her bank and set up an internet banking
facility. This would mean that Judy could make a payment to a
supplier by setting them up as a beneficiary on her internet banking
site. Judy would be able to make this payment from any computer
that was able to connect to the Internet. It would, however, not be a
good idea to make internet payments from internet cafés or other

unsecured computers, as computer fraud is a reality. Judy would not
want people to be able to find out the password that she had set up
to protect her bank account.
Internet banking is cheaper and more convenient than having to
go to the actual bank.
3.3.5 Cash receipt

On 2 January Judy sold goods to a customer for cash. She issued a
cash receipt as proof of payment.

The cash receipt indicates:
1. What has been purchased
2. Who has purchased the goods
3. How much the goods cost

Handbags for Africa sold goods on credit to Bags Delight on 6
January X1. Handbags for Africa will issue a credit sales invoice.
The following information generally appears on the invoice:
1. The name and address of the business selling the product.
2. The name and address of the individual or business purchasing
the product.
3. The invoice number. This enables the business to find the
document easily should there be a query regarding the
transaction. It is also used to check that all the sales are
recorded, as each invoice is numbered consecutively.
4. The account number. Businesses that regularly sell on credit will
issue each customer with an individual number. This number

will appear on all documentation relating to the particular
client.
6. Information regarding the items purchased.
7. The total amount of the sale.
8. Conditions of the sale. This could include payment terms and
discount rates.
The information about each transaction presented on the source
document allows the business to record the impact of the transaction
on the assets/liabilities/equity of the business. If we look at the
invoice above, Handbags for Africa sold inventory with a selling
price of R1 380.00 on credit (the invoice indicates payment will be
made in 30 days). When we showed this transaction under the
accounting equation (see page 57) the effect on A = E + L was as
follows:
It is important to note that the information required to identify the
effect on A, E, L is provided by the source document. However
businesses do not keep their financial records in the A = E + L
format as shown above. The information from the source document
is recorded in a journal entry.
3.4 Journal entry

The journal entry records the effect of the transaction on the assets,
equity and liabilities of the business.
When each transaction is recorded, the following two rules apply
simultaneously:
1. The accounting equation (A = E + L) must balance after each
transaction has been recorded.
2. For every debit entry there has to be an equal credit entry (DR =
CR). So, what are debits and credits?
Go and watch Understanding Debits and Credits: This video explains what the
terms debit and credit mean and how they fit into the accounting system.
This is the basis of the double entry system developed in the 15th
century by Lucio Pacioli, an Italian monk whom we discussed in
Chapter 1.
Accounting record keeping uses the terms debit and credit to
indicate whether an element (A, E, L) is increasing or decreasing.
Remember A = E + L and DR = CR must apply to each transaction.
We can see that the sale transaction above can be written as
follows:
Increase assets (Trade receivables) by R1 380
Increase equity (Sales income) by R1 380
It is important to remember that the term Debit (DR) is used to
indicate an increase in assets, so to prepare the journal entry the
business would indicate the following:
DR Trade receivables (A) 1 380
And as each transaction needs to show equal debit and credit
entry, the second line of the entry would look like this:
CR Sales income (E) 1 380
You will notice the explanation at the end of the journal entry, this is
referred to as the narration and is a brief explanation of the entry.
What can we see from the journal entry above?
• When assets increase we refer to this as a debit entry (DR)
• When equity increases we refer to this a credit entry (CR).
The business will also record the inventory that left the business and
the resultant cost of sales expense:
Decrease equity (cost of sales) by R570
Decrease asset (inventory) by R570.
The following journal entry will be processed:

What can we see from the journal entry above?
• When assets decrease we refer to this as a credit (CR) entry
• When equity decreases we refer to this as a debit (DR) entry
• For each transaction A = E + L
• For each transaction DR = CR.
When preparing a journal entry it is convention to record the debit
entry as the first line of the journal entry and the credit entry as the
second line of the journal entry.
Once the information from a source document has been recorded
in a journal, the information will be posted to the general ledger. The
general ledger allows us to record all the entries affecting a
particular type of asset, equity, liability in once place, for example,
inventory, sales income or trade payables will have their own
“space” or account in the general ledger.
3.5 Recording information in the general

ledger
The general ledger is made up of different accounts where each
account is used to record similar transactions that occur in the
business. Judy’s business, for example, would have an account for
bank, capital, furniture, equipment, sales, and so on.

3.5.1.1 What does an account look like?
Ledger accounts are also known as T accounts because, in a manual
system of accounting, the ledger accounts (see below) look like a
capital T:
In terms of the double entry system:
• if an ASSET INCREASES, the entry is recorded on the debit side of
the account. If an ASSET DECREASES, the entry is recorded on
the credit side of the account
• if EQUITY INCREASES the entry is recorded on the credit side of
the account. If EQUITY DECREASES the entry is recorded on the
debit side of the account
• if a LIABILITY INCREASES the entry is recorded on the credit side
of the account. If a LIABILITY DECREASES the entry is recorded
on the debit side of the account.
3.5.1.2 Posting from the journal to the ledger

The journal entry is an instruction which indicates what has
happened (increase/decrease) to individual asset, equity or liability
accounts. This information must be posted to the relevant individual
account in the ledger. Let’s look at the sale transaction from 6
January.
This information is going to affect the following ledger accounts:
It is important to note that we read the journal as an instruction:
The first line tells us to debit the trade receivable account with R1
380 on 6 January.
The second line tells us to credit the sales account with R1 380 on 6
January.
The final information that needs to be entered into the ledger
accounts is the contra account. The contra account refers to the other
account in the general ledger. In the trade receivables ledger account
the contra account is sales income, and in the sales income ledger
account the contra account is trade receivables.
Why are the contra account details important?
In order to present the information in the general ledger in a more
useful way, the contra account for each entry is recorded. The contra
account is the second leg of the double entry.
If you look at the sales income account with the contra account
information in it, you are able to identify that the sale was a credit
sale.
Think about this 3

If the business made a cash sale, what would the contra account in the sales
income account be?
To answer this question we would ask what the journal entry to record the sale
would look like, an asset (bank) would increase and equity (sales income) would
increase.
DR Bank (A)
CR Sales income (E)
So the contra account would be bank.
So when you record transactions in the general ledger you must
ensure that you correctly answer the following questions regarding
each transaction:
1. Which elements of the accounting equation will be affected
(assets, equity or liabilities)?
2. Are the elements increasing or decreasing?
3. Must the accounts be debited or credited?
Something to do 5
Record the following transactions in the general ledger of Handbags for
Africa (1 January X1):
1. Purchased a cellphone and paid R1 200
2. Purchased a trestle table and chair and paid R950
Check your answers

The Bank account has been credited with Cellphone (1 200) and
Trestle table (950). This tells us that money from the bank was used
to purchase both a cellphone and a trestle table.
The Cellphone and Trestle table accounts have been debited with
Bank (1 200) and Bank (950). This tells us that the cellphone and
trestle table have been bought and paid for in cash.
The business will not use a separate bank account for each
transaction. All transactions that affect the bank account will be
recorded in a single account called Bank. At the end of the month the
bank account will be balanced. The balance of the bank account
would indicate the net effect of that item (in this case, bank) over the
month. We will look at balancing accounts in more detail later in this
chapter (section 3.5.1.3).
Let's look at some of the above entries in more detail.

We have learnt that equity increases on the credit side and decreases
on the debit side.
1. Sales is a type of income; income increases equity, so the Sales
account is credited when income is earned.
2. Wages is an expense; expenses decrease equity, so the Wages
account is debited when the expense is incurred.
Note:
Students are often confused when it comes to recording expenses in the general
ledger. The wages are increasing and the tendency is to credit the Wages account.
When income and expense accounts are recorded in the general ledger, the
question that needs to be asked is, “What is the effect on equity?” If equity
increases, the account is credited, and if equity decreases, the account is debited.
As an expense decreases equity, expenses are debited.
Something to do 6
Use the information appearing at the beginning of Chapter 2 to complete the
general ledger of Handbags for Africa for January X1. For each account indicate
whether it is an asset, liability, equity, income or expense account. For each
account indicate on which side it increases and on which side it decreases.
Check your answers

Go and watch Balancing/closing off ledger accounts: This video explains
how to close off or balance ledger accounts in the general ledger.
3.5.1.3 Balancing ledger accounts
If Judy needed to complete the financial statements for Handbags for
Africa at the end of January, it would be useful to have single totals
representing each item in the business. In order to arrive at these
totals Judy would need to balance the general ledger accounts.
How would Judy balance the ledger accounts?
The debit side of the Bank account represents money coming into the
account. When we total up the debit side, it amounts to R13 101 (8
000 + 2 000 + 600 + 60 + 120 + 120 + 60 + 500 + 480 + 1 161). This
means that the business received R13 101 in cash during the month.
The credit side of the Bank account represents money being paid
out of the account. When we total up the credit side, it amounts to
R9 010 (1 200 + 950 + 3 600 + 300 + 300 +150 + 440 + 200 + 150 + 420
+ 150 + 1 000 + 150). This means that the business paid out cash
amounting to R9 010 during the month.
To calculate the amount of money left in the bank, we would
subtract the total of the credit side (R9 010) from the total of the debit
side (R13 101).

R13 101 – R9 010 = R4 091
Judy’s business has R4 091 left in the bank at the end of January.
The balance carried down (c/d) at the end of the month is equal to
the balance brought down (b/d) at the start of the following month.
If the balance b/d appears on the debit side of an account, we say
that the account (Bank) has a debit balance.
Something to do 7
1. Balance the following Bank account.
2. What type of balance does this Bank account have?
3. What type of account (asset, equity, liability) will this Bank account be?
Explain your answer.
Check your answers
1. The debit side of the Bank account amounts to R8 600. This is the amount of
cash received during the month.
The credit side of the Bank account amounts to R9 000. This is the amount of
cash spent during the month.
2. The Bank account has a credit balance.

3. The business spent R400 more money than the business had in the bank. The
business has gone into overdraft. An overdraft means that the bank has lent you
money. The Bank account is a liability to the business, as the business owes the
bank R400.
Something to do 8
Accounts in the general ledger of Handbags for Africa could have more than one
entry on one side of the account, and no entry on the other side. To balance
these accounts, it is sufficient to total the entries.
Balance the following accounts of Handbags for Africa: Trade payables, Trade
receivables, Inventory, Sales, Cost of sales and Wages.
Check your answers

Go and watch Processing business information: source document to ledger
account: This video explains how information from business transactions is
processed from a source document to a ledger account.

Once all the accounts in the general ledger have been balanced it is
possible to extract atrial balance. A trial balance is a list of all the

accounts in the general ledger and their final (or closing) balances. A
business will extract a trial balance at the end of each month. The
trial balance extracts a single figure for each ledger account that
represents the balance of all the transactions that affected that
account during the month. Each transaction would have led to a
double entry where the DR entry equaled the CR entry and the
ledger is a summary of all of these transactions. Accounts will either
have a debit or credit balance. Look at the Bank account – the
balance brought down on 1 February X1 is on the debit side of the
account, so we say that the Bank account has a debit balance, which
means it is an asset. The sales account will have a credit balance as
the R6 711 balance is on the credit side of the account. The trial
balance should balance as the total of the debit entries and the total
of the credit entries recorded in the ledger should equal.
Let's complete the trial balance of Handbags for Africa for the month
ended 31 January X1.
Account Debit Credit

Capital 8 000
Drawings 720
Loan 2 000
Cellphone/Equipment 1 200
Trestle table/Furniture 950
Trade receivables 3 730
Bank 4 091
Stationery on hand 200
Inventory 2 940
Prepaid electricity 300
Prepaid talk-time 440
Income received in advance (Deposit) 120
Rent expense 1 000
Sales 6 711
Cost of sales 1 860
Wages 600
18 031 18 031
The completed trial balance allows the bookkeeper to check the
accuracy of the recording. The trial balance, when it balances, means

that the books of the business have the same rand amounts on both
the debit and the credit sides of the ledger accounts. The trial balance
does not, however, identify all mistakes that could occur during the
recording process.
Something to do 9
Identify which of the following errors will or will not be identified by completing
a trial balance. Provide a reason for your answer.
1. Incorrect additions when balancing an account in the ledger.
2. Recording the payment of rent by cheque by only debiting the Rent
account in the general ledger, i.e. a debit entry but no credit entry.
3. Recording a cash sale of R550 by debiting Bank with R500 and crediting
Sales with R550.
4. Omitting an entire account from the ledger.
5. The business pays for motor vehicle repairs (expense account) but records
it in the motor vehicle (assets) account in error.
6. The debit entry in one transaction is overstated by R1 000. The debit entry
of a later transaction is understated by R1 000.
7. Stationery of R1 212 is purchased for cash. The Bank account is credited
with R2 121 and the Stationery account is also debited with R2 121.
8. Salaries of R6 000 for the month are paid by cheque. The Bank account is
debited with R6 000 and the Salaries account is credited with R6 000.
Check your answers
1. The trial balance will identify this error, as the debit and credit columns in the trial
balance will not balance.
2. The trial balance will identify this error, as the debit and credit columns in the trial
balance will not balance if one leg of the double entry is omitted.
3. When recording a transaction and different amounts are entered on the debit and
credit sides, the debit and credit columns in the trial balance will not balance. The
trial balance will identify the error.
4. This is known as an error of omission. Both the debit and credit entries were
omitted. The trial balance will balance and will not identify the error.
5. This is known as an error of principle. This occurs when a transaction is entered
into the incorrect class of account − an expense is recorded as an asset. Both
expense accounts and asset accounts are debited when they increase. The trial
balance will not identify this error, as the debit side of the entry will equal the
credit side of the entry.
6. This is known as a compensating error, which occurs when errors cancel out
each other. The total debit side of the trial balance will be correct, and the error
will not be identified by the trial balance.
7. This is known as an error of original entry. The incorrect figure has been used in
both legs of the double entry. The trial balance will, however, still balance and the
error will not be identified through the trial balance.
8. The correct accounts and figures have been used, but each item is on the
incorrect side. Bank should have been credited and Stationery should have been
debited. The trial balance will, however, still balance, and the error will not be
identified through the trial balance.
Judy is now able to record each transaction in the general ledger as it
happens. The information is recorded in such a way that the
accounting equation remains balanced after each entry. At the end of
the month, or at any other time that Judy requires the information,
the ledger accounts are balanced. The information is used to
complete the trial balance. Once Judy has this information, she is
able to complete both the statement of profit or loss and other
comprehensive income and statement of financial position without
having to refer to the individual transactions.
3.7 Closing entries

At the end of each month, the business will extract a trial balance, a
list of all the accounts in the general ledger. The trial balance will
include all the asset, equity and liability accounts. Equity accounts
include capital and drawings (transactions with the owner) as well
as income and expenses (transactions not with the owner).
At the end of the financial year, at the reporting date the business
will need to calculate the profit or loss that the business generated
during the period. The records, i.e. the general ledger, will need to
be updated to recognise that the income and expense accounts are
used to calculate the profit or loss for the period. It is also important
to understand that the same ledger is used over the years. Income
earned and expenses incurred in one financial period only influence
the profit or loss in that financial period. The income and expense
accounts need to be closed off to zero during the profit or loss
calculation process so that all income and expense accounts start the
new financial period with a zero balance.
Profit or loss = Income − Expenses
So all income and expense accounts in the general ledger at the
end of a financial period, for example, 28 February, 30 June or 31
December will be closed off to a temporary account, the profit or loss
account.
Let’s look at closing entries in the journal and see how they are
posted in the ledger:
If at the end of January the business wishes to prepare financial
statements it will need to calculate the profit or loss. The sales, cost
of sales and wages account will be closed off the profit or loss
account, these accounts will all be left with a zero balance.
The business will process the following closing entries:

This information would be posted to the general ledger.
Points to note
1. All the income and expense accounts now have zero balances,
for example, the Sales account has debit entries and credit
entries equal to R6 711.
2. All the income and expense account amounts earned or
incurred during the year have been transferred to the Profit or
loss account.
3. The difference between the total income (credit side of the Profit
or loss account) and the total expenses (debit side of Profit or
loss account) is the profit or loss generated/incurred during the
period.
4. The profit or loss generated/incurred during the period will
lead to the equity (net asset value of the business)
increasing/decreasing.
The Profit or loss account and the Drawings will be closed off to the
Retained earnings account.
Points to note
1. The Drawings account is not closed off to the Profit or loss
account as it is a transaction with the owner, i.e. is not a
business expense.
2. The closing balance in the Retained earnings account represents
the undistributed profit since the start of the business. In other
words, the Retained earnings account is increased/decreased
each year by that year’s profit or loss and decreased by
distributions (drawings) made during the year.
Something to do 10
1. What accounts should Judy have in her general ledger?
2. Do you think that the general ledger of all businesses will have the same
accounts? Explain your answer.
3. Do you think that Judy should have a separate account for each type of
stationery, for example, pens, invoice books, etc? Explain your answer.
Check your answers
1. Judy could have the following accounts in her books: sales, inventory, trade
payables, wages, prepaid talk-time, rent expense, stationery on hand, drawings,
loan, and capital.
2. The type of accounts in the general ledger will depend on the type of business.
The general ledger is used to summarise the transactions that happen in the
business so the type of accounts in the ledger will depend on the type of
transactions that it is summarising.
3. Businesses generally do not have a separate account for each individual asset
purchased. Instead of having a separate account for each type of stationery, for
example, pens, paper clips, envelopes, and so on, the business will have a single
account called Stationery. The accounts that are generally used to record non-
current assets are land, buildings, plant and equipment, furniture and fittings, and
motor vehicles. For example, instead of having a separate ledger account for each
individual piece of furniture purchased they are recorded in a single ledger
account called Furniture.
Businesses generally keep additional information regarding non-current assets in a
fixed asset register, which records details of individual items. This is done to ensure
that the business keeps track of what it owns for control and insurance purposes.

All transactions that occur within a business are recorded on a
source document. The source document must be kept as it is proof
that the transaction occurred as reflected in the books of the
business. Source documents are used to prepare a journal entry that
indicates how the transaction affected the assets, liabilities and/or
equity of the business.

A journal entry indicates which assets, liability and/or equity
account has increased and/or decreased. The journal entry is an
instruction to the bookkeeper as to how the transaction will be
recorded in the general ledger.

The general ledger is a book that summarises all the transactions that
occur within the business. The ledger consists of a number of
individual accounts that reflect the types of assets, liabilities and
equity items that have been affected by transactions that have
occurred. At each month-end the ledger accounts are balanced and a
trial balance is extracted. At the end of the financial year, income and
expense accounts are closed off and the profit/loss of the business is
calculated.
3.8.4 Trial balance

The trial balance is a list of all the accounts in the general ledger and
their balances (either a debit balance or a credit balance).

The information in the trial balance is used to draw up the financial
statements, namely the statement of profit or loss and other
comprehensive income (income and expense accounts) and the
statement of financial position (assets, equity and liability accounts),
the statement of changes in equity and the statement of cash flows.

3.9 How do specialised journals form
part of the accounting cycle?
Judy’s business is growing, and the number of transactions she
needs to record each month is increasing.
If Judy continues to record all her transactions directly in the
general ledger, the accounts in the general ledger are going to
become quite cumbersome as the ledger is filled up with a lot of
similar transactions. Remember that the general ledger system
developed out of a need for clear, concise information from which
the financial statements could be drawn up. As the number of
transactions increases, using the general ledger to record all the
transactions may not remain the best option.
What can Judy do instead?

As the number of transactions increases, businesses make use of
specialised journals (or books of first entry). In recording
transactions in specialised journals, similar transactions are
summarised in separate books (the specialised journals). At the end
of each month these books are closed off (added up) and the totals
from the journals are posted to the general ledger.
This means that the general ledger does not become cluttered
with detail. Should information be required regarding the detail of
any account, this can be found in the relevant specialised journal.
Businesses can make use of the following specialised journals:
Journal Use
Cash Receipts Records all cash
journal receipts
Cash Payments Records all cash
journal payments
Purchases journal Records all credit
purchases
Sales journal Records all credit sales

The Cash Receipts journal (CRJ) summarises all transactions that
deal with cash received by the business. The vast majority of cash
receipts for a company are cash received for cash sales and from
trade receivables, which are paying for sales previously recorded.
The source documents that initially record these transactions are
documents such as the deposit slip, receipts, cash slips, or EFT slips.
The Cash Receipts journal can be used to determine totals at the end
of the month for entries such as sales that occur regularly
throughout the month.
Let's look at the Cash Receipts journal.

The layout of the example given below is not prescriptive.
Businesses can adapt any of the formats, depending on the needs of
their business. Remember that the journal is a tool to make the
recording of information easier.
What information is recorded in the Cash Receipts journal?

1. The day on which the transaction happened.
2. The reference number of the source document used in the
transaction, for example, a cash slip for cash sales, or the receipt
number of trade receivables who have paid. 3. Relevant details
about the transaction, for example, the name of the debtor who
has paid.
4. The amount of cash or cheques received.
5. This column records the actual cash or cheques that are
deposited into the bank account. If the business deposits money
every third day, the figure in this column would be equal to the
sum of the past three days’ receipts (in the analysis of receipts
column – see 4) and would equal the amount appearing on the
bank deposit slip.
6. Separate columns can be created for certain transactions that
occur regularly. Examples of columns that Judy may use in her
business would be for cash sales and trade receivables (when
they pay).
7. The Sundry Accounts column is used when a transaction occurs
and the business has not created a separate column (as in 6) for
that type of transaction. The transactions that appear in this
column are those transactions that occur occasionally during the
month, and may include cash received for a loan.
8. The amount of the sundry transaction.
9. The name of the account affected by the sundry transaction.
10. If the business is using the perpetual method to record
inventory, the business will record the cost of the inventory sold
at the same time that the sales amount is recorded. Judy has
used the perpetual method of recording inventory. We will look
at inventory recording methods in more detail in Chapter 6.
11. The total amount received in the bank account during the
month.
The cash received from sales and trade receivables columns
12.
respectively will be totalled (added up) and only the total
amount of sales or trade receivables will be posted to the
general ledger.
13. The amounts in the sundry column are posted individually to
the accounts in the general ledger, for example, capital or loan,
that they affect. The total of the sundry accounts column is not
posted to an account in the general ledger.
14. The cost of sales column will be totalled (added up) and only
the total amount of cost of sales will be posted to the general
ledger.
Let's look at where journals fit into the accounting cycle.

Let’s record some of the transactions that occurred in Judy’s business
in January. We are not going to record all of the transactions but will
assume that those transactions we select are the only transactions
that occur during the month.
Source documents
1/1 Deposit slip for R8 000, capital contribution
1/1 Loan application for R2 000 from sister
1/1 Deposit slip for R10 000
2/1 Cash sales, R600, cost of inventory sold R240

5/1 Deposit slip for R660
10/1 Deposit slip R120
Specialised journals
Trial balance
Let's look at the recording above in a bit more detail.
The double entry principle that we dealt with earlier in the chapter
also applies when we are using the journal as the book of first entry.
All the transactions that are recorded in the cash receipts journal will
affect the Bank column. They will cause the Bank account to
increase. The total of the Bank column will be debited to the Bank
account in the ledger.
The other columns in the journal represent the second leg of the
double entry. The Sales account is credited with the total of the Sales
column. The Capital account and the Loan account will be credited
with the individual totals that appear in the Sundry column. The
cost of sales column is NOT a cash column, but is recorded to ensure
that the business keeps a record of the inventory that is leaving the
business once the sale has been recognised. The inventory account is
credited with the amount of inventory sold and the cost of sales
account is debited with the cost of the inventory sold. The business is
using the perpetual method to record inventory, which as the name
suggests implies that the accounting records should perpetually
(always) reflect the correct amount of inventory on hand. An
adjustment to the inventory account must therefore be made each
time a sales transaction occurs. We will look at inventory again in
Chapter 6.
The cash received is initially recorded in the Analysis of Receipts
column. When the cash is deposited in the bank, the total is
transferred to the Bank column. In Chapter 8 we will be looking at
bank reconciliation statements. In order to complete the bank
reconciliation, you need to compare the money received in your
Cash Receipts journal with the bank deposits. It is important that
your books reflect the actual deposits in order to ensure consistency
with the bank’s records.
Once the Cash Receipts journal has been completed, we can check
whether the double entry principle (for every debit entry there is an
equal credit entry) has been correctly followed. The Bank column
represents the money received (DR) and the Sales, Capital and Loan
columns indicate the source of the money (CR):
R10 780 (Bank column) = R780 (Sales column) + R10 000 (Sundries
column)
Remember that the Inventory account is credited with R330 and the
Cost of sales account is debited with the same amount.
Once the information has been posted from the journal to the
ledger, the ledger is balanced and a trial balance is extracted from
the information. There is less detail in the general ledger when a
business makes use of specialised journals. Look at the above
example. Both the Bank account and the Sales account have single
entries reflecting the total amount of cash received or cash sales
made during the month. If we had not used the journal, the Bank
account would have had five entries and the Sales account three
entries.
This may not seem like a large difference, but we have used a
small example. Many businesses would have to process hundreds, if
not thousands, of transactions per month.

Let's briefly look at some of the other journals.
The Cash Payments journal records all cash payments made by the
business. It is useful for businesses to open a cheque account at the
bank. Each cheque has its own individual number and is a
convenient source document. More recently, many businesses have
moved to internet banking and making payments using electronic
funds transfers.
The columns selected by the business, for example, Inventory and
Wages, would differ from business to business. Each business would
identify which items are purchased or paid for regularly during the
month. It is doubtful that a column for telephone or electricity would
be opened, as they are generally paid once a month. If, however, the
business used a pay-as-you-go cellphone or an electricity meter and
made a large number of smaller payments, the business might
choose to have a separate column for those items.
The Purchases journal records all credit purchases made by the
business. A business may record only the purchase of inventory in

the Purchases journal (also known as the Trade payables journal), or
it may have additional columns for the purchase of other items, for
example, Equipment, Vehicles.
The details completed in 1 would be the name of the creditors
from whom the purchase was made.
3.9.4 Sales journal
The Sales journal (also known as the Trade receivables journal) is
used to record all credit sales made by the business.

Using the transactions provided in Chapter 2 for Handbags for
Africa, complete the required journals and post the information to
the general ledger.
Check your answers

• The accounting equation is the foundation of all accounting
transactions.
• All accounting transactions appear on a source document, which
is kept by the business as proof that the transaction recorded in
the books of the business actually took place.

• When recording each transaction the double entry rule applies –
for every debit entry there must be an equal credit entry.
• The information from the source document is recorded in a
journal, the journal entry is an instruction to the bookkeeper
indicating how the transactions will impact on the accounts in the
general ledger.
• All transactions are recorded in the general ledger of a business.
• At the end of the month the accounts in the general ledger are
balanced.
• A trial balance is extracted.
• At the end of the financial year the income and expense accounts
are closed off to the profit or loss account.
• The information provided in the trial balance is used to complete
the statement of profit or loss and other comprehensive income,
the statement of financial position, the statement of changes in
equity and the statement of cash flows.
• Specialised journals are used to summarise similar transactions
and to ensure that the general ledger does not become too
cluttered with detail.
What's next?
In the first three chapters of this book we have started to understand
the language of accounting and where it fits into the business
environment at large. In Chapter 4 we look at the principles that
underpin accounting, and how to apply them to our accounting
information when we report financial information. In Chapter 4 we
also develop an understanding of the conceptual framework.

QUESTIONS
QUESTION 3.1 (A)

The following information appeared in the trial balance of Small

Stores Retailers on 28 February X5, the end of the financial year.
Advertising expense 12 300

Bank overdraft 8 000
Bank charges (expense) 450
Capital 94 000
Rent expense 5 321
Commission paid (expense) 367
Creditors (trade payable) 43 642
Debtors (trade receivable) 32 800
Delivery expenses 1 460
Interest expense 890
Interest income 11 450
Drawings 16 500
Electricity expense 8 450
Inventory asset 15 500
Land and buildings 118 500
Mortgage loan 82 000
Motor expenses 3 458
Cost of sales (expense) 162 626
Salaries expense 23 900
Sales (income) 292 500
Stationery expense 6 370
Store equipment 56 900
Wages expense 65 800
1. Prepare the statement of profit or loss and other comprehensive
income for the year ended 28 February X5. (16 marks)
2. Prepare the statement of financial position as at 28 February X5.
(10 marks)
QUESTION 3.2 (B)

Round off all figures to the nearest rand.

Anathi took over a computer business in June X8 and decided to
expand it to include the hiring of computers and providing
computer training. Separate columns for hiring income and training
income were added to the Cash Receipts journal, and it was decided
that adjustments for income received in advance and amounts
owing from customers would be journalised at the end of each
month.
The normal rates per hour for hiring a computer are:
• hire only – R88 (discounts can be negotiated if hiring in bulk in
advance); and
• training – R165.
The following were the transactions related to hiring and training in
August X8:
9 Cash was received for 20 hours of training given to customers
during the week.
15 Adams Ltd paid for 40 hours of hiring for its adult education
programme, and negotiated a 10% cash discount. 25 of these
hours were used during August.
20 Ms Patel purchased a computer for R5 830 and 10 hours’
training for cash. She is due to start the training courses on 1
September X8.
22 Mr Hendricks paid cash for 30 hours of hiring and 7 hours of
training. He completed the training on August 23. After 16
hours of hiring, he decided to buy a computer for R5 830 on
credit. Ava agreed to accept the remainder of the number hours
of hiring as part payment for the computer.
25 S Aziz had been invoiced on 25 July X8 for 30 hours of hiring.
31 Sent an invoice to Ms Sishuba. She had hired a computer for 6
hours on 29 August X8.
1. Calculate the totals per the cash receipts journal for hiring
income and training income at the end ofAugust X8 (show all
workings). (6 marks)
2. Prepare the journal entries in the General Journal that are
required at the end of August X8 to report the correct hiring
income and training income (omit narrations). (6 marks)

3. Explain to Anathi why it is advantageous to make use of multi-
column journals. (2 marks)
4. Prepare, in General Journal format, the entry to record the
transaction on 25 August X8 (omit narrations). (5 marks)
5. Prepare, in General Journal format, the entry to record the
transaction on 31 August X8 (omit narrations). (3 marks)
QUESTION 3.3 (B)

On 1 January 20X6, Frederick opened a stationery shop in Old
Transkei Road, East London. Dur ing the month of January, the
following transactions took place:
1. On 1 January, Frederick deposited R50 000 cash into the
business bank account.
2. On 2 January, Frederick took out a loan with ALBA bank to the
value of R30 000.
3. On 8 January, the business purchased inventory on account
from for R12 000 from Ollie (Pty) Ltd, a local wholesaler. This
inventory amounted to 1 000 pens.
4. On 9 January, the business purchased further inventory from
Dollie (Pty) Ltd for which they paid R7 000 cash. This inventory
amounted to 350 highlighters.
5. On 12 January, the business purchased equipment on account
from Freddy (Pty) Ltd for R22 000.
6. On 23 January, the business made their first sale to an elderly
German woman who was on holiday. She paid R100 cash for 4
pens. She paid R160 for 4 highlighters.
7. On 25 January, the business paid their debt owing to Ollie (Pty)
Ltd.
1. Show the journal entries to record transactions 1, 2, 4 and 6 .
2. Dates and narrations are not required. (10 marks)
3. Prepare the general ledger account for ‘bank’ in the month of
January 20X6. Dates are required. (6 marks)
QUESTION 3.4 (C)

Sweet Dreams is a retail shop which sells children’s bedroom
furniture as well as sleepwear. Sweet Dreams is owned by Candy
Sleepwell. The business is in its second year of trading and has a
year end of 31 March. You have been provided with the following
information:
Trial balance of Sweet Dreams for 11 months ended 29 February

20X6
Capital (1/4/20X5) 1 50 000
Accumulated pro t (1/4/20X5) 130 000
Drawings 60 000
Vehicle 282 150
Bank 157 300
Loan: Star Bank (12% p.a.) 75 000
Inventory 43 000
Stationery asset 4 500
Sales income 378 000
Cost of sales expense 173 000
Salaries expense 44 000
Petrol expense 23 000
Rent income 35 200
Interest expense ?
The following transactions took place during March 20X6:

1. On 3 March, purchased stationery from TNA for R1 350 cash.
2. On 8 March, sold a bed and a headboard to Mrs Moon on credit
for R8 700 (cost price R5 430).
3. On 12 March, purchased inventory on credit from Beds R Us for
R18 000.
4. Sweet Dreams rents part of the shop to Caroline Bathsalts.

Caroline runs a small retail business that sells children’s
toiletries. Caroline was going on holiday so on 15 March she
decided to pay the rent for April. Caroline has been renting the
shop space for the past 18 months. Rent is due on the first day of
each month. All rental payments were up to date on 15 March.
5. On 18 March, Candy brought a computer from her home to use
in the business. The computer was valued at R14 500.
6. On 23 March, Sweet Dreams paid trade payables an amount of

R10 000.
7. On 25 March, Candy took a quilted blanket for her niece’s
birthday. The selling price of the blanket was R1 620 and the
cost price was R950.
8. On 31 March, interest on the loan for March was due. The
interest due was only paid by Sweet Dreams on 3 April 20X6.

The loan had been taken out by the business on 1 April 20X1.
All other interest payments were up to date.

9. On 31 March, Sweet Dreams had stationery amounting to R650
on hand.
1. Show how transactions 4 and 5 effect the financial position of

the business as represented by A = E + L. You need to clearly
indicate whether the element has increased or decreased and
provide the relevant amount and account that would be
affected. (5 marks)
2. Prepare thegeneral journal entries that would have been

processed by Sweet Dreams for the following transactions:
a) Transaction 7
b) Transaction 8
c) Transaction 9
You are required to show dates and narrations. (10 marks)
3. Prepare the following accounts in the general ledger of Sweet

Dreams for the month ended 31 March 20X6. Show dates and
close off or balance the accounts where appropriate.
a) Inventory account (4 marks)
b) Trade payables account (3 marks)
c) Sales income account (3 marks)
4. Prepare the Profit or loss account in the general ledger of Sweet

Dreams for the year ended 31 March 20X6. Show dates and close
off or balance the accounts where appropriate. (10 marks)
5. Prepare the statement of changes in equity of Sweet Dreams for

the year ended 31 March 2012. You are NOT required to provide
a TOTALcolumn. (8 marks)
6. Prepare ONLY the CURRENT assets section of the statement of

financial position of Sweet Dreams for the year ended 31 March
20X6.Assume that the bank balance on 31 March 20X6 was
R144 300. (5 marks)
4 The conceptual
framework
Now that Judy has created a system for recording transactions, it
is a lot easier to focus on the business. She has learnt how to
prepare financial statements, which have been useful in showing
the effect of all the decisions made in her business. She is still
eager to move to the Waterfront, as this will give her business a lot
more exposure to the market and increase her sales. She is now
ready to take out the loan from the bank, so that she can start
planning the move to the Waterfront. She has collected all of the
information that the bank manager asked her to compile.
On Monday morning Judy was waiting at the bank to see the
bank manager, Mr Falcon.
She was a bit uncomfortable because she was sitting in the
waiting room with three huge boxes full of purchase invoices, sales
invoices, receipts and returned cheques which she had brought, as
she thought Mr Falcon would want to know how her business was
doing.
As expected, during the meeting Mr Falcon said, “Judy, please
tell me a bit about your business. I will also need you to give me
the financial statements I asked you to complete so that I can
analyse and review how the business is doing.”
Once Judy had told Mr Falcon about her business and her future
plans she said, “I have also brought all the purchase invoices,
sales invoices, cheques and receipts for the whole year for you to
review! I thought this was the best way of explaining how the
business is doing. You can see how well the stall has done by how
many sales invoices there are.”
After quite a long pause Mr Falcon replied, “I need to decide if
the bank should lend you the money to start your leather goods
chain. My decision depends on whether I think your business will
make enough cash in the future to repay the loan instalment and
the interest charges every month. There are a lot of businesses
competing for the funding available, so you need to communicate
the information about your business performance to me to help
me make this decision. Going through three boxes of slips will not
help me get a clear picture of how your business has performed. I
need to be able to review the business information so that I can
estimate what future cash flow your business will have. Financial
reporting, which includes what information is presented as well as
how this information is presented, is important, because it allows
users such as myself to make economic decisions based on the
information.”
Judy answered, “Now that I see what information you need to
help you with your decision, I understand that the slips in these
boxes are not very useful. Will the financial reports, i.e.
statements, show you the information you need to make your
decision?”
Mr Falcon immediately replied, “Understanding the conceptual
framework, which describes the objective of and concepts used in
general purpose financial reporting, will be useful for you in
preparing the financial statements. Financial statements will show
me the information in a way that will help me make the decision
efficiently and effectively. Perhaps I should qualify that and say
that financial statements prepared under generally accepted
accounting practice will be a good way to communicate financial
information about your business.”
Let's see if we can help Judy understand what it means to
prepare these financial statements using the conceptual
framework that is the basis of generally accepted accounting
practice.
Learning objectives
• Understand what is meant by generally accepted accounting practice
• Understand the purpose of the conceptual framework
• Understand the objective of financial reporting
• Know who the primary users of financial reports are
• Understand the going concern concept, which is the basic assumption that
underlies the preparation of all financial reports
• Realise that information in financial reports should have certain qualitative
characteristics that assist financial reports in achieving their objective
• Understand how qualitative characteristics enhance the usefulness of financial
reports
• Know how to apply the definition of elements (i.e. asset, liability, equity, income,
expense)
• Recognise assets and liabilities, income and expenses
• Understand the accrual concept.

Judy is not familiar with generally accepted accounting practice, nor
has she heard of the conceptual framework.

How are we going to help Judy solve her problem?
Let’s look at the conceptual framework and its impact on how
financial reports are prepared.
Let's look at what we have already learnt in Chapter 3.

All transactions are recorded in the bookkeeping system, i.e. the
journals and ledger of the business. To see how the business has
performed and how profitable the business has been during the
year, we prepare the profit or loss section of the statement of profit
or loss and other comprehensive income (SPLOCI). To see the
financial position of the business, what assets are controlled,
liabilities are owed and equity is held by the owners of the business,
the statement of financial position (previously known as the balance
sheet) is prepared.
To see how the equity in the business has changed over the
financial period, a statement of changes in equity is prepared. To see
how much cash has flowed in and out of the business, the statement
of cash flows is prepared.
The SPLOCI, the statement of financial position, the statement of
changes in equity and the statement of cash flows are the reports
included in the annual financial statements.
4.1 Generally accepted accounting

practice
As financial reports are used by many different users, there needs to
be a general understanding of the basis, i.e. what is used to prepare
these reports. If every organisation developed its own ideas
regarding how to prepare and present its report, you would need to
understand the ideas used by each organisation before you could
understand the information presented in their reports.
To ensure that the financial reports of businesses are prepared in
terms of principles that are widely understood, accountants have a
set of principles to follow when preparing financial reports. These
principles are called generally accepted accounting practice.
Generally accepted accounting practice (GAAP) provides the
underlying principles applied when preparing financial reports, as
well as additional standards that indicate how the principles are
applied in specific situations.
Financial reports that are prepared for a variety of users (known
as general purpose financial reports) need to make sense to all these
users. To do this, the reports must achieve “fair presentation”. This
means that the reports must accurately convey what the company
has achieved. Reports should also provide information that is useful
for making economic decisions. Financial reports should be
prepared in terms of principles that are widely understood and
consistently applied.
So what is the “Conceptual Framework for Financial Reporting”?
The conceptual framework describes the objective of general
purpose financial reporting and the concepts that underlie the
preparation and presentation of financial reports. The conceptual
framework is issued by the International Accounting Standards
Board (IASB). Well over 100 countries now use the standards issued
by the IASB, including the majority of the G20, which is the group of
20 countries with significant economic power.
The conceptual framework assists the International Accounting
Standards Board to develop standards that are based on consistent
principles. The conceptual framework is also used to decide how to
treat transactions when no specific standard applies. So what is a
standard? Some areas of accounting can be quite complex. Standards

are issued to explain how the general principles apply in more
specific situations. These are known as International Financial
Reporting Standards, and each Standard has a reference number
starting with IAS or IFRS. Over 40 Standards have already been
issued. These include IAS 2 “Inventories”, which Judy could use for
guidance on how to report and measure inventory (also known as
stock) on her statement of financial position, and IFRS 15 “Revenue
from contracts with customers”, which would help Judy to
understand how and when to recognise sales. It is important to
understand that the conceptual framework is not a Standard.
Remember the conceptual framework describes the concepts used in
general purpose financial reporting while individual Standards
indicate how these concepts are applied to specific items, for
example, inventory and revenue.
It is also important to understand that the conceptual framework
does not overide a Standard. What does this mean? If something in a
specific Standard differs from the general information provided in
the conceptual framework, you as a preparer or user of financial
reports will be guided by (and apply) what is in the Standard, and
not the conceptual framework.
4.2 The objective of financial reporting

According to the “Conceptual Framework for Financial Reporting”,
the objective of financial reporting is to provide financial
information about the business that is useful to existing and
potential investors, lenders and other creditors when they make
decisions about providing resources to a business. Mr Falcon is an
example of a lender who is deciding whether to provide resources
(that is, cash in the form of a loan) to Judy’s business. Users could
also be deciding to contribute equity into the business. Users such as

Mr Falcon are interested in the ability of the business to generate net
cash flows in the future. Net cash flows are the difference between
cash inflows and cash outflows. For a business to be successful, the
future net cash flows would have to be positive. Users will also be
interested in mangement’s stewardship of the economic resources in
the business.
So, what does “stewardship” mean? Stewardship is “the job of
supervising or taking care of something”. Users would be interested
in knowing how well the managers (in this case Judy) are taking care
of the resources in the business. Remember, if the resources are used
efficiently and effectively, the business is more likely to be successful
and to generate net cash flows in the future. Financial reports show
the impact that management decisions have had on a business’s
resources, claims on these resources, changes in its resources and
claims, and cash flows for the year. Financial reports are a way of
communicating financial information to users who make economic
decisions. Financial reports present financial information in a
manner that is most useful in helping users i.e. existing and potential
investors, lenders and other creditors make economic decisions
about the business.
The statement of financial position provides information about a
business’s resources and claims (assets, liabilities, and equity).
Changes in the business’s resources and claims can come about
because of the business’s performance (shown in the profit or loss
section of the statement of profit or loss and other comprehensive
income (SPLOCI)) and/or from other transactions, such as taking
out more debt or raising more capital.
Something to do 1
Having thought about the conversation between Judy and Mr Falcon and read
the conceptual framework, can you explain why Mr Falcon wants Judy to provide
him with financial statements?
Check your answer
Mr Falcon needs to make a decision about whether to lend Judy money. He will lend
Judy the money only if he thinks her business will produce enough cash to meet the
loan repayments each month and the monthly interest repayments. Mr Falcon will use
the financial reports to help him make this economic decision. He needs the financial
reports to be drawn up on a basis that he can understand and which will make it
possible for him to compare the results of two different businesses.
The profit or loss section in the statement of profit or loss and comprehensive
income (SPLOCI) will show Mr Falcon information about the performance of Judy's
business − the profitability of the business. He will use the current profit to predict
what the future cash flow of the business will be. In making his estimation of the future
cash flows, Mr Falcon will take into account any trend shown in the profit or loss
section in the SPLOCI from the past few years. For example, if sales have been
increasing each year by 10%, he will use this in his projections and increase the
current year's sales value by 10% when estimating the future cash flow.
A business uses assets it controls to try to make a profit. Judy's profit or loss figure
on the SPLOCI will show Mr Falcon how effectively Judy has used her business assets
to generate profit. He will use this as a basis for predicting how successful Judy may be
in the future in using the assets she currently controls to make a profit.
The statement of financial position provides a lot of information that is useful to
Mr Falcon. He will look at the total assets on the statement of financial position when
assessing how well Judy has used these assets to make a profit.
The statement of financial position also shows Mr Falcon the financial structure of
the business. “Financial structure” is the term used to describe where the business
obtained the funds to buy assets and pay for expenses, from the owner him- or herself
(called capital), from outside parties in the form of long- and short-term loans (called
liabilities), and from the business itself, the profit earned and kept in the business
(called accumulated profit or retained profit). The financial structure shows who has
funded the business and will help Mr Falcon to see how the cash made by the
business in the future will be distributed among all these parties. For example, if Judy's
financial structure showed she had borrowed funds from another bank, Mr Falcon
would have to take into account the cash outflow needed to repay this loan when
preparing his estimation of future cash flows.
These are just a few illustrations of how the financial statements are used to help
the users to make economic decisions. Economic decisions are based on an
estimation of what cash the business will generate in the future and when the
business will generate these cash flows. The information provided in the SPLOCI and
statement of financial position help users estimate the amount and timing of the
future cash flows of the business.
4.2.1 Who are the primary users of financial

statements?
Existing and potential investors, lenders, and creditors have been
identified as the primary users of financial information provided by
an entity.
4.2.2 Who else would be interested in the financial

statements?
Something to do 2
Can you think of any other people who would want to use the financial
statements of a business to make various economic decisions? What financial
information do you think these interested parties will need to help them with
their decisions?
Check your answers
Customers
When a customer is dependent on a business for the supply of
goods, the customer wants to know whether the business is going to
continue to operate in the future. He wants a dependable supplier.
Otherwise he has to plan to buy his goods from another supplier.
South African Revenue Service (SARS)

In South Africa, a business will pay income tax on the profit it earns
for the year. The government agency, SARS, needs to check how the
profit for the year was calculated and how the business calculated its
income tax liability.
Employees
Employees of the business are interested in whether the business is
going to continue to operate in the future and be able to pay their
salaries. Very often in South Africa, trade unions are interested in the
performance and position of a business because they want to
determine whether the wages being paid by the business are fair.

Financial reports prepared on the basis of generally accepted
accounting practice assume that the business is a going concern.
So what does the going concern assumption mean? This means
that the business intends to continue to trade in the foreseeable
future at a similar or on a larger scale of operations. This assumption
is relevant because it impacts on how we measure the elements. We
are able to use the normal measurement bases such as historic cost
and fair value only if we assume the business intends to continue
trading in the future. We will look at the measurement of the
elements later in this chapter.
If the statements have not been prepared on the going concern

basis, this fact must be stated in the financial reports, and an
explanation of the basis that was used must be included. If the
business is no longer a going concern, we have to use a special

measurement basis that is a break-up valuation of the assets and
liabilities.
The assets will be measured at the amount we think we will be
able to receive when we sell off all the assets. This will probably be
significantly less than the amount we could receive if we sold these
assets during the normal course of business. In liquidation (when the

business is wound up because it is bankrupt), the business has no
option but to sell the assets quickly, and this is referred to as a forced
sale.
The liabilities are measured at what the creditors will accept as
settlement of this debt. We normally negotiate a compromise
whereby we pay, for example, 20 cents for every R1 owed. If we
owed the creditor R20 000, we would pay R4 000 in full and final
settlement, and the liability would be recorded at the amount
payable − R4 000.
4.4 Qualitative characteristics of useful

financial information
Judy gave the statement of profit or loss and other comprehensive
income and statement of financial position to her friend, Andrew,
and said: “Do you think that someone who was going to invest in my
business or lend my business money would find the information
provided by the financial statements useful?”
After having spent a few moments reading, Andrew said, “These
financial statements look great, Judy, but I still have a few questions
about the statement of profit or loss and other comprehensive
income and statement of financial position.”
The conceptual framework refers to certain qualities that financial
information should have in order to be useful to existing and

potential investors, lenders and creditors (that is, the primary users
of financial information). The framework identifies two fundamental
qualitative characteristics of useful financial information: relevance
and faithful representation. Comparability, verifiability, timeliness
and understandability are identified as enhancing qualitative
characteristics. These qualities increase the usefulness of information
that is relevant and faithfully represented.
Let’s take a closer look at what these qualitative characteristics
mean, and how they make financial information more useful.
4.4.1.1 Relevance
Andrew asked, “Do you think you need all this information in the
notes to the SPLOCI? Do you think Mr Falcon wants to know in how
many patterns and colours the leather bags are available?”
Judy replied, “I thought those facts might be interesting!”
The conceptual framework indicates that financial information is
relevant if it is capable of making a difference to the decisions made

by users. Information is relevant if it assists in estimating net future
cash flows and when in the future the cash flows are likely to be
produced. Information which does not help to predict the amount
and timing of future cash flows does not help the users of financial
statements make their decisions and so is not relevant to the users.
Information that is not relevant to the users should not be included
in the financial reports because it is costly to generate this
information and it may distract attention from the useful
information.
Knowing the number of patterns and colours available for a
leather bag is unlikely to assist Mr Falcon to predict the amount and
timing of the future cash flows to be produced by Judy’s business.
This information is irrelevant to Mr Falcon because it does not give
him any of the future cash flow information he needs to make his
decision. Financial information is capable of making a difference if it
has predictive or confirmatory value. Financial information has
predictive value if it can be used to predict what could happen to
future cash flows, and it has confirmatory value if it provides
feedback about previous predictions (what we had thought would
happen).
For example, sales income is shown in the financial statements.
The sales income has both predictive and confirmative value. Users
of the financial statements can use this years’ income as the basis for
predicting income in future years. The income generated this year
can be compared to predictions about the business’s ability to
generate income which were made in past years.
Materiality
After agreeing that only relevant information should be included in

financial reports, Andrew asked, “Judy, do you think you should have
included the balance of 50 cents you still owe your father on the
original business loan on the statement of financial position?”
Let's see if we can help Judy answer this question.

We have learnt that we include information in the financial reports if
it is capable of influencing economic decisions. When we are unsure
whether to include information, we need to ask, “Is this capable of
influencing the economic decisions made by the user?” If the
information is capable of making a difference to the decisions they
make using the information, we should include it in the financial
reports. This information is material because it influences the
economic decisions of the users. Materiality is entity-specific, which
means that the decision as to whether information will affect the
economic decisions made by the user needs to be made on a
business-by-business basis. Information is material if omitting it or
misstating it could influence decisions based on the information.
If Judy did not show the loan of 50 cents to her father separately
on the statement of financial position, would Mr Falcon make a
different decision from the one he would have made had Judy
shown this loan on the statement of financial position?
No! Mr Falcon would reach the same economic decision, being to
lend money to Judy’s business, because he would not be influenced
by the omission of the 50 cent loan from the statement of financial
position. This information is immaterial to Mr Falcon, so it does not
need to be included as a seperate line item on the face of the
Andrew had asked Judy quite a few questions already and said
nothing for a few moments. “Why are you so quiet all of sudden,
Andrew?” asked Judy.
Andrew replied, “So do your financial statements actually reflect
what has happened in your business? Would a business not be
tempted to show its results in the best possible way?”
Let's help Andrew understand what faithful representation means.

A faithful representation of information records the actual outcome
of actual transactions and events. The information should be a
faithful representation of the reality of the transaction or event.
Information is a faithful representation of that which it says it
represents or that which it could reasonably be expected to
represent, when it is neutral (free from bias), free from error and
complete, and can be depended upon by the users.
Free from error

Free from error does not mean that the information is perfectly
accurate. Information that is free from error means that there were
no errors in the process used to produce the information.
Neutral (free from bias)

Information presented should be neutral and free from bias to be a
faithful representation. Information should not be presented in a
way that is designed to ensure that the user arrives at a particular
decision. Although Judy wants Mr Falcon to give her business the
loan, she cannot make her financial statements look better by
including income that does not exist or show assets at amounts that
are greater than what they are worth. Neutrality is supported by the
exercise of prudence. So what does prudence mean? Prudence does
not allow for the overstating of assets and income or for liabilities or
expenses to be understated. Preparers of financial statements are

being prudent by being cautious when making judgments under
conditions of uncertainty.
What does “making judgments” mean?

The South African Concise Oxford Dictionary explains judgement as
“the ability to make considered decisions or form sensible opinions”
(2002: p 624). It is important to understand that some of the figures
used in preparing financial statements are estimates. The conceptual
framework recognises that using estimates implies a level of
uncertainty (referred to as measurement uncertainty), however the
prudent use of estimates still means that the information is useful.
Additional information explaining the estimates (completeness) is
necessary to faithfully represent the information.
When reporting useful information it may be necessary to balance
relevant and faithfully represented information. For example, the
most relevant information may have a very high level of
measurement uncertainty. In this case it would be better to use
information with a lower measurement uncertainty, even if it is a
little less relevant.
Complete
Financial information has to be complete to be a faithful
representation. Information is complete if everything that is
necessary to understand the event is provided. Information is
complete if the financial statements can be compared with similar
information reported by other businesses and information reported
by the same business in prior periods. For example, for information
on inventory to be complete, information relating to the amount of
inventory on hand, how this amount was calculated, and prior
years’ figures for inventory may need to be provided.

Financial statements of the business can be audited. A team of
independent people (auditors) come into the business and check that
the financial statements are faithfully represented. They do this by
checking the source documents (bank records, invoices, inventory-
count records) and accounting processes against the financial
statements to ensure that the amounts in the financial statements
reflect what actually happened. The auditors issue an audit report
(which is published with the financial statements) in which they
express their opinion on the faithful representation of the financial
statements.
Let's look at an example of faithful representation of information.

Remember that the faithful representation of information means that
the information faithfully represents the substance of what it
purports to represent.
Andrew finished looking at Judy's statement of financial position and

asked, “Judy, why haven't you shown the Nissan twin cab you use as
a delivery vehicle as an asset on the business statement of financial
position?” Judy replied, “I am not the legal owner of the twin cab. I
bought this car through my bank, and they are the legal owners of
the vehicle until I have repaid them all I owe on the purchase price. I
cannot show the Nissan as an asset on my statement of financial
position because you have to own something for it to be an asset.”
When deciding how to recognise a transaction in the financial
statement, we should look at the economic reality that is the result of
the transaction and not just the legal consequences of the transaction.
For information to be a faithful representation of actual
transactions, the transactions must be recorded based on their
economic reality and not their legal form.

The economic consequence of Judy’s purchase of the Nissan twin
cab is that Judy has has full use of the vehicle. Judy has the exclusive
right to use the vehicle to earn future cash flow for the business. If
the vehicle were destroyed, Judy would have to continue to repay
the purchase price to the bank, even though she would no longer
have the use of the vehicle − this is because Judy has assumed the
risks of ownership. Judy should show the twin cab as an asset of the
business even though the bank is the legal owner of the twin cab.
Judy will recognise the liability by indicating that the business still
has payments to make on the vehicle.
Something to do 3
List all the characteristics financial information should have to make the
information faithfully represented.
Check your answer
Financial information should be free of error, neutral and complete.

Enhancing qualitative characteristics (comparability, verifiability,
timeliness and understandability) enhance the usefulness of
information.
Andrew was looking at the profit calculation on the statement of
profit or loss and other comprehensive income and comparing this
year's expenses to the expenses shown in the previous year. He was
confused because none of the expenditure was similar to the
previous year. Andrew asked Judy, “Did the business change a lot
from the previous year? All your expenses are very different from last
year.”
Judy replied, “No, the business didn't change, but I did rename a
few of the expense accounts this year because I thought the new
names were more self-explanatory. I also reallocated expenses to
new accounts this year because I thought it was more appropriate.
For example, when I purchased paper last year, I recorded this
expense as a consumable stores expense, but this year I recorded
the purchase as a stationery expense. Do you think this is a
problem?”
Let's see if Judy's reallocation of expenses and renaming of accounts

will cause a problem.
The information in the financial statements relates to events that
happened in the past. The users of the financial statements use this
historic information to estimate the amount and timing of future
cash flows of the business. To do this, the user establishes trends by
comparing information in the financial statements over the past few
years.
Users of financial statements also need to be able to judge the
performance of the business. They do this by comparing the
financial statements of the business with previous statements of the
business as well as by looking at the financial statements of similar
businesses in the same industry and comparing their performance.
For users to be able to compare the financial information of a
business over time and against other similar businesses in the
industry, the measurement and display of like transactions and

events should be carried out in a consistent manner over time and
between different companies.
In Judy’s profit calculation on the statement of profit or loss and
other comprehensive income, her information is not comparable,
because she has changed the display of like transactions over the
years. This could cause a user to make an incorrect or different
decision because he would have based his cash flow projections on
incorrect trends established from incomparable historic information.
Similar transactions should also be measured in the same way
over time and between different companies. It can be difficult to see
how different businesses have measured transactions and so they
are required by generally accepted accounting practice (GAAP) to
tell the users of the financial statements how they measure the
various transactions. This explanation is set out in a note to the
financial statements and is called the accounting policy note. Users
can now read how similar transactions were measured in each
company and use this information when making a comparison of the
companies’ financial performance and position.
Do you remember learning about generally accepted accounting
practice earlier in the chapter? We have this set of principles to make
sure that all similar transactions are measured and displayed in
similar ways by all companies. The reason for this is to make the
financial information of all companies comparable, no matter in
which industry or country the company operates.
Did you know?

Generally accepted accounting practice describes all the qualities financial
information should have. This means that all South African companies and close
corporations are required to use this document when preparing their financial
statements. Independent auditing firms audit company financial statements to
make sure that their annual financial statements comply with all the GAAP
statements. If they have not complied, the auditor makes a statement to that effect
in the audit report, which is part of the financial statements. This means all users
of the financial statements will be aware that the financial statements were not
prepared in accordance with the principles set out in GAAP, and the auditors' report
will usually show how the statements deviated from accepted practice.
4.4.2.2 Timeliness
Andrew and Judy had finished discussing the financial statements

when Andrew said, “I can't believe how much work it is to prepare
the financial statements. You have to spend a lot of time making
sure the information has all the qualities to make it useful to the
users. I wouldn't be surprised if the financial statements of a
business for the financial year 1 January X1 to 31 December X1 are
ready to be published only in July X2 at the earliest!”
Judy replied, “Well, Mr Falcon is not prepared to wait that long. I
wonder what the users of the financial statements think about the
delay in getting the information they need to make decisions?”
Let's see if we can answer Judy's question.

Users of financial statements need the financial statements to be
published as soon as possible after the end of the financial year. The
longer the time between the end of the year and the publication of
the financial statements, the less relevant this financial information is
to their decisions. Financial statements include historic information
about the business. All decisions are based on the most up-to-date
information, and the user will no longer want to look at the financial
statements if they are published long after the year-end, because the
information is no longer current and is not relevant to his or her
economic decision. When we prepare financial statements we have
to weigh up the benefit of taking time to make sure that the
information is a faithful representation against the disadvantage of
the information losing relevance over the time taken. We strive to
find the balance between relevance and faithful representation that

will satisfy the needs of the users who are making the economic
decisions.
4.4.2.3 Verifiability
It is possible to verify information directly, for example, by watching
the bookkeeper counting cash or performing an inventory count.
Information can also be indirectly verified by checking how the
information was generated, for example, by re-doing an inventory
count by checking the inputs (quantities and costs) and recalculating
the closing inventory using the same costing formula (for example,
first-in-first-out). Verifiability is enhanced by providing information
on any assumptions and estimates used in the financial statements.
4.4.2.4 Understandablity
Can the user understand the information?
Andrew said, “To begin with, I don't understand what some of the
assets on your statement of financial position are. What do you own
if you have trade receivables and inventory? Are trade receivables a
special type of leather goods?”
Let's see if we can help Andrew to understand.

The statement of financial position was not useful in helping
Andrew decide whether he would invest in Judy’s business. This
was because Andrew did not understand the terms used. Andrew is
an artist and is not familiar with the terms. To make the financial
statements useful to Andrew, Judy would have to take his lack of
business knowledge into account. Perhaps the terms “People who
owe the business money” and “Leather goods in the stall” would
have been more understandable than “trade receivables” and
“inventory”.
However, Judy shouldn’t change these terms in the statement of
financial position, because financial statements are considered to be
understandable if they are understood by people with a reasonable
knowledge of accounting. Judy has prepared the financial
statements for Mr Falcon, who is a banker and is comfortable with
business terms. We can assume he has reasonable knowledge about
business and financial statements and if Judy uses the terms trade
receivables and inventory to represent “People who owe the
business money” and “Leather goods in the stall”, Mr Falcon will be
able to understand and use this information correctly in making
decisions about the business.
Did you know?

A business can produce a separate set of financial statements for its employees,
called an employee report. This is because the accountant realises that an
average employee does not have a great deal of business and accounting
knowledge, and so to make the financial statements useful to the employees, a
simplified report is prepared. That report focuses on information that is important
(relevant) to employees and is presented in a way that employees can understand.
4.4.3 Will financial information always have all of

the enhancing qualitative characteristics?
The conceptual framework acknowledges that information may not
possess all of the enhancing characteristics but that it may still be
useful. When we prepare any financial information, we always have
to remember that the benefit we get from the information should be

greater than the costs of preparing the information.
Something to do 4
Can you list the fundamental and enhancing qualitative characteristics that
financial information should have to make the information useful to users
making economic decisions?
Check your answer
Fundamental qualitative Enhancing qualitative

characteristics characteristics
Relevance Understandability
Faithful representation Comparability
Veri ability
Timeliness
4.5 Elements of the financial statements

In order to understand the financial statements, it is important that
we understand the elements of the financial statements, namely
assets (resources of the business), liabilities and equity (claims
against the business) and income and expenses (changes in resources
and/or claims due to financial performance). In order for assets and
liabilities to be recognised on the statement of financial position, the
item needs to meet the element definition, which shows that the item
is an asset or a liability, as well as the recognition criteria, which
shows that the item can be recognised (appears) on the statement of
financial position as an asset or liability.

4.5.1 Assets
An asset is a present economic resource controlled by the business as
a result of past events. So what is meant by “an economic resource”?

An economic resource is a right that has the potential to produce
economic benefits.
Rights include:
1. Rights that relate to an obligation of another party, for example:
• the right to receive cash
• the right to receive goods or services
2. Rights not related to an obligation of another party, for example
the rights over physical items such as vehicles, land or
inventory
Rights are usually established by contracts or legislation, for
example the right to receive cash repayments and interest payments
(loan agreement). However, rights can also arise in different ways,
for example, the right to use created intellectual property (that is not
publically available).
It is important to note that if the right does not create an exclusive
right for the business, it is not considered a right that has the
potential to produce economic benefit.
For example, Judy has the right to use public roads, however, as
this is not an exclusive right to her business, she cannot recognise the
roads as an asset to her business.
The potential to produce economic benefit

An economic resource has the potential to produce economic benefit
if it enables the business to, for example, produce cash inflows,

avoid cash outflows, or receive contractual cash flows or another
economic resource.
The economic resource is of value to the business because of its
present potential to produce economic benefits in the future.
However, it is important to understand that the economic resource is
the present right (to the potential future benefit) and not the future
economic benefits that the right may produce.
Let’s look at an example.
If you purchase a lottery ticket, the economic resource is the right
to claim the winnings should your ticket be the winning ticket, and
not the amount that you could potentially win. To be identified as an
asset, the potential to produce economic benefits needs to already
exist and, at least one example of how economic benefit could be
produced beyond that which is available to any other business, must
be shown.
Control
Control is the present ability to direct the use of an economic
resource and obtain the economic benefits that may flow from it.
This means that the business has the right to decide what to do with
the economic resource and is able to prevent others from directing
the use or obtaining the benefits (positive or negative) that flow from
the resource.
Go and watch Control: This video explains the term “control”; a term that is
often used in accounting.
Something to do 5
Judy's business purchased a delivery vehicle for R510 000, which has been
delivered. This vehicle will be used to deliver leather goods to the stalls and to
customers.
Is the delivery vehicle an asset?
Support your answer by applying the asset definition to the delivery vehicle.
Check your answer
The delivery vehicle meets the asset definition. The vehicle is a present economic
resource controlled by the business due to past events.
The vehicle is a present economic resource – Judy's business has the right to use or
sell the delivery vehicle. The delivery vehicle already has the potential to generate cash
(future economic benefit) indirectly, as it is used in the business, or directly, if it is sold.
The delivery vehicle is controlled by Judy's business as she has the ability to decide
what to do with the vehicle, and will obtain the economic benefits from whatever she
decides. No one else has any rights to the vehicle. The past event was that Judy's
business took delivery of the vehicle.
Something to do 6
Judy's business rents a delivery vehicle costing R510 000 from Avis car rental
for R10 000 per month. The business uses the vehicle to transport leather
goods from suppliers and to customers.
Judy wonders if this vehicle would be considered as an asset for her business.
This is because using the vehicle results in economic benefits flowing into the
business.
Do you think that this vehicle would be considered to be an asset in Judy's
business?
Check your answer

The right to use the delivery vehicle meets the definition of an asset for Judy's
business. The right to use the delivery vehicle is an economic resource, because, just
as with the purchased delivery vehicle example, the vehicle has the potential to
produce economic benefits for Judy's business, either indirectly, or directly. This
economic resource is controlled by Judy, for the duration of the rental period, because
during this time, Judy alone (not Avis car rental) can decide how it will be used in the
business and can prevent anyone else from using it, and will obtain the benefits of its
use.
It's important to realise that Judy doesn't need to own the vehicle to have an asset.
Judy doesn't even have to rent the vehicle for the vehicle's entire lifespan to have an
asset. As soon as Judy has any right that someone else doesn't have, and that right
has the potential to benefit Judy economically, Judy has an asset (as long as the past
events have occurred).
Think about this 1

We assume control of a present economic resource as a result of an event that has
happened in the past. An item will not meet the asset definition if there is no past
event transferring control of the present economic resource (i.e. the right that has
the potential to produce economic benefits). With the purchase of the delivery
vehicle, Judy's business gained control of the right to use or sell the vehicle when
the vehicle was delivered. The past event was the delivery.
Judy's business ordered a vehicle on 1 November X1, and paid a R100 000
deposit for the vehicle on 1 December X1. The vehicle will be delivered on 1
February X2 and the final payment of R500 000 is then due. Would the vehicle
meet the asset definition for Judy's business on 31 December X1?
On 31 December X1, the only events relating to the vehicle that have already
happened are ordering the vehicle and paying for it.
Has either of these events transferred control of the vehicle to the business?
Does Judy's business have the present ability to direct the use of the economic
resource (the vehicle)?
This would depend on whether the payment of the deposit of R100 000
transferred the right to sell or use the vehicle to Judy's business. Assume that
based on the contract terms the deposit payment does not transfer any exclusive
rights to the vehicle to Judy's business.
On 1 December X1, the business would recognise a receivable asset and not a
vehicle asset. The receivable is the present economic resource controlled by the
business.
The deposit payment is the right that has the potential to produce economic
benefit (i.e. receiving the vehicle or receiving a refund of the cash).
The business controls the receivable as the future economic benefit from the
deposit will flow into Judy's business. The car supplier either has to give the
business its cash back or it has to give it the vehicle. The past event is making the
payment. The payment entitles the business to receive either the vehicle or its
money back.
What journal entry will be processed when the vehicle arrives on 1 February X1?
Go and watch The Asset Life-Cycle: This video explains the financial reporting
process from initial recognition until derecognition, with a focus on assets.
4.5.2 Liabilities
A liability present obligation of the business to transfer an
is a
economic resource as a result of past events. An obligation is a duty
or responsibility that the business has no practical ability to avoid.
Let’s look at the definition a little closer. The “present” obligation
means that the business must have already received an economic
benefit or acted in some way, as a result of which the business has to
transfer economic resources that it would not otherwise have had to
transfer. In other words an obligation means that something is owed.
So what does “no practical ability to avoid” mean? It could be
argued that a business may have no practical ability to avoid transfer

of an economic resource if any action it took to avoid this transfer
would have negative economic consequences significantly worse
than the transfer itself.
Preparing financial statements on a going concern basis implies
that the business has no practical ability to avoid a transfer if this can
only be avoided by liquidating the business or stopping trade (i.e. by
no longer being a going concern). Similarly, historical practices, such
as paying an annual bonus to staff, even if this is not stipulated in
their employment contracts, creates a valid expectation by staff that
such practices will continue. A business may have “no practical
ability” to avoid this responsibility going forward, if not paying the
annual bonuses would have a significant adverse effect on the
business.
If Judy’s business receives inventory but has not yet paid for it, is
there a liability to pay for the inventory? Judy’s business has
received economic benefit (the inventory) and will have to transfer
an economic resource (cash) because it has received the inventory.
Not paying for the inventory is likely to have a significantly negative
impact on the ability to purchase inventory in the future (i.e. there is
no practical ability to avoid paying).
Something to do 7
Judy's stall at Greenmarket Square has a thatch roof that needs to be replaced
every two years at a cost of R30 000. Judy's business is responsible for this cost.
The roof was replaced in the current year ending 31 December X1, and this has
been paid for. Judy wants to know if the R30 000 she will pay in two year's time is
a liability at present.
Check your answer

Does Judy have a present obligation to transfer an economic resource (R30 000) due
to past events?
A present obligation means that Judy's business has to have already received
economic benefit. As no work has been performed on the roof, there is no such
obligation.
Future expenditure is not a liability because there is not a past event that has
resulted in a present obligation.
4.5.3 Equity
Assets are funded by either equity or liabilities so equity can be
described as the residual interest in the assets after deducting all of
its liabilities. The equity amount represented on each statement of
financial position assumes that the assets would be realised (sold) at
the amount stated on the financial statements and that the liabilities
would be settled at the amount stated on the financial statements, i.e.
the equity is the residual value.
Equity is also referred to as the net asset value (assets – liabilities).

It is important to understand that each transaction that the business
records will affect the assets and/or liabilities of the business. If a
transaction leads to a change in the net asset value of the business,
equity is recognised as having increased or decreased.
Transactions that lead to a change in equity (net asset value) can
come about due to transactions with the owner and transactions not
with the owner.
Increase in assets, or decreases in liabilities that result in increases
in equity, other than contributions from owners, are considered to be
income.
Decreases in assets or increases in liabilities that result in
decreases in equity, other than distributions (drawings) to owners,
are considered to be expenses.

Transactions that lead to an increase/decrease in equity (net asset
value) due to transactions with the owner are recognised as
capital/drawings.
Something to do 8
Judy has just received an inheritance of R100 000 and decides to invest this
cash in her leather goods business. She deposits the money in the business
bank account.
Prepare the general journal entry to record this transaction in the general
ledger.
Can you briefly explain what elements this transaction affects?
Check your answers
Assets (bank) increases, and there is no change in any other asset or liability. This is a
transaction with the owner so it is recognised as capital (an increase directly to equity).

Income and expenses occur when transactions (not with the owner)
result in an increase or decrease in either assets or liabilities of the
business. The increase/decrease in the assets or liabilities changes
the equity of the business. We recognise this change in equity as
either income or an expense.
Think about this 2

The profit for the period, on the profit or loss statement, shows the changes in
the net asset value of the business, not due to transactions with the owner that
happened during the year.

Andrew was looking quite pleased because he could identify whether
transactions met the asset and liability definitions. Now that he
could do this, he thought he could report these items on the financial
statements. When he told Judy, she replied, “Just because a
transaction meets the definition does not necessarily mean that the
asset or liability will be recognised on the financial statements.”
Go and watch What are liabilities: This video explains when a business can
recognise a liability and introduces provisions and contingent liabilities.
Recognising assets, liabilities, income and expenses
Recognising an asset, liability, income or expense means that the
item appears in the financial reports of a business.
An asset, liability, income or expense can be recognised on the
financial statements if it meets the definition and recognition criteria
of the element.
• If the definition has not been met, there cannot be an asset or
liability.
• If the definition has been met, we must determine if we can
recognise the asset or liability on the statement of financial
position.
Assets, liabilities, income, expenses or changes in equity will be
recognised if such recognition provides users of the financial

statements with relevant information and a faithful representation of
the underlying transaction.
Relevance is influenced by uncertainties, i.e. it may be uncertain
whether an asset or liability actually exists (for example, the know-
how of a business that is not legally protected). Uncertainty also
exists where there is a low probability of inflows or outflows of
economic benefit occurring. In other words, recognising an asset or
liablity may not provide relevant information, if there is significant
uncertainty about the asset or liability’s existance, or where the
chances of any inflow or outflow of economic benefits is very slim.
Faithful representation can be affected by the level of
measurement uncertainty. Using estimates implies a level of
uncertainty so, if all estimates available are highly uncertain, then
recognising the item may not faithfully represent what the financial
statements indicate they are representing. If no estimates are
available, it is not possible to recognise an item.
Judy’s business bought a delivery vehicle for R110 000 to
transport all the leather goods for her business. Judy’s business paid
and took delivery of the vehicle on 31 December X1.
Can Judy recognise the vehicle as an asset?
Check your answer
The delivery vehicle meets the asset definition on 31 December X1. Go back to page X
to check why it is an asset.
The vehicle meets the definition of an asset, so we can recognise the asset if the
recognition criteria are met.
Remember the asset is recognised if it results in relevant information that is a
faithful representation of the transaction.
The existence of a vehicle with the potential to produce economic benefit has
predictive value for decision makers, thereby providing relevant information. Presenting
the asset at what it cost the business would fairly represent the transaction.
This vehicle is an asset on 31 December X1 as recognition criteria are met on this
date. The vehicle appears as an asset on the statement of financial position as at 31
December X1.
4.7 Derecognition of assets and

liabilities
Derecognition is defined as the removal of all or part of a previously
recognised asset or liability from a business statement of financial
position. Derecognition of an asset normally happens when the
business loses control of all or part of the recognised asset.
Derecognition of a liability happens when the business no longer has
a present obligation for all or part of the recognised liability.
The conceptual framework states that derecognition should aim
to faithfully represent both:
• any assets and liabilities retained after the transaction that lead to
derecognition, and
• the change in the assets and liabilities as a result of that
transaction. For example:
If Judy’s business sold inventory, the inventory sold would be
removed from the amount of inventory shown on the statement of
financial position:
• The increase in bank, which increases equity and is not a
contribution by the owner, will be shown as income.
• The decrease in inventory, which decreases equity and is not a
distribution to an owner, will be shown as an expense.

Andrew had been looking at the business’s financial statements and
said to Judy, “I see you have shown the property at R500 000, but
you purchased it for R300 000.”
Let's help Andrew to understand measurement.

Elements can be recognised on the financial statements once the
definition and recognition criteria have been met. In deciding on the
amount at which to recognise the asset, liability, equity, income and
expenses, we will need to understand how the elements are
measured.
What does the conceptual framework say about measurement?

The conceptual framework offers two categories of measurement
bases that can provide information that is useful. The choice of
which basis to use would depend on which would provide the most
useful information (based on the individual circumstance).
The measurement bases are historical cost measurement and
current value measurement.

According to the historical cost measurement basis, an asset is
valued at the cost paid to purchase (or create) the asset. Transaction
costs such as import duties or legal fees are considered part of the
historical cost of an item.
According to the historical cost measurement basis, a liability is
the value of the consideration received, i.e. the value of the liability
would be the cost of the inventory taken on credit (the amount of the
obligation required to settle the liability).

The historical cost of an asset is reduced if the asset (or part of the
asset) has been consumed (referred to as depreciation for non-
current assets) or has been damaged (referred to as impairment). We
will review depreciation in Chapter 5 and impairment in Chapter 11.

These bases provide information updated to reflect conditions at the
measurement date.
What is meant by the “measurement date”? This is any point in
time (for example, when an asset is acquired, or any financial year
end after the asset has been acquired).
4.8.2.1 Fair value

Fair value is the price that would be received to sell an asset, or paid
to transfer a liability, in an orderly transaction at the measurement
date. Fair value is also referred to as “market value”.
4.8.2.2 Value in use (assets) and fulfillment value

(liabilities)
The value in use of an asset is the present value of the future cash
flows generated from using the asset and disposing of the asset, less
any costs incurred on disposal.
The fulfillment value of a liability is the present value of the
future cash flows required to settle (fulfill) the liability plus any
future transaction costs required to do this.
What is meant by “present value”?

Present value is calculated by discounting a future cash flow to the
present time. This recognises the time value of money. In other
words, R1 000 received today is worth more than R1 000 received in
a year’s time. Why is this? The R1 000 I have today can earn interest
for a year and there is also no risk of not getting the money as it can
be safely invested with a reputable bank. So how do I calculate the
present value in the following scenario?
Future value = R100 000 (31/12/X1) Fair interest rate = 12%. What is
the present value on 1/1/x1?
R100 000 = 112% (cost of asset + 12% interest)
100% = R100 000 x 100/112
Present value = 100% = R892 857

Current cost refers to the amount that would be paid to acquire an
equivalent asset or the amount that would be received to take on an
equivalent liability.
4.8.3 Deciding which measurement base to use

when initially recognising an asset
In deciding whether an asset or a liability should be measured using
historical cost or current value, the decision should be based on
which measure would provide useful information. In other words,
which measurement would provide the most relevant information
that is a faithful representation of the transaction?
Let's look at an example of initial measurement: historical cost.

The following transactions occurred on 1 January X1:
1. Took delivery of a vehicle and paid R100 000 by cheque.
2. Took delivery of inventory. The business will pay R40 000 on 31
March X1. The payment period is less than one year.
3. Took delivery of equipment. The business will pay R1 000 000
on 1 January X2. The payment period is more than one year.
Assume a fair interest rate of 12%.
Prepare general journal entries to record the recognition of the above
assets in the books of the business.
1. If cash is paid at acquisition, the historical cost is the amount of

cash paid.
What if import duties were paid to get the vehicle to South Africa?
The historical cost at which the vehicle is initially recognised will
include the import duties.
2. If payment for the asset is deferred, but the payment is made
within a year, the historical cost is the amount of cash that will
be paid. If payment is made within a year, the business will not
pay any interest on the deferred payment.
3. Since thepayment period is more than one year, the asset must
be recorded at the present value of the future cash payment on
the date of acquisition.

What if the business pays for the asset after the date of acquisition
(deferred payment)?
If payment is expected within a year, the consideration will be the
R40 000 to be paid. It will not be discounted to present value, which
means that no allowance will be made for the time value of money.
If the payment period is expected to be more than one year, the
consideration will be the present value of the amount to be paid.
What do we mean by the term “present value”?

The present value of the asset is calculated by discounting the future
cash payments made to acquire the asset back to the date on which
the asset was acquired (the date that control was transferred). The
cash payment is split into two components − the cost of the acquired
asset, and the financing cost incurred as a result of paying for the
asset some time after control was transferred.
Given that a fair interest rate is 12%, the present value of the cash to
be paid on 1 January X2 is calculated as follows:
R1 000 000 = 112% (cost of asset = 100% plus interest @ 12% for
one year)
How much is 100%?
R1 000 000 × 100/112
= R892 857, which is the portion of the payment relating to the
assets acquisition.
Note:
The liability (trade payables) is recognised at the value of the equipment received
in exchange for the obligation.
On 1 January X2, the journal entries will be:
Note:
The cost of the equipment is less than the amount of cash paid. This is because the
cash was paid for two things − the equipment, and financing for a year. The total of
the cost of the asset plus the interest expense is equal to the amount of money that
was paid.
In the calculation of the historical cost at which we initially measure
the asset, we sometimes have to make use of future amounts. What
if, instead of Judy purchasing the building for R450 000 cash, she
purchases the building and has to pay the seller R130 000 each year
for 10 years?
We need to calculate the consideration paid for this asset. We do
that by calculating the total of these future cash flows in today’s
money terms (discounting the cash flows to the present value).
If we assume an interest rate of 10%, the cash flows in this
example are an outflow of R130 000 for 10 years. This stream of
payments in the future, assuming an interest rate of 10% for all 10
years, is worth R798 793 on 1 January X0 (which means that the fair
value is R798 793).
(You will come across the use of present value often in your
future studies of manage ment accounting and financial accounting,
where the actual calculation of the present value will be more fully
explained. The calculation can be done using a mathematical

formula, in tables that are published with the necessary adjustment
factors − PV 10% for 10 years = 7.98793.)
The journal entry to record the purchase of the building on 1
January X0 is as follows:
Did you notice that the building was measured at less than R1.3
million (10 years at R130 000 per year), which is the total cash paid
for the building? The amount is less because the measurement on 1
January X0 takes into account that money payable in the future is
worth less than money now. This principle is known as the time
value of money.
Go and watch Using a financial calculator − Time value of money − Part 1.
This video explains the concept of Time value of money.
Go and watch Using a financial calculator − Time value of money − Part 2.
This video explains how to use a financial calculator and shows how to present
workings in an exam.
Initial measurement: current values
At initial recognition the cost of an asset is normally similar to its fair
value at that date. However, if a current value basis is being used (as
it will provide more useful information at subsequent measurement
dates), this information (i.e. the basis used) must be indicated.
Something to do 9
What amount do we use to record the value of the building if we give the seller,
in exchange for the property, a painting with a fair value of R550 000?
Prepare the general journal entry to record this purchase.
Check your answer
At initial recognition, assets are recorded at the fair value of the consideration given in
exchange for the asset.
The value of the building will be measured at the fair value of the painting, being the
consideration given for the property.
(If the painting had not been recognised at its fair value, the difference between the
carrying amount of the painting and its fair value would be a profit or loss on disposal.
Disposal of assets will be covered in Chapter 11, Property, Plant and Equipment.)
Something to do 10
Judy's business owes creditors R20 000 for bags purchased during the year. The
creditors have a policy whereby they will accept 50% of the debt as full payment
for the balance owing if a business is in danger of going bankrupt. They offer this
compromise (accepting less than what they are owed) to prevent clients from
going bankrupt and losing potentially good clients.
How should Judy measure her obligation for these trade payables in the records?
The question that is being asked is which measurement basis would provide
useful information, i.e. relevant and faithful representation.
1. If there is no indication that Judy is in danger of going bankrupt, the historical
cost (R20 000), i.e. the value of the consideration received (the value of the
inventory).
2. If Judy's business is facing bankruptcy then a current value (fulfilment value)
of R10 000 would be a more relevant amount and would faithfully represent
the conditions at the current time.
What measurement basis do you think a business should use if it
purchases an asset on a forced sale? In other words it pays R500 000
for the asset, but the fair value of the asset amounts to R900 000. The
question is, “Which basis will provide users with the most relevant
and faithful representation of the business?”
In this case using the fair value measurement basis provides users
with better information. The asset would be recognised at R900 000
on initial recognition.

At the end of each financial period, or at any other time when
financial statements are prepared, the assets and liabilities must be
accurately presented.
The framework recommends using the same measurement basis
for initial recognition and subsequent measurement. This is so that
change in the value of the asset/liability is not due to a change
measurement basis.
If the asset had initially been recognised at historical cost, the
carrying amount at any subsequent measurement date would be the
unconsumed or uncollected historical cost that is considered to be
recoverable.
If the asset had initially been recognised at fair value, the carrying
amount at any subsequent measurement date would be the price
that would be received to sell the asset at that point in time.
Remember that if a portion of the asset has been sold or consumed,
this will decrease the carrying amount shown at that date.
At each subsequent financial year end if an asset such as property,
plant and equipment has been used, or assets such as property, plant
and equipment, inventory or trade receivables have been damaged,
the amount at which they are recognised on subsequent financial
statements could be lower than the amount at which they were
initially recognised.
Let’s briefly look at subsequent measurement with respect to two
examples indicated in the PPE Standard and Inventory Standard.
With respect to property, plant and equipment, the business can
use either the cost or the revaluation model to subsequently measure
property, plant and equipment. If the business uses the cost model,
the business will show the asset at depreciated historical cost (in
other words, the cost at which it was initially recognised, less an
amount to account for the use of the asset, known as depreciation).
If the business uses the revaluation model, the business will show
the asset at the fair value of the asset on the reporting date (less
depreciation).
The business will also need to question whether the asset has been
damaged. If the asset has been damaged, an impairment test needs
to be carried out. If the recoverable amount expected from the asset
is below the carrying amount (the amount the asset currently
appears in the books), the asset will need to be impaired, i.e. written
down.
Property, plant and equipment will be written down to its
recoverable amount if this is below the asset’s carrying amount.
Recoverable amount refers to the maximum future economic benefit
that the item of property, plant and equipment can generate. This is
the higher of the value in use (the benefit generated from using the
asset and selling it at the end of its useful life) and the fair value less
costs to sell (the benefit generated from selling the asset).
Depreciation, impairment, the cost and revaluation model are
dealt with in greater details in Chapter 11.

Inventory will be written down to its net realisable value (selling
price less disposal costs) if the net realisable value is below cost.
IAS16 (Property, plant and equipment) and IAS2 (Inventory)
provide additional information relating to subsequent measurement
of these particular assets (as do the IAS statements relating to all
other assets).
Let's look at an example

Judy’s business bought a building that cost R400 000 two years ago
on 1 January X0. On 31 December X1 the market value of the
building is R450 000. What amount could we use to measure the
building (asset) on the statement of financial position as at 31
December X1?
If the business used historical cost to initially measure the
property, the business would recognise the property at R400 000, as
this is what we paid for the property.
If the business used the fair value basis, assuming that the building
was purchased in a normal sale, (i.e. that the amount paid represents
the fair value) then the following journal entry would be processed
(i.e. the same as for historical cost).
What would be recognised on 31 December X1 if the historical
cost basis was used, and assuming that none of the historical cost
has been consumed (no depreciation) and that the entire historical
cost is recoverable (no impairment)? There is no change in the
amount recognised. The building is still recognised at R400 000.
If the fair value basis was used the building will be measured
(carried) at the current fair value of R450 000. We have selected the
fair value method of accounting for the building (called the
revaluation model − refer to Chapter 11) and so we increase the
value of the building to the fair value.
The revaluation gain will not form part of the profit of loss section of
the statement of profit or loss and other comprehensive income.
The revaluation gain is an example of other comprehensive
income and is closed off to the revaluation surplus equity account
that appears on the statement of financial position.

Judy was worried about Andrew because he had been hunched over
her financial statements for about 30 minutes, banging away on a
calculator. Judy asked Andrew, “Is there anything wrong with my
calculations? You seem to be having difficulty calculating some
numbers.”
Andrew replied, “Well, Judy, when I subtract your expenses from
the sales income, I arrive at the profit for the year that you have
shown. I know the profit for the year should be equal to the net
amount of cash you received during the year. I was surprised when
the profit for the year did not agree with the amount by which your
bank account has changed from the beginning of the year.”
Judy replied, “The profit or loss statement and the statement of
financial position are prepared using the accrual concept and not the
cash concept.”
“Judy, tell me what you mean when you say that these financial
statements are prepared on the accrual basis,” said Andrew.
The accrual basis requires the effects of transactions to be reported in
the financial period in which they occur, i.e. when assests/liabilities
change, not necessarily in the period in which cash is received or
paid. Reporting information about the business’s resources and
claims (in the statement of financial position), and its changes in its
resources and claims (in the statement of profit or loss and other
comprehensive income and statement of changes in equity) on the
accrual basis results in a better basis for assessing a business’s past
and future performance. The statement of cash flows, however,
reports on the cash received and paid during a financial period.
Let's try to help Andrew to understand the accrual concept.

The transaction for a sale is reported when bank increases (a cash
sale) or trade receivables increase (a credit sale). The transaction for
an expense occurs, for example, when inventory decreases
(inventory is sold) or when liabilities increase (for unpaid but used
electricity), or when bank decreases if we are paying for the
electricity once it is used.
Preparing financial statements such as the profit or loss statement
or the statement of financial position on the cash basis means that
transactions are recorded only when cash is actually paid or
received. This information is not useful to the user in estimating the
future cash flows of the business. The record of all past transactions
that occurred during the year is also incomplete when using the cash
basis to record transactions.
Something to do 11
Judy sold 1 000 bags at R350 per bag during the year. All sales were on credit.
Judy received payment for these bags only on 4 February X2. The financial
statements for the year ended 31 December X1 are prepared on the cash basis.
What do you think the sales income will be in the profit calculation prepared on
the cash basis for the year ended 31 December X1?
Check your answer
There will be no sales income shown in the profit calculation, because the financial
statements are prepared on the cash basis.
The profit calculation would not be useful to a user, because, even though the
business had derecognised assets (inventory used during the year), when 1 000 bags
were sold and left the stall, no income had been recognised during the year.
The cash basis is even more misleading if we look at the following example.
Assume that Judy spends R200 000 cash on expenses to run her business during
the year and help generate the sale of the 1 000 bags on credit. On the cash basis of
accounting, Judy's profit calculation over the next two years would be as follows:
Profit calculation − cash basis
31 December X1 31 December X2
Sales − bags Nil 350 000
Expenses (200 000) Nil
Profit/loss for the period (200 000) 350 000
On the cash basis, Judy shows a loss in X1 of R200 000 and a profit in X2 of R350
000. This results in hugely fluctuating results that make it difficult for the user to
project future cash flows and make economic decisions. It is better if all the economic
consequences of transactions that occurred during the current year are recorded
together so that the user can understand the net result of the transactions.
If we calculate the profit using the accrual concept, we record the sales income in
X1, because this is when the transaction occurred − this is when the assets/liabilities
in the business changed.
When applying the accrual concept, the profit calculation would look like this:
Profit calculation − accrual basis
31 December X1 31 December X2
Sales − bags 350 000 Nil
Expenses (200 000) Nil
Profit for the year 150 000 Nil
A profit of R150 000 is recorded in X1. This makes sense, because the sales took
place in X1 and the overall consequence of this transaction is that we made a profit of
R150 000.
Users have a better idea of the economic consequences of transactions that
occurred during the year.
Something to do 12
Judy's business purchased 100 leather bags on 1 January X1 for R200 each
and paid the supplier cash. On 31 December X1 she had 20 of these bags left in
the stall. The bags sell for R350 each.
Prepare the profit calculation on the accrual basis for the year ended 31
December X1.
Check your answer
Profit calculation − 31 December X1

Sales − bags (80 bags at R350) 28 000
Expenses (80 bags at R200) (16 000)
Pro t 12 000
Judy's business has sold 80 bags during the year (100 bags purchased, less the 20
bags left at the end of the year). Therefore 80 of the leather bags will be derecognised,
and so, using the accrual basis, we recognise an expense equal to the cost of the
goods used during the year.
The cost of the 20 unsold bags (R4 000) are recognised as an asset because Judy's
business still has the right to sell them.

• Financial statements are useful if users understand the principles
used to prepare them.
• The objective of financial statements is to provide financial
information about the business that is useful to existing and
potential investors, lenders and other creditors when they make
decisions about providing resources to a business.
• Financial statements are prepared on the going concern
assumption.
• The qualitative characteristics increase the usefulness of financial
information to users. The fundamental qualitative characteristics
are relevance and faithful representation. Comparability,
verifiability, timeliness and understandability are identified as
enhancing qualitative characteristics.
• All transactions can be allocated to groups of transactions with
similar economic consequences. These are called elements. There
are five elements: assets, liabilities, equity, income and expenses.
• A transaction can be recognised in the statement of profit or loss
and other comprehensive income and statement of financial
position only if it meets the definition and recognition criteria of
the element.
• The elements can be measured using different measurement
bases, namely historical cost or current values.
• The accrual concept means that transactions are reported when
the transactions happen, i.e. when assets/liabilities change and
not necessarily when the related cash flow occurs. We recognise
income and expenses when assets/liabilities change even if we
have not received or paid the cash.
What's next?
In the next chapter we are going to look at year-end adjustments that
need to be processed before the statement of profit or loss and other
comprehensive income and statement of financial position of a
business are drawn up. The adjustments ensure that the information
presented on the statement of profit or loss and other comprehensive
income and statement of financial position accurately reflects the
assets, liabilities, equity, income and expenses of the business for the
relevant reporting period.

QUESTIONS
QUESTION 4.1 (C)

Simphiwe Dlamini, an old university friend, has started a business
importing machinery from the United States and then selling the
machinery to businesses in South Africa. He has to prepare financial
statements for the first time for the financial year ended 31
December X0 and has asked you for some help with this process.
When he asked you for help he said, “I remember how well you
understood the conceptual framework for financial reporting when
we covered this in Financial Accounting 1. With this knowledge you
are the obvious person to help me prepare my first set of financial
statements.”
There are a number of accounting issues you have to think about
during the course of helping your friend. Some of these issues have
been set out below for you to think about.
Transactions:
• Simphiwe ordered a machine called a “Blader” from his supplier
in the United States on 1 February X0. He ordered only one of
these machines as he had not previously sold this type of machine
in South Africa and had not as yet done any market research to
see if there was demand for this machine type. Once he has this
machine in his showroom he is going to do some research as to
potential sales.
The machine cost R150 000 and Simphiwe had to pay a 10%
•
deposit on the date of order, which he did. The balance of the
purchase price was to be paid on delivery. This machine took 8
months to manufacture and the supplier shipped the machine on
1 October X0. The ship docked in the Cape Town harbour on 31
January X1 and the machine was delivered to Simphiwe on the
same day.
• On 31 December X1 the machine had not as yet been unpacked by
Simphiwe nor put into the showroom. Simphiwe had still not
done any research into whether it would be possible to sell the
machine in South Africa. He had been slow in unpacking the
machine and since ordering the machine he had become aware
that his competitor was promoting a similar product that was
considerably cheaper and more efficient.
• Included in the terms of the purchase agreement with the supplier
was the acknowledgement that if the ship sank on the way to
South Africa, the supplier would be responsible for replacing the
machine and providing Simphiwe with a new machine.
1. Explain to Simphiwe how the above transaction should be
reflected in the financial statements for the year ended 31
December X0. Use all the definitions and terms in the
conceptual framework in preparing your answer. (13 marks)
Part A
Explain how Simphiwe should recognise this transaction in the
financial statements for the year ended 31 December X1. (13 marks)
Part B
Prepare the general journal entry Simphiwe should process on 31
January X1 in respect of the above transaction. (4 marks)
QUESTION 4.2 (A)

On 10 January 20X2, Timeless Way Bakery ordered an industrial
oven for its premises in Athlone. The supplier, based in Port
Elizabeth, agreed a price of R56 000. On 1 February 20X2 Timeless
Way paid the full price by electronic transfer. The supplier
dispatched the oven on 26 February 20X2 and it was delivered to the
bakery on 1 March 20X2, as agreed in the sales contract.
1. Indicate the date on which Timeless Way should recognise the

oven as an asset.
2. Discuss why the oven should be recognised as an asset on this
date. Your answer should refer to the asset definition and
recognition criteria as detailed in the conceptual framework.
QUESTION 4.3 (C)

Jakira Journal and Peter Personnel are both employed by Bettie
Bookworm, trading as Concepts Corner. Jakira is the accountant and

Peter, the store manager. Concepts Corner specialises in the sale of
financial accounting textbooks, computer software and stationery.

The business sells goods to customers for cash and on credit. Cash
customers receive a trade discount of 10% and credit customers
benefit from a settlement discount of 5% if certain payment terms
are met. Concepts Corner adopts the perpetual method of recording
inventory and calculates selling prices based on a gross profit
margin of 40%. The business has a year-end of 31 December.
The latest summarised financial statements of Concepts Corner

are as follows:
Concepts Corner
Statement of comprehensive income for the year ended 31
December X1
Sales 2 000 000
Less: Cost of sales 1 400 000
Gross pro t 600 000
Less: Expenses 435 000
Rent expense 84 000
Advertising 70 000
Insurance 15 000
Salaries and wages 215 000
Sundry operating expenses 25 000
Depreciation 6 000
Bad debts 20 000
Pro t 165 000
Concepts Corner
Statement of financial position as at 31 December X1
TOTAL EQUITY AND LIABILITIES 296 000
TOTAL ASSETS 296 000
NON-CURRENT ASSETS (net carrying amount) 54 000
CURRENT ASSETS
Inventory 105 000
Bank 5 000
Prepaid rent 7 000
The two colleagues, Peter Personnel and Jakira Journal, enter into a
discussion about the financial statements. The conversation between
them goes as shown below.
Complete the answers that Jakira should give to Peter’s questions (in
other words, you are expected to provide Jakira’s responses 1–9
below).
Peter: I realise that I don’t know much about financial
accounting, but I’m confused as to why the profit on the
statement of comprehensive income is not equal to the
balance in the bank account. The statement of
comprehensive income is showing quite a good profit
this year, but the bank balance is so low.
Jakira: RESPONSE 1 (3 marks)
Peter: Jakira, a number of our customers are students
from surrounding universities. At the end of December
each year, the students pay for books that have been
ordered for their next year of study. This year the value
of these orders is R124 000. Can you explain in detail how
this transaction has been treated in the financial
statements?
Peter: Although advertising amounting to R80 000 was
paid for in cash during the year, only R70 000 appears in
the statement of comprehensive income. Am I correct in
thinking that the business has inadvertently understated
the expenses, or is there another explanation?
Peter: The business purchased three new computers at
R20 000 each at the beginning of the year. The total cost
was R60 000. These are the only computers that the
business owns. Why are they recorded on the statement
of financial position at R54 000? What has happened to
the other R6 000?
Peter: If the business had purchased the computers on
hire purchase (on credit) with an agreement to pay for
the computers over a period of, let’s say, three years, the
computers would obviously be recorded in the financial
statements as a liability and would be recorded as an
asset only once the final payment had been made. Is this
a correct assumption to make?
Peter: Your explanations are certainly helping me in my
understanding of financial statements, Jakira. Just a few
more questions. During the physical inventory count, it
was discovered that a stack of books had been damaged
by water as a result of a leak in the roof. These books had
a selling price of R45 000. If I remember correctly, you
calculated that Concepts Corner could sell these books
for R28 000 if R4 000 was spent on replacing their covers.
How would you value the inventory in this case, and

what amount would be reflected on the statement of
financial position?
Peter: Thanks for your patience, Jakira. Thanks to you, I
can improve on the ways in which I manage this store
and contribute positively to improved profitability.

5 Adjustments
Judy is pleased with the level of accounting knowledge that she
has gained over the past month and feels quite confident that she
is able to prepare a statement of profit or loss and other
comprehensive income and statement of financial position
correctly. She is able to identify which items appear on the
statement of financial position: assets, liabilities and equity, and
which items form part of the profit calculation on the statement of
profit or loss and other comprehensive income: income and
expenses.
Judy was chatting to Thabo, one of the other stallholders. Thabo
raised a number of questions that made her realise that there
were still areas in accounting that she needed to learn about.
Thabo asked her whether she thought stationery should be
reported as an asset on the statement of financial position or
whether it was an expense and should be reported as part of the
profit calculation. Judy told him that she thought stationery was an
expense because she had bought the stationery to use in running
the business. When she drew up her financial statements she
would report the stationery as an expense in the profit calculation.
Thabo's only comment was: “But what if you haven't used all the
stationery by the end of the year, what would you do then?” This
got Judy thinking. Thabo certainly had a point.
Learning objectives
• Understand what adjusting journal entries are
• Understand why it is important to process adjusting entries
• Adjust accounting information to reflect the financial position and performance of
a business more accurately
• Process closing transfers at the end of the financial period
• Prepare financial statements after adjustments have been taken into account
• Understand the implications of the accrual basis.

Judy needs to understand what is meant by “adjusting journal
entries”. She needs to realise that the information recorded in her
general ledger reflects the transactions that have actually happened
during the year (i.e. that are driven by cash), and that calculating the
profit using these figures may not give her an accurate picture of the
change in the assets and liabilities for the financial period. She also
needs to realise that without processing adjustments, the amounts
she would have taken to her statement of financial position for

assets, liabilities and equity may not accurately reflect the assets,
liabilities and equity of the business.
How are we going to help Judy to solve her problem?

Let’s help Judy understand and answer the question that Thabo
posed: “But what if you haven’t used all the stationery by the end of
the year, what would you do then?”
In Chapter 2 Judy drew up a trial balance, the statement of profit
or loss and other comprehensive income and a statement of financial
position for the month of January using the following information:

At the end of January the trial balance of Handbags for Africa looked
like this:
Pre-adjustment trial balance as at 31 January X1

Capital 8 000
Drawings 720
Loan 2 000
Bank 4 091
Inventory 1 860
Prepaid electricity 300
Rent expense 1 000
Sales 6 711
Cost of sales 2 940
Wages 600
18 031 18 031
Let's look at Judy's general ledger.
The amounts of R200 shown in the stationery account and R440
shown in the talk-time account reflect what was spent on stationery
and talk-time during the month.
Do those amounts reflect the stationery and talk-time expense for the
month? This will depend on whether Judy has used all the stationery
and talk-time.
Go and watch Recording and reporting financial information: This video
explains the difference between the recording and reporting of financial
information.

During any financial period, Judy will record the effect of all of her
transactions in the journals. At the end of each month, Judy will post
this information to her general ledger and will extract a trial balance.
If Judy needs to prepare financial statements, she will need to ensure
that the information on the trial balance represents the information
that should be reflected on the financial statements.
At the end of any financial period, when Judy prepares the
statement of profit or loss and other comprehensive income and
statement of financial position, she wants to know what part, if any,
of the stationery and talk-time is still an asset, and what part has
become an expense.
If we look at the pre-adjustment trial balance (see page 143),
stationery and talk-time have been reflected as assets: stationery on
hand and prepaid talk-time. However, if Judy’s business had used
all of the stationery and talk-time, Judy is going to have to adjust her
accounting records so that they accurately reflect what has happened
in her business during the month.

How will Judy adjust her records?
Judy will need to update her records to show that the stationery and
talk-time have been consumed. She will record the adjusting entries
in her general journal. This information will then be posted to her
general ledger.
The stationery and talk-time expenses have increased (which means
that equity will decrease); so Judy has debited the relevant expense
account. She no longer has any stationery on hand or talk-time to use
in the future. The asset accounts have decreased, so Judy credited
the relevant asset account. The information recorded in the general
journal is posted to the general ledger.
Let's look at the general ledger.
After Judy has completed all the adjustments, she will extract a trial
balance from the general ledger. This trial balance is known as the
post-adjustment trial balance.

This trial balance accurately reflects the income earned and
expenses incurred during the period under review. It also accurately
reflects the assets and liabilities of the business at that point in time.
The information in the post-adjustment trial balance is used to
prepare the financial statements as it accurately reflects the assets,
liabilities, income and expenses of the business at that point in time
Something to do 1
Prepare the general journal entry to record the petrol that has been used
during the month.
Check your answer
In the post-adjustment trial balance Judy extracted, the prepaid petrol account will no
longer appear. However, a petrol expense account will appear.
5.2 Closing entries

Once the business has processed all the year-end adjustments, the
income and expense accounts for the period are used to calculate the
profit or loss for the period. To calculate the profit or loss that has
been made, the income and expense accounts are closed off and
transferred to a profit or loss Closing entries are

account.
transactions that allow all income and expense accounts to have the
balance in the account netted off to zero.
The profit or loss account is a temporary account that is used to
calculate the profit or loss for the period. The profit for the period is
calculated as follows: sales less cost of sales plus any other income
less any other expenses.
The profit or loss account calculates a single figure representing
the profit or loss made by the business. The profit or loss amount
calculated in the profit or loss account is transferred to a retained
earnings account. If the owner has withdrawn any cash or inventory
from the business, it is recorded as drawings. The drawings account
is closed off to the retained earnings account as this distribution has
reduced the amount the owner has invested in the business. The
final balance in the retained earnings account represents the
undistributed profit.
Did you know?

The business could use a separate trading account to calculate gross profit. The
trading account is a temporary account that is used to calculate the gross profit.
The gross profit of a business is the difference between what the business sold
inventory for and what it cost the business to buy the inventory that was sold
(sales less cost of sales). The gross profit is closed off to the profit or loss account.
Let's prepare the closing entries for Handbags for Africa as at 31
January X1.
The closing entries are recorded in the general journal and then
posted to the general ledger.
Remember that sales is an income account, which means that it will
have a credit balance in the account before the closing entries are
processed. In the closing entry above, we have debited sales with R6
711. This means that the sales account will have both a debit and a
credit entry of R6 711 and will balance off to a zero balance, and the
profit or loss account will have a credit entry amounting to R6 711
(the sales amount).
Let's post this information to the general ledger.

#These are examples of an adjusting (year-end) entry.
*This is an example of a closing entry.
1
Depreciation is also an adjusting entry. We will look at this in detail
later in the chapter.
Points to notice:
1. Only income and expense accounts are closed off at the end of
the financial period.
2. Closing entries are done only once any adjusting entries have
been processed, for example, transferring stationery on hand to
the stationery expense account if it has been used.
3. Adjusting entries are processed to get the correct balances to
prepare the financial statements.
4. Closing entries are processed to get all the income and expense
account balances netted off to zero.
5. Once the income and expense accounts have been closed off,
they have a zero balance.
6. The profit for the year is calculated in the profit or loss account.
7. The accumulated profit account is updated at the end of the
financial year. The accumulated profit account will increase by
the amount of profit made or will decrease by the amount of
loss the business made. The accumulated profit account will
also decrease by the amount of drawings made by the owner.
The accumulated profit account represents that total profit (or
loss) made by the business since its inception that has not been
distributed to the owner.
8. The asset and liability accounts are not affected by closing
entries.
Using the information on pages 146–148, Judy drew up the
statement of profit or loss and other comprehensive income and

Statement of profit or loss and other comprehensive income for
the period ended 31 January X1
Sales 6 711
Less Cost of sales (2 940)
Gross pro t 3 771
Less Operating expenses (2 606)
Rent expense 1 000
Wages and salaries expense 600
Petrol expense 300
Depreciation expense 66
Remember that all the stationery, petrol and talk-time had been
used, so they appeared as expenses in the profit calculation.
Statement of financial position at 31 January X1

Assets
Furniture and equipment [950 − 16] 934
Cellphone [1 200 − 50] 1 150

Inventory 1 860
Trade receivable [4 230 − 500] 3 730
Bank 4 091
Total assets 11 765

Equity 8 445
Capital 8 000
Accumulated pro t [1 165 − 720] 445
Loan 2 000

Deposit for bags 120
Think about this 1

How would the following information be recorded in the Judy's books? Would it
affect the trial balance, the profit calculation, or the statement of financial
position?
1. What if talk-time amounting to R250 still remained at the end of the
month?
2. What if stationery amounting to R90 was still on hand at the end of the
month?
Check your answers

Let's look at the talk-time first .
Judy's business paid R440 for talk-time. At the end of the month she still has R250
worth of talk-time left. This means that Judy has used only R190 (R440 − R250) worth
of talk-time during the month. The R190 fits the definition of an expense. Remember
that expenses are reported when assets decrease and equity decreases, not due to a
distribution to the owner. The R190 should be recognised as an expense on the profit
or loss statement at the end of January.
What about the R250 left over? Judy still has talk-time of R250 on hand. The R250
meets the definition and recognition criteria of an asset as Judy's business has the
right to use the talk-time, and will appear on the statement of financial position.
Let's look at how to treat the stationery .
Judy paid R200 for stationery. At the end of the month she still has R90 worth of
stationery on hand. The stationery on hand of R90 meets the definition and
recognition criteria of an asset as the stationery is an economic resource. The right (to
use the stationery) has the potential to produce economic benefit. The stationery on
hand of R90 is an asset and will appear on the statement of financial position at the
end of January.
What about the R110 that was used? Judy used R110 (R200 − R90) worth of
stationery during the month. The R110 fits the definition of an expense. Remember
that expenses are reported when an asset decreases that leads to a decrease in equity
– not due to a distribution to the owner (i.e. consume an asset). The R110 should
appear as an expense in the profit calculation on the statement of comprehensive
income at the end of January.
Let's look at how this would have been recorded in Judy's general
journal and general ledger .
The stationery on hand and prepaid talk-time will appear on the
statement of financial position as current assets.
The stationery and talk-time expenses will be closed off to the Profit
or loss account − they will form part of the profit calculation.
Let's look at an extract from Judy's post-adjustment trial balance.
Debit Credit
When Judy initially purchases an item, she must not spend time
worrying about what she should call the accounts in her general
ledger, for example, stationery expense, or stationery on hand. It is
only when Judy prepares the statement of profit or loss and other
comprehensive income and statement of financial position that she
will question whether the item will be recognised as an expense − or
whether it is still on hand and will be recognised as an asset.
Let's look at an example to see that it does not matter whether Judy
initially records the account as an asset or as an expense.
Assume that Judy purchased stationery amounting to R500 on 1
January.
1. Judy initially records the amount in the stationery expense
account.
2. Judy initially records the amount in the stationery on hand
(asset) account.
At the end of January stationery amounting to R220 is on hand.
1. Stationery had initially been recorded in an expense account,
but at the end of the month Judy needs to determine how much
has actually been used. She bought stationery for R500, of which
R220 is still on hand and is an asset. She used R280 worth of
stationery (R500 − R220).
The expense account in the general ledger must be reduced
(credited) by the amount that is still on hand (R220). The
amount on hand represents the stationery asset. The stationery
on hand account is debited with this amount (R220).
2. Stationery had initially been recorded in an asset account, but at
the end of the month, Judy needs to determine how much is
actually still an asset. The R220 still on hand is an asset. The

difference of R280 (R500 − R220) has been used and is an
expense.
The asset account in the general ledger must be reduced
(credited) with the amount that has been used (R280). The
amount used represents the stationery expense; the stationery
expense account is debited with this amount (R280).
1. The amount of stationery used (R280) will be recognised as an
expense in the profit calculation. The amount of stationery left
(R220) will appear as a current asset on the statement of
financial position.
2. The amount of stationery used (R280) will be recognised as an
expense in the profit calculation.
The amount of stationery left (R220) will appear as a current
asset on the statement of financial position.
Regardless of what Judy initially called the stationery − asset or
expense − she will recognise the amount of stationery used (R280) in
the profit calculation on the statement of profit or loss and other

comprehensive income, and the amount of stationery left (R220) on
the statement of financial position.

Let’s look at other adjustments Judy may have to process before
preparing the statement of profit or loss and other comprehensive
income and the statement of financial position.
Go and watch Adjustments: This video explains what adjusting journal entries
are and why they are necessary as part of the financial reporting process.
Judy’s business took a loan of R2 000 from her sister. The business is
is going to have to pay interest to her sister on the money borrowed.
Let’s assume that her sister is charging interest at 10% per annum
(p.a.). At the end of January the business has not, as yet, paid the
interest. This does not mean that the expense has not been incurred.
The business has used the loan for the month and owes the interest,
i.e. an increase in liabilities that results in a decrease in equity, not
due to a distribution to the owner. The interest for the month should
be recognised as an expense.
Calculate the interest expense:
R2 000 × 10% × 1/12 = R16.67
Loan amount × annual interest rate × time period

Judy is calculating the interest for one month. This is why she has
multiplied the interest rate by 1/12. The interest expense per month
is R16.67.
How will the adjustment be recorded in Judy's books?
A liability is recognised (interest is still owed). Liabilities have
increased resulting in a decrease in equity, not due to a distribution.
So an expense is recognised. The business will debit the interest
expense account as equity decreases and credit a liability account,
called accrued interest. The interest expense will be recognised in the
profit calculation and the accrued interest (liability) on the statement
of financial position as a current liability.
The expression accrued means that the benefit has been used but
not paid for. In other words, a liability is recognised.
In preparing the adjusting entry, the bank account is not debited
or credited. This is because, although the expense has been incurred,
it has not been paid.

Let’s assume that the rental per month is R500. Judy paid R1 000 rent
on 28 January. This payment was for January and February’s rent.
When she calculates the profit at the end of January, she will need to
adjust her records so that only January’s rent expense appears in the
profit calculation. Judy has paid the rent for February, the payment
provides the right to use the stall in February without having to pay
any more rent, i.e. the payment is an asset.
Judy must calculate the rent expense for January. She paid R1 000
for two months, so January’s expense is R1 000/2 = R500. Remember
that Judy had debited the rent expense account when she made the
payment.
# A prepaid expense account is used when an amount is paid in advance of
incurring the expense.
Judy has used up only one month of rent. The rent expense account
is credited (she has not used all of the R1 000 and should post only
R500, the amount used, to the profit or loss account as part of the
profit calculation). The Prepaid rent account is debited as R500 is an
asset. Although the Bank account has decreased by R1 000, the rent
expense in the profit calculation amounts to R500. The remaining
R500 (the prepaid rent) will appear on the statement of financial
position as a current asset.

Something to do 2
If Judy had initially debited the R1 000 payment to the Prepaid rent account,
what entry would have been processed to record the adjustment? Clue:
remember that the expense should be the portion that is used up and the rental
that will still provide benefit is an asset.
Check your answer
The adjusting entry would be:
Did you notice that the same amount will be recognised in the profit calculation and as
an asset irrespective of whether the original entry was to an expense or asset account?

Judy’s business invested R1 000 in a fixed deposit. When she made
the fixed deposit, she would have debited the Fixed deposit account
(asset) and credited her Bank account (the bank asset has decreased).
The business will earn interest on the fixed deposit. At the end of
the month interest payment has, as yet, not been received. The bank
was able to use the money for the month, so the bank owes the
interest to Judy’s business. An asset (accrued income) increases
which results in an increase in equity not due to a contribution by
the owner. The business recognises an income (interest income).
Let’s assume that the fixed deposit is earning 8% p.a.

The interest earned amounts to R6.67 per month: R1 000 × 8% ×
1/12.
Interest income is credited because the income has been earned and
must be recognised on the profit calculation. The Accrued income
account is debited. This account is a current asset and will be
reflected on the statement of financial position. The Accrued income
account is used if a business has earned income which has not as yet
been received. This account could also be called a receivable.

Let’s assume that Judy organises students to work at some of the
stalls over the busy holiday period. Judy charges the stallholders
R200 per month for supervising trustworthy students. She arranged
for a student to work for one of her neighbours during January and
February. As the stallholder was taking a vacation, he paid Judy
R400 on 1 January. Judy debited her Bank account and credited an
account called Service fees income. At the end of January she still
owes the stallholder one month of supervision (a liability). The
entire R400 therefore cannot be recognised as income. She will need
to adjust her records to reflect the amount she has earned and to
reflect the service that she still owes the stallholder. The one service
she owes will be reflected as a current liability.

Judy has earned R200 in January (R400/2).
The Service fees account has been credited with R400. This is the
amount that Judy received on 1 January. At the end of January, if
Judy wishes to calculate the profit, she needs to determine whether
she has earned the entire R400. The R400 was a payment for services
to be provided during January and February. The R200 relating to
January should be included in the profit calculation and the
remaining R200 should appear on the statement of financial position
as a liability. Judy owes her neighbour a month’s service. This is
reflected on the statement of financial position as a current liability.
Let's look at an example to see that it does not matter whether Judy
initially records the account as income or as a liability.
Assume that Judy had received R600 for supervising student help to
stallholders during January and February. Assume that she will earn
R400 in January as the stalls are far busier, and R200 in February. She
received the full R600 on 1 January.
1. Judy initially records the amount in the Services fees account
(income).
2. Judy initially records the amount in the Income received in
advance account (liability).
During January R400 worth of income was earned.
1. Income received recorded in an income account (service fees).
At the end of the month Judy needs to determine how much has
actually been EARNED. Although she received R600, she earned
only the R400 for the service provided during January. The R200
she received for the service she will provide in February must
be reflected as a current liability.
The income account in the general ledger must be reduced
(debited) by the unearned amount (R200). The unearned
amount represents the liability. The income received in advance
account must be credited.
2. Income received recorded in a liability account (income received
in advance). At the end of the month Judy needs to determine
how much of the amount is still owed. Although she initially
owed services for January and February, by the end of January
she owes the stallholders services amounting to only R200 and
has EARNED the R400 for January.
The liability account in the general ledger must be reduced
by (debited) the amount that has been earned (R400). The
income account must be credited with the amount that has been
earned (R400).
1. The income (R400) earned will be recognised in the profit
calculation. The service owed (R200) will appear on the
statement of financial position as a liability.
2. The income (R400) earned will be recognised in the profit
calculation.
The service owed (R200) will appear on the statement of
financial position as a liability.
Regardless of how Judy initially treated the income received, as
income or liability, she will take the amount earned (R400) to the
profit calculation and the amount of service owed (R200) to the
Reviewing accruals and prepayments

Cash related to expenses can be paid when the expense is incurred,
after the expense has been incurred, or before the expense is

incurred.
Effect on profit Effect on the

calculation statement of
financial position
Cash paid this year and the Recognise an No new asset or
bene t from the expense used expense this year − liability recognised
this year pro t decreases
Cash paid this year but the No effect on this Recognise a prepaid
bene t from the expense will be years pro t expense (asset)
used next year calculation
Bene t from the expense used Recognise an Recognise an
this year but the cash will be expense this year − accrued expense
paid next year pro t decreases (liability)
Cash related to income can be received when the income is
earned, before the income is earned, or after the income has been
earned.
Effect on profit Effect on the

calculation statement of
financial position
Cash received this year Recognise an No new asset or
and service provided this income this year − liability recognised
year pro t increases
Cash received this year but No effect on this Recognise income

the service will be provided year's pro t received in advance
next year calculation (liability)
Service provided this year Recognise an Recognise an accrued

but the cash will be received income this year − income (asset)
next year pro t increases
Go and watch Cash to Accrual: This video explains how a ledger account
reflects both cash and accrual information.
5.3.5 Depreciation
Businesses use non-current assets in their businesses. If the business
is a tour operator and owns a minibus, the minibus is an asset. This
asset has a limited useful life. What this means is that the business
will use the asset for only a limited time, after which the asset will be
replaced. When Judy bought the assets (cellphone and furniture),
she anticipated using these assets for a while and then replacing
them with new assets. She bought the assets as part of the
infrastructure that she needs to operate her business, but the assets
will not last forever.
Go and watch Depreciation: This video explains the concept of
depreciation.
5.3.5.1 Estimated useful life

The useful life of an asset can either be time-based − based on the
time period that an asset is expected to be used (using the vehicle for
five years) or unit-based − based on the number of units that are
expected to be produced by the asset (500 000 kilometres of driving).
Although Judy is using the assets in her business, it would not be
correct to allocate the full cost of the cellphone and furniture to an

expense account when they are purchased. If the asset is measured
at fair value, the expense is the fair value of the asset consumed. It
would also be incorrect to calculate the profit for the year without
reconising the cost of the part of the asset consumed. The correct
treatment is to recognise the cost of the part of the asset consumed as
an expense each year. This expense is known as depreciation.

Depreciation is calculated separately for each asset, as different
types of assets are used differently. Computers, for example, are
overtaken by new technology very quickly and will be used for a
shorter period than, for example, a machine.
When Judy purchased the cellphone and the furniture, she would
have estimated how long the assets would be used in the business.
This is referred to as the estimated useful life of the asset.
Let’s assume that Judy reliably estimates that the cellphone will
have a useful life of two years and the furniture a useful life of five
years. At the end of the two-year period Judy reliably estimates she
will be able to sell the phone for R300. The value Judy believes the
asset may have at the end of its useful life is known as the residual
value.
5.3.5.2 Residual value

The residual value refers to the amount that the business can sell the
asset for at the end of its useful life. The residual value is used only
for the purpose of the depreciation calculation. It is not recorded
anywhere in the accounting records but helps only to calculate the
portion of the cost (or fair value/current cost – depending on the
measurement basis used) of the asset that is going to be consumed
over the estimated useful life of the asset (referred to as the
depreciable amount).
On 1 January Judy paid R1 200 for the cellphone and R950 for the
furniture we are going to assume that the business has chosen to
measure these assets on the historical cost basis. If Judy had drawn
up a statement of financial position on 1 January, these assets would
have appeared on the statement of financial position as R1 200 and
R950. As Judy uses the assets she will need to allocate the
The
depreciable amount of each asset over the useful life of the asset.
depreciable amount is the cost of the asset less the estimated

residual amount.
Let’s look at the cellphone. Judy paid R1 200 for the cellphone.
She is going to use the phone for two years. At the end of that time it
is estimated that the phone can be sold for R300. This means that
over the two-year period, the cost of using the phone is R900 (R1 200
− R300). So the depreciable amount for the cellphone is R1 200 −
R300 = R900. The depreciable amount of the cellphone must be
written off over the two-year period.
5.3.5.3 Calculating depreciation

We can allocate the cost of the asset over the useful life of the asset
using the straight-line method or the diminishing balance method.

We will look at the diminishing balance method later. The straight-
line method assumes that the business uses the asset evenly over its
useful life. This means that depreciation (the expense) is allocated
evenly over the useful life of the asset.
To calculate the depreciation for the month of January, Judy
divides the depreciable amount (the cost less the residual amount)
by the useful life of the asset (in years) and then multiplies it by
1/12.
How would Judy record this information in her books?

When Judy purchased the cellphone, she would have recorded the
following entry in her books:
At the end of the financial period we recognise the cost of
consuming (using) the asset when calculating the profit and
recognise the assets at historical cost less the amount consumed, i.e.
the carrying value on the statement of financial position. The
carrying value of the asset is the cost − the total depreciation written
off at that point.
Something to do 3
What portion of the historical cost of the cellphone has been used during
January?
Original cost = R1 200
Residual value = R300
Check your answer
We would show only one month of depreciation:

1 200 − 300 = 900/2 × 1/12 = R37.50
Something to do 4
Assume that a business pays R120 000 to purchase the minibus on 1 January
X1. The business intends using the bus for five years, after which it intends to
trade it in for a new one. The business reliably estimates it will be able to trade in
the bus for R20 000 on 31 December X5. Calculate the depreciation per year.
Check your answer
The business will use up R100 000 (R120 000 − R20 000) over the five years. Using
the straight line method the cost of using the minibus per year is R20 000. This is
recognised as an EXPENSE. This expense is referred to as depreciation.
As at 31 January X6, the cellphone asset account has a carrying
amount of R1 200. This amount reflects the amount at which the
asset was purchased (initial recognition at historical cost). Prior to
preparing the financial statements, the accountant would question
whether the amount on the trial balance, i.e. R1 200, should appear
on the statement of financial position with respect to Property, plant
and equipment: cellphone. The asset has been used for one month
and the cost of using the asset should be recognised as an expense.
The amount on the statement of financial position should represent
the unused portion of the asset, in other words, the cost less the cost
of the one month already used.
How does this affect the assets, equity, and liabilities of the
business?
A portion of the asset has been consumed, i.e. one month of the two
years offered by the asset has been used, and the historical cost of
the portion consumed is recognised as an expense. The asset
decreases, resulting in a decrease in equity, not due to a contribution
by the owner, so an expense, depreciation, is recognised.
How is this information recorded in the general journal and general

ledger?
Judy could have credited the cellphone account (decreased the asset)
and debited the depreciation account (increased the expense).
However, it is accepted practice not to decrease the asset account
directly but to credit an account called Accumulated depreciation:
Cellphone. The Accumulated depreciation account records the total
amount of the asset that has been consumed. The difference between
the the asset account (the cost of the asset) and the Accumulated
depreciation account is referred to as the carrying amount of the
asset. This represents the the amount at which the asset is shown on
How would this information be reported in the financial statements?

Depreciation is a business expense and should be recognised on the
statement of profit or loss and other comprehensive income, as part

of the profit or loss section.
The carrying amount of the cellphone, i.e. the cost less the
accumulated depreciation as at the reporting date (R1 200 – R37.50)
should be shown on the statement of financial position.
Something to do 5
Calculate the depreciation expense that would appear on the profit calculation for
the year ended 31 December X1. How would this information be recorded in the
general journal and general ledger? Show how the information appears on the
statement of profit or loss and other comprehensive income and statement of
financial position at the end of the year.
Check your answer
R1 200 − R300 = R900/2 = R450 [cost − residual value/estimated useful life]

(1 200 – 450 = 750)
It is important to note that the residual value is not recorded in the accounting records.
The residual value is used only in determining the amount of depreciation to be
recognised each year.
Something to do 6
What would Judy's books look like at the end of the second year? Calculate the
depreciation expense. How would this information be recorded in the general
journal and general ledger? Show how the information would be disclosed on the
statement of profit or loss and other comprehensive income and statement of
financial position at the end of the year.
Check your answers
R1 200 − R300 = R900/2 = R450

The depreciation amount recognised (straight line method) is the same for both year 1
and year 2 as the asset is used evenly over the two years.
The depreciation expense on the statement of profit or loss and other
comprehensive income in the second year is exactly the same amount
as in the first year.
Extract from the statement of financial position as at 31
December X1
Assets
Non Current Assets
Cellphone 300
The accumulated depreciation account has increased from R450 to

R900. This is because the asset has been used for two years. The
carrying value at the end of the two year period, which is the end of the
asset's estimated useful life, is the residual value (R300).
Think about this 2

Why do you think the cost and accumulated depreciation amounts are shown
separately rather that setting them off against each other?
Check your answer
If the amounts are shown separately, users of the financial statements can determine
the future case flows required to replace the assets and when these are likely to occur.
If an asset is due for replacement soon, the carrying value (cost less accumulated
depreciation) will be small, indicating that the asset is nearing the end of its useful life.
5.3.6 Bad debts

Judy’s business sells some of the bags on credit (which means she
does not get paid immediately). Before extending credit to her
clients, she should check their creditworthiness to ensure that she
sells on credit only to people who are likely to pay their debt when it
falls due.
When would Judy recognise the income from the credit sale?
When a credit sale is made, the buyer generally takes possession of
the goods and control of the goods are transferred to the buyer.
Judy’s business will derecognise the asset as the right to use or sell
the inventory has been transferred to the buyer. Income can be
recognised when the sale takes place. An asset (trade receivables)
has increased, resulting in an increase in equity, not due to a
contribution from the owner. An asset (debtor) will be recognised on
the statement of financial position and sales income is recognised on
the statement of profit or loss and other comprehensive income.
Income is recognised even though the cash has not, as yet, been
received (accrual concept).
When the payment date arrives, some customers may be unable
to pay the debt. Judy could try to renegotiate payment terms to
ensure that payment is eventually made. In time she may hand the
debt over to debt collectors or start legal proceedings against the
non-paying debtor.
In some cases Judy may realise that there is no chance of receiving
payment from the client or it may cost more to collect the debt than
the debt is actually worth. At this point Judy may decide to write the
debtor off as a bad debt. The bad debt is an expense to the business
and will be recognised on the statement of profit or loss and other
comprehensive income. When a debtor if written off, assets decrease
which results in a decrease in equity, not due to a distribution to the
owner, in other words an expense is recognised. When Judy decides

that she will not be paid, the debt is said to be irrecoverable (it is not
possible to recover the money from the debtor).
5.3.6.1 Recording bad debts

Let’s assume that a debtor, A. Jones, who owes Judy R700, is
untraceable, and Judy has decided to write the debt off as
irrecoverable.
In the example above, Judy decided to write off a specific debtor, A.
Jones, who was untraceable. This is recognised as a bad debt

expense. The Bad debt expense account was debited (a decrease in
equity) and the trade receivable account was credited (a decrease in
assets).

With credit sales, there is a delay between the time of sale and the
date cash is expected to be received. Customers may purchase goods
during the X1 financial year and payment is only expected during
the X2 financial year, or a debt may become irrecoverable only
during the X2 financial year.

In practice, no business is likely to sell you inventory on credit
unless they have assessed your creditworthiness, and have decided
you are able to pay. However, most businesses still have some
customers who seemed creditworthy but are written off as
irrecoverable. The business is, of course, unable to identify who
those customers are when credit is initially given.
Businesses do not want to make their credit policy too strict, as
they could lose a number of good customers. Businesses expect that
in time a certain percentage of their trade receivables will be written
off as irrecoverable, as this is an unavoidable business risk.
Management will however manage their debtors to minimise this
amount.
Some customers who have purchased on credit during one year
will become irrecoverable only in the following year. Through
experience, the business can estimate the percentage of the total
trade receivable balance still outstanding (customers still owing) at
the end of the year that is likely to become irrecoverable during the
following financial period.
The trade receivable balance is an asset, i.e. an economic resource
which is a right that has the potential to produce economic benefit:
the cash received when the trade receivables pay.
If some of the trade receivables are not expected to pay, it would
not be a faithful representation to show 100% of the trade receivables
as an asset when the business’s own experience shows that a certain
percentage of the year-end debtors’ balance does not pay. The
portion of debtors who are unlikely to pay in the following year do
not meet the recognition criteria of the asset (i.e. the financial
statements would not be a faithful representation of the actual
business). The amount that Judy does not expect to receive should
no longer be recognised as an asset (assets, decreased). This amount

will be recognised as an expense (a decrease in equity not due to a
distribution to the owner).
Remember that the statement of profit or loss and other
comprehensive income and statement of financial position should
faithfully represent the income, expenses, assets and liabilities of the
business. If experience shows that a certain percentage of the trade
receivable balance will not be collected (not received in cash), the
trade receivable balance shown on the statement of financial position
needs to be adjusted (reduced) to reflect this.
Another way of looking at doubtful debts is that, although the
trade receivable amount becomes irrecoverable in the following
year, the income from sales has been generated this year and is
reflected on the current year’s profit calculation. According to the
accrual concept, the business recognises income in the period in
which it has earned the income. The expense should be recognised in
the same period as the income it generated. This means that the
percentage of the trade receivable balance that it is estimated will
become irrecoverable during the following year should be reflected
as an expense in the year in which the income was generated, in
other words, in the year the sale was made and reflected in the profit
calculation.
5.3.7.1 Recording doubtful debts

Let’s assume that through experience Judy has realised that 2% of
her closing trade receivable balance will be irrecoverable. On 31
December X1 she has the following information in her books: trade
receivable R15 000, credit sales R100 000.
This means that Judy does not expect to receive R300 (R15 000 ×
2/100) of the outstanding trade receivable balance. At the end of the

year, however, she does not know which of her customers will not
pay their debts when they fall due.
The Bad debts expense decreases equity (debited), and we have
created an account called Allowance for Doubtful debts. The
Allowance for doubtful debts account decreases the Trade receivable
amount shown on the statement of financial position. The Trade
receivable amount on the statement of financial position will
therefore be a more accurate reflection of what the business actually
expects to receive from the trade receivables.
Points to notice:
The Allowance for doubtful debts account is an asset account. This
account does not appear on the face of the statement of financial
position but reduces the amount of trade receivables that is shown
on the statement of financial position.
Judy will not credit (reduce) her Trade receivable account at this
point as the debts have not, as yet, become irrecoverable. The Bad
debt expenses (recognised in the profit calculation) could include
individual debtors who have been declared irrecoverable and a
percentage of trade receivables who purchased during the current

year and are expected to become irrecoverable during the following
financial period.
The Trade receivable account is credited when the specific
customer is known, whereas the Allowance for Doubtful debts
account is credited when it is expected that some customers will not
pay, but the specific customers have not been identified. The bad
debts expense account is debited in both cases.
What adjustment would be processed at the end of the second year?

Let’s assume that Judy has outstanding trade receivable amounting
to R18 000 as at 31 December X2.
Two per cent of the current Trade receivable balance amounts to
R360 (R18 000 × 2%). At 31 December X2, Judy expects that R360 of
the trade receivables outstanding on 31 December will not pay their
debt. The trade receivable amount that should appear on the
statement of financial position amounts to R17 640 [18 000 − 360].
At the end of the X2 financial year, Judy will increase the
allowance to R360. She already has an allowance for doubtful debts
amounting to R300 (this is the allowance that was created at the end
of the previous financial year). This means that she will increase the
existing doubtful debts allowance by R60 (R360 − R300).
Note that the final balance in the Allowance for doubtful debts
account as at 31 December X2 should amount to 2% of the trade
receivables balance as at 31 December X2.

How would this be recorded in Judy's books?
Bad debts of R60 will be closed off to the Profit or loss account.
Something to do 7
How would Judy record the adjustment to Allowance for doubtful debts if the
closing Trade receivable balance as at 31 December X2 amounted to R12 000,
and it was still expected that 2% of the customers would not pay?
Check your answer
As at 31 December X2, Judy would require a balance on the Allowance for doubtful
debts account amounting to R240 (12 000 × 2%). She already has an allowance of
R300 recorded in her books. The Allowance for doubtful debts account needs to be
reduced by R60 (R300 − R240).
How would this be recorded in Judy's books?
The trade receivables will appear on the statement of financial position as R17 760
[18 000 − 240].
5.4 Let's pull it all together

At the end of January the pre-adjustment trial balance of Handbags
for Africa looked like this:
Pre-adjustment trial balance as at 31 January X1

Capital 8 000
Drawings 720
Loan 2 000
Bank 4 091
Inventory 1 860
Prepaid petrol 300
Rent expense 1 000
Sales 6 711
Cost of sales 2 940
Wages expense 600
18 031 18 031
You are given the following additional information relating to
Handbags for Africa at 31 January X1:
1. Stationery on hand amounted to R75.
2. Unused talk-time amounted to R120.
3. All the petrol had been used.
4. Rental amounts to R1 000 per month.
5. The cellphone is expected to be used for 2 years, after which it
could be sold for R300.
6. Furniture is expected to last for 5 years, after which it could be
sold for R150.
7. Interest on the loan has been negotiated at 15% per annum.
8. Judy has decided to write off a debtor, J. Smith, as irrecoverable.
He owed R450.
9. After writing J. Smith off as a bad debt expense, Judy has
reliably estimated that 1% of the remaining trade receivable
balance as at 31 January should be recognised as a doubtful
debt.
Something to do 8
1. Process the adjusting journal entries to record the information above.
2. Post the adjusting entries to the general ledger.
3. Extract a post-adjustment trial balance.
4. Process the closing entries in the general journal.
5. Post the closing entries to the general ledger.
6. Extract a post-closing trial balance.
7. Prepare a statement of comprehensive income and a statement of
financial position.
Check your answers
1. Adjusting journal entries

2. Posting adjusting entries to the general ledger
3. Post-adjustment trial balance
Post-adjustment trial balance as at 31 January X1

Capital 8 000
Drawings 720
Loan 2 000
Accumulated depreciation: Cellphone 37.50
Accumulated depreciation: Furniture 13
Allowance for doubtful debts 32.80
Bank 4 091
Inventory 1 860
Stationery on hand (Prepaid stationery) 75
Accrued expense 25
Cost of sales 2 940
Sales 6 711
Wages expense 600
Rent expense 1 000
Petrol expense 300
Interest expense 25
Depreciation expense 50.50
Bad debts expense 482.80
18 139.30 18 139.30
What do we notice?
The assets, liabilities, income and expenses on the post-adjustment
trial balance represent the correct information that will be used to
prepare the financial statements.
4. Closing entries in the general journal

5. Posting closing entries to the general ledger
6. Post-closing trial balance
Post-closing trial balance as at 31 January X1

Capital 8 000
Retained earnings 147.70
Loan 2 000
Accumulated depreciation: Cellphone 37.50
Accumulated depreciation: Furniture 13
Trade receivable 3 280
Allowance for Doubtful debts 32.80
Trade payable 1 200
Bank 4 091
Inventory 1 860
Stationery on hand (Prepaid stationery) 75
Accrued expense 25
11 576 11 576
What do we notice?
• It is important to remember that the transactions posted from the
journals, the adjusting entries and the closing entries will be
posted to the same general ledger.
• The post-closing trial balance does not have any income or
expense accounts, as these accounts have been closed off to a zero
balance and transferred to the Profit or loss account. The profit or
loss for the year has been transferred to the Retained earnings
account.
7. Statement of profit or loss and other comprehensive income and
statement of financial position
Sales 6 711
Less cost of sales (2 940)
Gross pro t 3 771
Less operating expenses (2 903.30)
Wages expense 600
Rent expense 1 000
Petrol expense 300
Interest expense 25
Depreciation expense 50.50
Bad debts expense 482.80
Profit for the period 867.70

Assets
Non-current assets
Furniture and equipment 2 937
Cellphone 2 1 162.50
Current assets
Inventory 1 860
3 3 247.20
Trade receivables
Bank 4 091
Total assets 11 492.70
Equity
Capital 8 000
Retained earnings 1 147.70
Loan from sister 2 000
Current liabilities
Accrued interest expense 25
Total equity and liabilities 11 492.70
Notes:
1. Retained earnings
Profit for the period 867.70
Less drawings (720.00)
147.70
2. Non-current assets
3. Trade receivables
Trade receivables 3 280.00
Less Doubtful debts (32.80)
3 247.20

Adjusting journal entries are prepared at the end of the financial
year so that the profit calculation includes the actual income earned
and expenses incurred during the year. Preparing the adjusting
journal entries also ensures that the correct assets and liabilities are
recognised on the statement of financial position at the correct
amount. If the bookkeeper records cash received and cash paid for
income and expenses in an income or expense account, then
preparing adjusting journal entries can lead to the creation of new
asset and liability accounts such as accrued expenses (liability),
prepaid expenses, accrued income (asset), and unearned income
(liability). These accounts will still appear in the general ledger at the
start of the following period.

If the business used an expense account to record expenses during
the year, an adjusting entry will be processed at year end if either too
much or too little has been paid. If too much has been paid the
business will recognise an asset and decrease the expense account.

Adjusting entry
If too little has been paid, the business will recognise a liability and
increase the expense account, i.e. decrease equity.
At the beginning of the following year the business will have an
asset (prepaid expense) or a liability (accrued expense).
Let’s assume that these accounts referred to electricity.
The prepaid expense means that the business will use electricity
this year that had been paid for last year.
The accrued expense means that the business used electricity last
year that will be paid for this year.
Remember that the business uses an expense account when
electricity is paid.
If the electricity account, as is, is closed off to Profit or loss, only 11
months’ electricity will be recognised as an expense. The Prepaid
Electricity expense amount needs to be transferred to the Electricity

account so that the full 12 months used this year can be recognised
as an expense for this financial year.
Something to do 9
Assume that Judy treats stationery and talk-time as an expense (debits the
stationery expense and talk-time expense account) when she initially pays.
1. What reversing entries would Judy process on 1 February X1?
2. What journal entries would Judy process during February X1 to record the
purchase of stationery amounting to R500 and talk-time amounting to
R350?
3. If Judy had no stationery or talk-time left as at 28 February X1, would it be
correct to recognise a stationery expense of R500 and a talk-time expense
of R350 for February, assuming that these were the only purchases during
the month?
4. Prepare the following ledger accounts for February X1: Stationery on hand;
prepaid talk-time; stationery expense; talk-time expense.
Check your answers

3. No! The business already had stationery on hand of R75 and prepaid talk-time of
R120 as at 1 January X2. The business would have used up this stationery/talk-
time as well as the additional stationery and talk-time that was purchased during
February X1.
The business processes a reversing entry. This will transfer the stationery on
hand and prepaid talk-time into the Stationery expense and Talk-time expense
accounts.
Preparing the reversing entries allows us to recognise the correct expense for
stationery, R575, and talk-time, R470, as at 28 February X1 (assuming that we
were preparing financial statements at this date).

Judy’s business has a year-end of 31 December. Let’s assume that
Judy receives her electricity bill for December during the following
January. By the end of the year she has made eleven payments for
electricity.
On 31 December X1 she estimates the electricity expense for
December amounted to R500 and processes her adjusting entries.
This information is then posted to her general ledger.
The R5 900 electricity expense will appear on the statement of profit
and loss and other comprehensive income, and the R500 accrued
electricity will appear on the statement of financial position as a
liability.
During January X2 Judy pays R500 for electricity, and records the
following entry.
This information is posted to her general ledger, where it will appear
as if she has incurred an electricity expense of R500 during the X2
financial period, when in fact the payment is for an electricity
expense incurred last year.
At the beginning of January X2 the adjustments processed on 31
December X1 should be reversed.
Let’s look at the journal entry for the reversal and understand
why it would solve Judy’s problem.
At the beginning of January, Judy would have posted the reversal to
her general ledger. The Electricity expense account would have a
credit entry of to R500 and Judy would no longer have an Accrued
electricity account in her ledger as, once she has paid the electricity,
she no longer has this liability. When the R500 was paid in January
(for December’s electricity) and the Electricity account was debited,

it would cancel the credit entry, and the Electricity account would
start the X2 year with a zero balance.
Judy has two choices in handling this accrual. She could reverse the
accrual and credit the expense account, as indicated above − which
is netted off to zero when the actual payment is debited. The other
approach is to remember that, when the payment is made in X2, the
debit should go to Accrued expense (liability) instead of Electricity
expense. The second approach may sound easier, but it means that
someone has to think about every payment made in January and
decide if it should go to the liability (Accrued expense) if it was for
the previous year, or to the expense account if it is for the current
year. Reversing all the accruals means that this decision does not
have to be made.
Think about this 3

What do you think would happen if Judy thought the electricity expense for
December X1 would be R500 and it turned out to be R490?
Check your answer
If the accounts had been finished, it would not be worth redoing them for a difference
of R10, as it is not material (refer to Chapter 4 if you have forgotten what that means).
The difference would be picked up in the following financial year (X2). The credit entry
would be for R500, the debit entry (the actual payment) would be for R490. The effect
would be that electricity in X2 would be reduced by R10.

accrued interest
Something to do 10
1. What reversing journal entries would Judy prepare on 1 February X1?

2. During February X1, Judy provides her client with the handbags and pays the
interest expense of R25 on 10 February X1. If Judy prepared financial
statements as at 28 February X1, would she include R120 as income and
the R25 as an expense?
3. Prepare the following ledger accounts for February X1: income received in
advance; sales; accrued interest expense; interest expense.
Check your answers
1.
2. Judy should recognise the R120 as income. A liability (income earned in advance)
is decreasing, resulting in an increase in equity not due to a contribution by the
owner. She should not recognise the R25 as interest expense for February. The
R25 paid will settle the outstanding amount (R25 owed for last month) so there is
no change in equity, i.e. no expense is recognised.
3.

• Income and expenses are recognised in the financial period in
which the asset/liability changes that results in a change in equity
not due to a contribution by or distribution to the owner. This is
not necessarily in the financial period in which it is received.
• At the end of the financial period, the business may need to
process adjusting entries to correctly state the income, expenses,
assets and liabilities. Adjusting entries include prepaid or accrued

expenses, unearned or accrued income, depreciation, and bad or
doubtful debts.
• At the end of the financial period all income and expense
accounts are closed off to the Profit or loss account.
• The Profit or loss account is closed off to reained earnings and any
drawings during the year is also closed off to the retained
earnings account.
What's next?
In the next chapter we are going to look at inventory. We will
understand when inventory is recognised as an asset, what is
included in the cost of inventory, the different methods for recording
inventory, namely the periodic and perpetual systems, and
understand how to measure closing inventory at the end of the
financial year.
QUESTIONS
QUESTION 5.1 (B)

Clean and Green is a solar power company specialising in individual

solar panels for residential use. You have been provided with an
extract from the pre-adjustment trial balance of Clean and Green for
the year ended 29 February 20X12.
Land 1 500 000

Equipment ?
Accumulated depreciation: Equipment (01/03/20X1) ?
Revaluation surplus 200 000
Rent expense ?
Telephone expense 86 025
The following additional information has been provided:

1. All reversals were posted on 1 March 20X11.
2. Clean and Green has rented property in Melville since 1 May

20X8. The rental agreement states that the rent is payable
monthly in arrears on the first day of the following month. All
rental payments during the year ended 29 February 20X12 have
been correctly made. The agreement indicates that rental
increases annually by 7% on 1 May each year. The rental for

April 20X11 amounted to R4 800. All rental payments are
debited to rent expense account.
3. Land is measured on the revaluation model and equipment is
measured on the cost model. Land is revalued every two years
and was last revalued on 28 February 20X10.
4. Clean and Green has two machines that are used in the
production of the solar panels. Machine A was purchased on 1
April 20X9 for R1 750 000 and has a residual value of R50 000.
Machine B was purchased on 1 October 20X11 for R2 000 000
and has a residual value of R150 000. Machine A will be used
evenly for five years and Machine B will be used to produce 500
000 solar panels. Machine B produced 50 000 solar panels
during the year ended 29 February 20X12.
5. On 29 February 20X12, after a factory inspection, Clean and

Green noticed that Machine A did not appear to be functioning
correctly. On 29 February 20X12, an independent valuation
expert confirmed that the machine could be used to generate
R700 000 in future benefits and could be sold for R750 000 if a
full overhaul costing R55 000 was performed.
6. The fair value of the land on 29 February 20X12 amounted to R1
250 000.
7. Clean and Green had prepaid telephone vouchers of R14 060 on

hand as at 28 February 20X11 and prepaid telephone vouchers
amounting to R3 200 on hand as at 29 February 20X12. All
telephone payments are debited to the telephone expense
account.
1. Prepare the rent expense account as it would appear in the
general ledger of Clean and Green for the year ended 29
February 20X12. Close/balance off as required. (6 marks)
2. Prepare the adjusting journal entry/ies required on 29 February

20X12 to record additional information 4. Ignore dates and
narrations. (4 marks)
3. Prepare the adjusting and closing journal entry/ies required on

29 February 20X12 to record additional information 5 and 6.
Ignore dates and narrations. (10 marks)
4. Refer to additional information 7:
a) Prepare the adjusting journal entry required on 29 February

20X12 to process the information in point 7. Ignore dates
and narrations. (2 marks)
b) Calculate the total amount of cash paid with respect to

telephone expense during the year ended 29 February
20X12. (1 mark)
c) Calculate the telephone expense that will appear in the

statement of comprehensive income of Clean and Green for
the year ended 29 February 20X12. (1 mark)
QUESTION 5.2 (B)

For transactions 1−3 below indicate, in table form (see example
below), the impact on assets and liabilities on the statement of
financial position as at 31 December 20X17 and the impact on profit

for the year ended 31 December 20X17.
Indicate whether assets, liabilities and/or profit would be
overstated, understated or no effect”.

“ Where relevant, provide
amounts and if profit is affected, provide a short explanation as to
why it is affected.
Assume that all adjustments were correctly processed at 31
December 20X16 i.e. the end of the previous financial year.
Show all workings.
Example:
The telephone bill for December 20X17, amounting to R200 had not,
as yet been paid. No adjusting journal entry was processed.
1. On 31 December 20X17, the stationery expense account has a
balance of R7 000. A stationery count on the same day revealed
stationery on hand amounted to R2 430. The bookkeeper
records all stationery payments as stationery expense. No year-

end adjustment was processed.
2. On 1 October 20X16, the business launched a magazine called
“Going Green”. The business only sells annual subscriptions to
the magazine, with the fee of R420 payable in full in advance.
An annual subscription entitles the subscriber to 12 issues of the
magazine: one every month. The first issue was released in
November 20X0. Cash was received for 40 annual subscriptions
starting on 1 November 20X0 and 75 annual subscriptions
starting on 1 May 20X1. All cash receipts for magazine
subscriptions are credited to the magazine subscription income
account.Reversal entries were processed but no year-end

adjustment was processed.
3. Salaries are usually paid on the last day of each month. On 31
December 20X0 (the end of the previous financial year), a new
employee had not yet sent his bank account details to the
human resources manager. As a result his December 20X0
salary payment of R6 000 did not take place until 10 January
20X1. The bookkeeper records all salary payments as salaries
expense. No reversal entry was processed during the year.
QUESTIONS 5.3 (A)

Part A (2 marks)
An amount of R80 000 was invested in a fixed deposit on 1 April X1
earning interest at 12% per year. The amount of interest received in
cash by 31 March X2 was R8 800.
Show how this information will be reported in the statement of
financial position at 31 March X2. (2 marks)
Part B (18 marks)
An amount of R5 000 was received from a client on 1 February X2 for
consulting services. These services were to be delivered in terms of a
contract agreed with the client from the period 1 January to 30 April
X2.
1. Prepare the adjusting journal entries required at 31 March X2,
assuming that:
a) An account called Unearned service income (a liability) was
credited with the R5 000 received. (3 marks)
General journal
Debit Credit
b) An account called Service income (an income account) was
credited with the R5 000 received. (3 marks)
General journal
Debit Credit
2. Prepare the adjusting journal entries required to prepare
financial statements at 31 March X2 for the following events,
assuming that the amounts paid were initially recorded as an

expense:
a) Purchased R30 000 worth of cleaning equipment on 15
November X1. Cleaning equipment worth R12 000 was still
unused at 31 March X2. (3 marks)
b) Monthly rental for the use of the premises amounts to R1
200. The amount in the Rent expense account in the general
ledger at 31 March was R15 600. (3 marks)

3. Prepare the adjusting journal entries required to prepare
financial statements at 31 March X2 for the following events,
assuming that the amounts paid were initially recorded as an

asset:
a) Purchased R30 000 worth of cleaning equipment on 15
November X1. Cleaning equipment worth R12 000 was still
unused at 31 March X2. (3 marks)
b) Monthly rental for the use of the premises amounts to R1
200. The amount in the Rent asset account in the General
ledger at 31 March was R15 600. (3 marks)

6 Inventory
Judy's business was doing well, and the stall at the Waterfront
attracted a large number of customers. However, she was a little
concerned about how much cash she seemed to spend on buying
inventory. “Most of the money I spend is used for buying bags,
purses, my cellphone, and my trestle tables. If I expand, I am going
to need more of all of these. I am also not sure when to buy new
purses or whether I am charging enough when I sell them,” Judy
said to Thabo.
“Are cellphone and trestle tables inventory?” wondered Thabo.
Learning objectives
• Know what is meant by the term “inventory”
• Know when to recognise inventory
• Know at what cost to recognise inventory initially
• Know the difference between trade discount and settlement discount
• Record trade discount and settlement discount in the general ledger
• Understand how to record inventory: the perpetual recording method and the
periodic recording method
• Record transactions using both the perpetual recording method and the periodic
recording method
• Understand how value added tax (VAT) affects the recording of inventory
• Understand how inventory is disclosed in the financial statements
• Understand how to measure inventory by calculating the cost of goods sold and
inventory on hand using the First-in-First-out (FIFO) and weighted average cost
allocation methods
• Know when to de-recognise inventory and how to record these transactions
• Calculate the gross profit and gross profit percentage
• Calculate mark-up on selling price and mark-up on cost price
• Understand the relationship between mark-up on selling price and gross profit
percentage.

Tracey sold African clothing from the stall next door to Judy. One
morning Judy overheard Tracey discussing inventory with her bank
manager.
“To give you a loan for your business we will need a list of the
assets of the business,” said the bank manager. Tracey asked the
manager, “Is the unsold clothing in the stall an asset?”
The bank manager immediately answered, “Of course. The unsold
clothing in your stall is inventory, and this is an asset to your
business.”
Judy wondered what inventory was, and why inventory is an asset.
6.1.1 Definition of inventory
Inventory is an asset which a business buys to:
• Resell during the normal everyday activity of the business, or
• Use in the production of assets (performing a service) that are
sold during the normal activity of the business, or provide a
service provided in the normal activities of the business.
The following are examples of inventory:
• Goods acquired for re-sale
• Manufactured goods:
− Finished
− Work-in-process
• Raw materials used for manufacturing goods
• Consumables used for manufacturing goods
• Consumables used for providing services.
Let's help Judy understand why inventory is an asset.

To answer this, go back to the asset definition and recognition
criteria.
6.1.2.1 Asset definition

Inventory is a present economic resource controlled by Judy’s
business due to a past event. Judy’s business has the right to sell the
inventory and receive payment from the customers (the potential to
receive economic benefit). The unsold inventory meets the definition
of an asset.
6.1.2.2 Recognition criteria
Before we recognise an item as an asset or liability, the item also has
to satisfy the recognition criteria.
Do you recall the recognition criteria mentioned in Chapter 4?
An item should be recognised if such recognition provides the
users with relevant information that is a faithful representation of
the business.
The inventory exists and can produce benefits. This information is
relevant to the users and to show it will be a faithful representation
of the assets of the business.
We can see that the unsold leather goods meet the recognition
criteria of an asset and can be recognised as an asset. Now that the
goods have satisfied the criteria necessary for recognition as an asset,
the next question is whether it is appropriate to recognise them in
the “inventory” category of assets.
6.1.2.3 Resale in the normal course of business
Tracey was checking her list of assets before she sent it to the bank
manager when Judy walked in. Tracey said, “Judy, I am glad you are
here because you can check whether I have left any assets off the
list.”
Judy quickly looked at the list and asked, “Why is the inventory
asset reflected at only
R10 000? Your business owns a computer, some furniture and a
delivery vehicle. These items are all assets and should be included in
the total amount of inventory.”
Tracey replied, “I think you are confused about what inventory is.”
Judy exclaimed, “No, Tracey, I am very sure about my facts. Inventory
is an asset, and because the computer, furniture and vehicles are
assets, surely these items are also called inventory?”
Let's help Judy understand why the computer, furniture and delivery
vehicles are not included in inventory.
Judy was right when she said inventory is an asset, but what she has
forgotten is that not all assets are inventory. What makes an asset
inventory?
Let’s go back to the definition of inventory. Inventory is an asset
bought for a specific purpose − reselling it in the normal course of
business activities.
Judy’s normal everyday business is to buy leather bags, suitcases
and briefcases and sell these items to the public. The leather goods
are assets bought by Judy for the purpose of resale as part of her
normal business activities. Therefore, they are called inventory.
Consider the following example that clearly shows the difference.
Something to do 1
Judy purchased a motor vehicle to help with business deliveries. During the
same month, she purchased 100 leather bags to sell from the stall.
Do you think both these purchases are inventory? Explain your answer.
Check your answer
Whether an asset is inventory depends on what the business plans to do with it

(intention) and what the normal business activity is. Normal business activity is what
happens on a day-to-day basis to make a profit for the business. The bags are
therefore recognised as inventory.
Think about this 1

Do you think that motor vehicle purchases can ever be inventory?
Check your answer
Motor vehicles would be inventory if they were purchased by a business that trades in
motor vehicles. If the normal daily operation was the sale of motor vehicles (for
example, for a motor dealer), then the purchase would be treated as inventory.
Did you know?

Inventory is sometimes called stock − you may have seen signs in shop windows
saying “stocktaking sale”. Stocktaking takes place when a business counts the
stock (inventory) in the shop. Companies often have sales just before stocktaking
to reduce the amount of inventory that they have to count. Stock is the old-
fashioned term for inventory. The term “inventory” is used by IFRS and GAAP. One
of the reasons for the change is that in some countries (for example, the US), the
term “stock” also applies to certain types of investments (shares), so it could
become confusing.

Inventory is recognised as an asset when it meets the asset definition
and recognition criteria. Let’s help Judy understand whether the
bags given to her friend and loaded on the ship should be
recognised as an asset on the financial statements on 31 July X1.
The asset definition states that the business must control the
present right to produce benefits.
When we decide who has control of an asset we don’t necessarily
look at legal ownership. We look at who controls the asset (i.e. has
the present ability to direct the use of the economic resources).
We control an asset when we have the present ability to direct the
use of the economic resource. Judy’s business has the right to sell the
inventory.
Judy was working at the stall one morning when her accountant
phoned and asked, “Judy, I am preparing a list of business assets
you control on 31 July. What value should I include for the inventory
your business has today?”
“Well, that's easy! The cost of the unsold leather goods in the stall
today is R20 000,” replied Judy. The accountant asked, “Judy, are
you sure that R20 000 is all the inventory the business controls?
Your inventory is not only inventory you have in your stall. What other
inventory do you know of that is not in your stall today?”
After thinking for a few moments Judy replied, “I have ordered 15
bags at R200 per bag from Italy, and the supplier insisted that the
purchase contract include the term “FOB shipping point”. Firstly, I
don't know what “FOB” means. Secondly, the bags were loaded onto
the ship in Italy on 1 July X1. The shipment is on its way, but hasn't
reached Cape Town harbour yet. I think I am right not to think of the
15 bags as inventory because they are not kept in the stall! I have
also given 10 leather bags costing R200 each to a friend in KwaZulu
Natal to sell on consignment at R350 per bag.”
6.1.3.1 FOB shipping point and destination
What about the 15 Italian leather bags?

Who has control of the bags (i.e. the present right to direct how the
inventory is sold) on 31 July X1?
The terms of the purchase agreement was FOB (free on board)

shipping point. This means that control over the bags is transferred
from the moment the inventory is loaded.

FOB destination is another term that can be used in a purchase
agreement. This means that control only transfers when the
inventory arrives at its destination, in this case, Cape Town harbour.
6.1.3.2 Consignment stock

What about the 10 bags Judy sent to her friend in KwaZulu-Natal?
Let’s think about who has control over these bags on 31 July X1.
Judy’s business gave the bags to her friend Vanessa to sell for her
in KwaZulu-Natal. Vanessa is an agent for Judy. Vanessa sends Judy
any payment she receives when she sells a bag.
Judy agreed she would pay Vanessa a 10% commission for
helping to sell her bags in KwaZulu-Natal. When Vanessa makes a

sale, she deducts the commission Judy owes her and sends Judy the
balance of the cash.
The 10 bags kept by Vanessa areconsignment stock.

called
Consignment stock is inventory that a business sends to an agent to

sell on its behalf.
The business retains control over the inventory, as the agent is
only helping the business to sell the stock, a service for which the
agent will receive a commission − a percentage of the selling price.
Judy’s business still has control over the 10 bags. If the 10 bags are
not sold, Vanessa will return the bags, and the bags still belong to
Judy’s business.
Judy’s business also has the right to direct how the bags are sold.
If Vanessa sells the bags, she gives Judy’s business the payment
received from customers, less the commission owing to her
(Vanessa). In other words, Vanessa can only sell the bags on behalf
of Judy’s business.
Judy’s business has control over the 10 bags even though they are
not kept in her store. Therefore, consignment stock is included in
Judy’s inventory. When Vanessa sells the bags, Judy’s business will
have to adjust her inventory records to show the decrease in
inventory.
Despite the fact that the bags are in Vanessa’s shop, it would be
incorrect to include them as inventory in Vanessa’s records, as she
does not have the right to sell the bags on her own behalf, i.e. control
over the inventory has not been transferred.
Something to do 2
Judy sent the 10 leather bags to Vanessa on 1 July X1. Vanessa sold all the bags
(at R350 per bag) on 31 July X1 and sent Judy the cash on the same day. These
bags had a cost of R200 each.
Prepare the general journal entries (if any) to record the shipment of the
inventory on 1 July X1 and the cash received from Vanessa on 31 July X1.
Check your answers
1. 1 July X1
On 1 July X1 we do not record any entry in the general ledger, because Judy still
has control over the bags. The 10 bags remain part of inventory.
2. 31 July X1
We record the sale at the full selling price and then record an expense for the
commission paid to the agent.
Judy also has to decrease the inventory asset by the cost price (R200) of the units
sold when Vanessa sells any of the bags.
Something to do 3
Judy sent the 10 leather bags to Vanessa on 1 July X1. Vanessa sold all the bags
on 31 July X1, but by agreement, sent Judy the cash only on 30 November X1.
The cost per bag amounted to R200.
What journal entries do you think should be processed to the general ledger to
record the above information?
Check your answers
1. 1 July X1
On 1 July X1 we do not record an entry in the general ledger, because Judy still
has control, so the 10 bags remain an inventory asset.
2. 31 July X1
Judy recognises a sale on 31 July X1 because, using the accrual concept, she
earned the income when she provided the customer with the goods.
Judy also has to record the commission expense on 31 July X1, because
Vanessa provided the service on the day she sold the bags. We recognise the
expenses when we receive the service and not when we pay the supplier of the
service the cash. The commission expense is recognised at the same time as the
sale income from the sale of the goods, thereby matching this income with the
costs incurred in producing it.
On 31 July X1 control is transferred to the buyer of the 10 bags. We would update

our inventory records on 31 July X1.
3. 30 November X1
Something to do 4
Calculate the total value of inventory for Judy's business on 31 July X1.
Check your answer
Cost of inventory in the stall 20 000

Add: Cost of consignment (10 bags at R200) 2 000
Add: Cost of inventory FOB shipping point (15 bags at R200) 3 000
Total inventory value on 31 July X1 25 000
To summarise, the inventory recognised in the financial statements does not include
only inventory that can be physically counted in the business, but all inventory, no
matter where it is located, that the business controls.
6.2 Calculating the cost at initial

recognition
Judy was at the stall speaking to her accountant, telling her she had
bought some leather bags from small manufacturers in Lesotho for
R200 per bag. Judy was excited by this purchase, because the same
bags would have cost her R250 if she had bought them from her
usual suppliers in Cape Town.
Judy explained to the accountant, “I use a mark-up of 50% on
cost, and I calculated the selling price on the Lesotho bags to be
R300. These bags sold very quickly compared to the Cape Town
bags, which I had to sell at R375 (a 50% mark-up on the cost of
R250).”
The accountant shook her head, muttering, “But the selling price
of the Lesotho bags should have been higher because these bags
cost you more than R200 each.”
Judy replied, “I paid R200 for the Lesotho bags and R250 for the
Cape Town bags; even I can see the Lesotho bags are cheaper.
Financial management is not so difficult after all!”
“Well, Judy, do you really think the Lesotho bags cost you only
R200?” asked the accountant.
“What about the R60 per bag you had to pay to transport the
Lesotho bags to your stall? What about the R20 per bag import tax
you had to pay at the border to import the Lesotho bags?”
“What about the costs of delivering some products to my clients?
Should that be included too?” Judy wonders.
Let’s help Judy understand the cost at which inventory is initially
recognised.
6.2.1 Definition of “cost of inventory”

The cost of inventory includes all costs of purchasing the inventory,
any conversion costs (if required), and any other cost which we
spend in bringing the inventory to a place and condition where it
can be sold (IAS 2, para 10).

BEFORE Date the AFTER
inventory
is ready
for sale
The costs incurred are debited The point Costs incurred are debited to
to the inventory account, which at which an expense account; in other
means they are included in the inventory words, they are excluded from
cost of inventory if incurred to the cost of inventory if incurred
bring the inventory to the is in the after the inventory is in the
place and condition where it place and place and condition where it
can be sold (an example is condition can be sold (an example is
import duties) where it advertising)
can be
sold
The transport cost of R60 per bag and import tax of R20 per bag are
part of the cost of the bag as it is necessary to spend these to bring
the bags to the stall to be sold.
If Judy had not paid for transport and import duty, she would not
have had the bags in her stall to sell. The costs of transport and
import duty are therefore included in the cost of the inventory.
The accounting standards specifically include import duties and
other taxes, as well as transport and handling costs relating to the
purchase of inventory in the term “costs of purchase” (IAS 2, para
11).
The transport cost and the import tax are part of the cost of the
inventory, and the total cost of the Lesotho bags is R280 (R200 + R60
+ R20).
What about the delivery cost of goods sold to clients?

Do they form part of the cost of inventory? The answer is no. These
costs are incurred in order to sell the inventory and therefore are not
a cost incurred to bring the inventory to the condition and location
where it can be sold. These transport costs are selling costs, and will
be expensed when they are incurred.
Something to do 5
A business purchased 100 items at R1 each, paid R50 in total to have them
transported to the warehouse, a further R25 in total to have them transported to
the shop, and R50 in total for wages to have them unpacked and placed on the
shelves. Calculate the total amount that should be debited to the inventory
account, and the cost per item.
Check your answer
The total amount debited to the inventory account includes all the costs incurred up to
the point at which the inventory can be sold:
R1.00 × 100 = R100 + R50 + R25 + R50 = R225
The cost per unit = R225/100 units = R2.25 per item.

Judy was trying to find the best cost price for her leather bags. She
phoned all the suppliers in Cape Town so she could compare and
choose the best price to supply bags of an acceptable quality.
So far she has received prices from two suppliers. The first
supplier quoted a price of R200 before a trade discount of 10% and
no settlement discount, and the other supplier quoted a price of
R200 before a settlement discount of 10%, assuming that Judy pays
within 30 days of being invoiced.
Judy does not understand the difference between trade discount
and settlement discount and because of this is finding it difficult to
compare the quotes. She is also unsure whether the discounts would
have an impact on the cost of inventory recorded in her books.
Let’s help Judy understand trade discount and settlement discount
and their impact on the recorded cost of inventory.
6.2.3.1 Trade discount

A trade discount is usually offered to encourage businesses to buy in
bulk (large quantities) as these businesses are often good customers.
Suppliers of goods will offer a trade discount that will reduce the
purchase price of the goods. Once it has been agreed upon that the
purchaser is buying sufficient quantity to qualify for the trade
discount, the new purchase price (after trade discount has been
deducted) is what will be shown as the final total on the purchase
invoice. The cost to the buyer is the purchase cost net of the trade
discount (less the trade discount).
We record the purchase of inventory at cost. The purchase cost is
the cost after the trade discount has been deducted (IAS 2.11), so the
trade discount is not recorded. If Judy decides to buy from the first
supplier, the inventory would be recorded at a cost of R180 (R200 −
(R200 × 10%)) per bag. The supplier would recognise sales revenue
of R180 per bag.
6.2.3.2 Settlement discount

As with the trade discount example above, when we consider how
settlement discount affects the reporting of transactions we need to
consider both the buyer and the seller. It is important to remember
that the seller will recognise the revenue from the sale once control
over the inventory has transferred to the buyer. This is the point at
which the buyer will recognise the inventory as their asset.
Suppliers of goods may offer a settlement discount, which means
if the business pays early and within a specified time, a discount on
the outstanding amount is offered, i.e. a reduced price for the goods
purchased is paid.
Let us look at how settlement discount is recorded in the buyer’s
books. Remember the items have a selling price of R180 with a 5%
settlement discount offered if paid within 10 days, or full payment
due in 30 days. The supplier will record the revenue at the fair value
of the amount the business expects to receive on the date of the sale.
The supplier would need to decide (based on past experience or
business judgement) whether it is probable that the buyer will take
advantage of the discount or not.
The supplier offered the following credit terms: 5% settlement
discount, if paid in 10 days, or the full settlement due within 30
days. The selling price per item is R180. On the date of the sale the
supplier will recognise sales revenue. The amount of revenue
recognised will depend on whether the supplier considers it
probable that the buyer will take up the discount offer or not.
Let’s assume the sale occurs on 1 Jan X1 and 100 items are sold.
Supplier's books
Probable that buyer will take up discount

1/1/X1
R180 × 100 × 95% = R17 100
By 10 Jan X1, the buyer will either make the payment of R17 100 (i.e.
take up the offer of early payment) or not make a payment, in which
case the full amount of R18 000 would be due by the end of the
month.
If payment is made on 10 Jan X1, the supplier will process the
following entry:
10/1/X1
If no payment is received on 10 Jan X1, the supplier would need to
adjust both the amount now owed by the buyer as well as the sales
amount the business will earn.
10/1/X1
R18000 − R17100 = 900 or 18000 × 5%
When the buyer pays at the end of the month, the following entry is
processed:
30/1/X1
Probable that buyer will not take up discount
1/1/X1
R180 × 100 = R18 000
By 10 Jan X1, the buyer will either make the payment of R17 100 (i.e.
take up the offer of early payment) or not make apayment, in which
case the full amount of R18 000 would be due by the end of the
month.
If payment is made on 10 Jan X1, the supplier will process the
following entries:
10/1/X1
R18 000 × 5% = R900
This entry reduces the sales amount to the actual amount that the
supplier earns from the transaction. The entry simultaneously
reduces the amount owing by the buyer.
10/1/X1
The supplier has received 95% of the original sale as the buyer took
up the discount offer.
If no payment is made on 10 Jan X1 and payment is received at the
end of the month, the following entry is processed:

30/1/X1
The buyer has paid the full amount as expected and has not taken
advantage of the discount.
When recording the cost of the inventory purchased and the
amount owed to the creditor (liability), or the decrease in bank your
business must decide (based on past experience) whether it is
probable that your business will take advantage of the discount or
not.
If it is probable that you will take advantage of the discount:
• The business will recognise the cost of inventory net of the
discount, as this represents the actual cost incurred to buy the
inventory, i.e. R180 × 95% per item.
• The trade payables or bank figure will also be stated net of the
discount (excluding the discount).
If it is probable that you will NOT be taking advantage of the
discount:
• The business will recognise the FULL cost of the inventory (in
other words, not take off the 5% settlement discount), as this
represents the actual cost we anticipate incurring to buy the
inventory.
• The trade payables or bank figure will be the FULL amount
owing (in other words, not taking off the discount).
Something to do 6
Your business, Kayak Africa, purchases inventory from a supplier on 1 Jan X1
for R10 000. Your supplier offers you a 5% settlement discount if you settle
within 15 days, full payment due in 45 days.
1. What would the cost of inventory and trade payables in Kayak Africa's
books be if:
a) It is probable that your business, Kayak Africa, will take advantage of
the discount
b) It is probable that your business, Kayak Africa, will not take advantage
of the discount.
2. What would happen if the opposite of what you expected occurs? In other
words:
a) If Kayak Africa does not take advantage of the discount although it
expected to do so
b) If Kayak Africa takes advantage of the discount although it did not
expect to do so.
Check your answers
1. (a) It is probable that your business, Kayak Africa, will take

advantage of the discount .
The expected purchase cost and liability are net of settlement
discount and therefore amount to R10 000 × 95% = R9 500.
The transaction is recorded in the books as follows:
At purchase date:
1/1/X1
When payment is made (as expected, i.e. within 15 days):

15/1/X1
(b) It is probable that your business, Kayak Africa, will NOT take
advantage of the discount .
The expected purchase cost and liability are the full amount
(ignoring the settlement discount) and therefore amount to
R10 000. The transaction is recorded in the books as follows:
At purchase date:
1/1/X1
When payment is made (as expected, i.e. within 45 days):

15/2/X1
2. (a) What would happen if Kayak Africa did not settle in 15 days
although at purchase date it had expected to do so?
When payment is made (not as expected, i.e. not on 15 Jan
X1):
15/1/X1
R10000 - R95000 or R1000 × 5%

The business has a liability of R500. This liability has
arisen because the early payment has not been made and the
buyer now owes the full amount of R10000 by 15 Feb X1 (as
per the credit terms). The cost of the inventory amounts to
R10000 (and not the R9500 recorded on 1 Jan X1).
15/2/X1
The entry above is recorded when payment is made on 15 Feb
X1 as per the credit terms (assuming payment made on time).
(b) What would happen if Kayak Africa settled in 15 days
although at purchase date it did not expect to do so?
When payment is made (not as expected, i.e. payment made
on 15 Jan X1):
15/1/X1
The buyer settles the debt to the trade payables with a

payment amounting to R 9500. This is because the actual cost
of the inventory purchased, if the settlement discount is taken
up, amounts to R9500. The cost of the inventory is reduced to
R9500 to recognize the actual cost of the inventory purchased.
6.3 Recording inventory in the general

ledger
Judy was unpacking an order of 100 bags, costing R200 each, that
had been delivered to the stall that morning. While working, she was
thinking about how she was going to record this purchase in her
general ledger. Judy decided to ask Tracey how to record a purchase
of inventory in the ledger.
When Judy asked Tracey she replied, “Well, when I asked my
accountant the same question, all he did was mumble about using
the periodic method of recording purchases. He said I needed to
count only the unsold clothing in the stall on the last day of the year
and not worry about changing my inventory records for purchases
and sales during the year.”
Judy was still a little unsure about how to record the 100 leather
bags in her general ledger.
Let’s help Judy understand two ways of recording the purchase of
inventory in the general ledger.

periodic
In Chapter 5 we learnt that for financial accounting purposes, how
we record transactions during the period − as an asset or an expense
− is not the most important issue.
Our main concern is that the financial statements are drawn up
correctly. When we prepare the statement of profit or loss and other
comprehensive income and statement of financial position, we need
to determine whether an item has been used, in which case it is an
expense, or whether it is still on hand, in which case it is an asset.
Recording the purchase of inventory is no different from the
stationery example used in Chapter 5. When we purchase inventory,
there are two bookkeeping methods we can use. The perpetual

method records the inventory purchased during the period in the
inventory account. The periodic method records the purchase of
inventory during the period in a purchases account. The word
“perpetual” means “always”, so the perpetual method means that
the inventory account is always updated. The word “periodic”
means “at a point in time”, so the periodic method means that
inventory account is updated only at a point in time, which is at the
end of the period.

These methods differ in the initial record of purchases and sales.
When we prepare financial statements, we have to find out what
inventory has been sold (used) and what inventory is still on hand.
The used inventory is an expense that we call Cost of sales and the
unused inventory is an asset − Inventory. The necessary adjusting
journal entries to show the correct expense amount and asset balance
depend on the initial recording system we used.
Note:
The perpetual and periodic systems are just different methods of
recording the purchase and sale of inventory during the year in the
general ledger. In the post-adjustment trial balance, from which we
prepare the statement of profit or loss and other comprehensive
income and statement of financial position, both methods will have
the same balance in the Inventory account and the Cost of sales
(expense) account.
6.3.1.1 Perpetual system

The perpetual system is a recording system that keeps track of
inventory at any time. Every time inventory is purchased or
returned by clients, the Inventory account is increased. Every time
inventory is sold or returned to the supplier, the Inventory account
is decreased. In theory, the Inventory account balance reflects the
how much inventory is available to sell. This is the case because we
record all purchases, sales and returns in the Inventory account.
When we sell goods during the period, we transfer the cost of the
goods sold out of the Inventory account to the Costs of sales expense
account. The Cost of sales expense in the general ledger will show
the correct cost of all inventory sold to date. This makes sense,
because once the inventory has been sold, the inventory can no
longer be shown as an asset.

6.3.1.2 Periodic system
The periodic system is a system that calculates the inventory balance
only at the end of each accounting period. When we want to know
the inventory balance or financial position, the inventory that should
be recognised on the statement of financial position is determined
(usually by counting it). The cost of sales is calculated and
recognised on the statement of profit or loss and other
comprehensive income. Under the periodic system, the Inventory
account does not reflect the actual inventory that is available for sale.
Therefore it cannot be used to check whether inventory has been lost
or stolen. This will be discussed in more detail later in the chapter.
With the periodic inventory system, all purchases and purchases
returns during the period are recorded in the Purchases account (or
the purchases returns can be shown in a separate Purchases returns
account). The general ledger accounts for cost of sales and inventory
are adjusted only at the end of the period.
How do we calculate cost of sales under the periodic method?
Inventory on hand at beginning of period X

Plus: Purchases during the period X
= Inventory available to sell during the period X
Less: Inventory on hand at the end of the period (X)
= Cost of sales X
To calculate the cost of inventory sold during the period, we need to
work out the total amount of inventory we had available to sell
(inventory on hand at the beginning of the period, plus purchases
during the period). We physically count the inventory to find out
what inventory is still on hand at the end of the period, and this is
subtracted from the total amount of inventory we had available to
sell.
6.3.2 Recording inventory transactions in the

general ledger
What inventory transactions typically take place?
• Purchases of inventory from suppliers
• Purchases returns to suppliers (returns outwards)
• Sales of inventory to clients
• Sales returns from customers (returns inwards)
• Owner using inventory for personal purposes
• Year-end stock count.
6.3.2.1 Recording a purchase

6.3.2.1.1 Recording a purchase in a perpetual
system
When inventory is purchased, the Inventory account is increased,
and as inventory is an asset, the inventory account is debited.
The credit entry depends on whether inventory was purchased
for cash or on credit. If we bought the inventory on credit, we credit
the trade payables account. If we paid cash for the inventory, we
credit the Bank account.
Let's help Judy prepare the general journal entries to record her
purchase of 100 bags at R200 each in the general ledger, using a
perpetual inventory recording method.
1. If Judy had bought the inventory on credit (she still owed the
supplier):
2. If Judy bought the inventory and paid cash:
6.3.2.1.2 Recording a purchase in a periodic system

Any purchases of inventory during the period are debited to an
account called Purchases. If we buy the inventory on credit, we
credit the trade payables account, and if we pay cash, we credit the
Bank account. We do not adjust the Inventory account during the
period for any purchases of inventory made.
Let’s help Judy prepare the general journal entries to record the
purchase of the 100 bags in the general ledger.
1. If Judy had bought the inventory on credit:
2. If Judy had bought the inventory and paid cash:
Something to do 7
1. Calculate the total cost of inventory for the following example.
2. Prepare the journal entries required to record the transaction, using both
the perpetual and periodic systems, and assuming that all costs are paid
in cash.
Check your answers
1. The cost of inventory is made up of:

Purchase cost 2 000
Transport inwards (Carriage inwards) 500
Import duties on bags 100
Wages of staff to unpack the bags on delivery at stall 200
2 800
All costs incurred in getting the bags (inventory) to the point at which they are
available for sale are included in the inventory cost.
2. a) Perpetual system
When using the perpetual method, the costs are debited
directly to the Inventory account.
Note that if all the wages had already been recognised as
wages expense, the journal entry would be to re-allocate the
R200 from wages to inventory, and the following journal entry
would be processed.
b) Periodic system
When the periodic method is used, the purchases account is debited with
the cost of purchasing inventory during the period.
(i) On the date of delivery of the bags to the stall:
(ii) On the date the transport service is provided:
(iii) On the date the import service is provided:

(iv) On the date the staff unpacks the purchases:
The periodic recording system can either directly take these costs to purchases when
they occur or can open the import duty/transport account. If the individual accounts
are used they will be closed off to either to the purchases account or directly to cost of
sales expense at year-end. See section 6.3.2.6.2.3.
6.3.2.2 Recording purchases returns (returns

outwards)
Judy was walking through the stall when she noticed loose stitching
on 10 of the leather bags she had recently purchased. She knew that
no customer would buy a leather bag with a flaw, so she contacted
the suppliers. The supplier was horrified to learn about the defective
bags and agreed that Judy should return them as soon as possible.
After Judy had packed the 10 leather bags and sent them back to
the supplier, she knew she should update her general ledger for the
purchases return, but was not sure whether her journal entry was
correct.
Let’s see if we can help Judy prepare the general journal entries to
record a purchases return using both recording systems (perpetual
and periodic).
6.3.2.2.1 Recording a purchases return in a
perpetual system
When inventory is returned, the Inventory account should be
reduced (credited) to reflect that less inventory is available for sale.
When the Inventory account is credited with the purchases
return, another account must be debited. The contra account

depends on how Judy is refunded and whether she had already paid
for the purchase.
If Judy had already paid cash for the bags

If the supplier refunds Judy the cash immediately, she will debit the
Bank account. If Judy returns the bags but waits for the cash refund,
she will credit the Inventory account when she returns the inventory
and will debit a Trade receivables account (as the supplier now owes
Judy the cash). When the supplier pays Judy, we debit Bank and
credit Trade receivables, because the supplier no longer owes Judy
any refund.
Judy has paid the supplier and receives the refund on the date the
purchase is returned:
If Judy has already paid the supplier and does not receive the refund
on the date the purchase is returned:
• On the date the bags are returned to the supplier:

• On the date the cash for the bags is received from the supplier:
If Judy had not paid for the bags yet

As Judy returned the defective bags, she no longer owes the supplier
for these bags, and her liability to the supplier is reduced − the Trade
payables account is debited.
• On the date the bags are returned to the supplier:
Something to do 8
What happens if the supplier replaces the 10 defective bags with 10 new bags
on the date on which the defective bags are returned?
Check your answer
If the supplier gives Judy 10 identical bags to replace the defective bags at the same
time as she returns the damaged bags, we do not process any transaction, because
the inventory is unchanged.
6.3.2.2.2 Recording a purchases return in a periodic

system
All purchases made during the year are debited to a Purchases
account. When we return purchases to the supplier, we decrease
purchases by crediting the Purchases account with the original cost
price of the bags. (Or we could open a Purchases returns account.
This account is closed off to the Purchases account at the end of the
period.)
The general journal entries Judy should process to the general ledger
are:
1. If Judy has already paid the supplier and receives the refund on
the date the purchase is returned:
− On the date on which the bags are returned to the supplier:
2. If Judy has already paid the supplier and does not receive the
refund on the date the purchase is returned:
− On the date the cash for the bags is received from the supplier:
3. If Judy has not paid the supplier:

4. If the supplier replaces the bags:
− Once again, if the supplier replaces the bags, we do not
process any transaction, because the inventory is unchanged.
6.3.2.2.3 Import duties and transport costs on

purchases returned
Go back to the example where Judy purchased bags from Lesotho
and incurred import duties and transport costs.
We recognised these costs as part of the cost of inventory because
they are necessary to get the bags to the location and conditions
required to sell the bags.
What do you think would happen if Judy returned 10 of these
bags to the supplier (10/50 = 20%)?
1. Perpetual system
Judy would have to reduce the inventory account by the cost of the
bags that were returned − R2 000 (10 bags × R200).
We also have to allocate to cost of sales the portion of the other costs
relating to these bags. You may think it is strange to include these
costs in cost of sales when the bags have not actually been sold.
Remember that all costs that are incurred in the process of getting
inventory ready for sale are included either in inventory (asset) or in
the cost of sales account (expense). Wasted costs (such as the import
duty and transport costs of returned goods) will be included in cost
of sales as they cannot be treated as an asset.
Twenty per cent of the bags were returned, and therefore 20% of
the transport costs and import duties no longer relate to inventory
held by Judy. We would credit Inventory and debit the Cost of sales
expense account with this amount.
2. Periodic system
Judy would have to credit the Purchases account (or a Purchases
return account) with the cost of the bags that were returned − R2 000
(10 bags × R200).
No other entry will be processed at this time as the correct cost of
sales amount is only identified at the end of the reporting period. We
will look at the entries Judy will need to process at the end of the
year in section 6.3.2.6 on adjusting journal entries for inventory.
6.3.2.3 Recording the sale of inventory
Judy was having a great morning because she had made a cash sale
of 20 leather bags at a selling price of R350 each to a customer. As
she was wrapping the bags, she wondered how she was going to
record this sale in her general ledger. “I wonder if I can ask Tracey
how she records a sale in her general ledger? I know she uses the
periodic method of recording, but surely there is no difference
between the recording methods when it comes to recording a sale?”
Let’s help Judy record a sale in the general ledger using both the
perpetual and the periodic recording methods. We will ignore value
added tax in this section, and will look at the VAT in section 7.8.
6.3.2.3.1 Recording the sale of inventory in a

perpetual system
The perpetual system updates the Inventory account for all changes
in inventory − after every purchase, purchases return, sale and sales
return.
We adjust the Inventory account for the inventory sold by
crediting the Inventory account. This is done on the day the business
loses control over the inventory.
Remember that when an asset decreases (and no other asset or
liability changes), and this leads to a decrease in equity that is not
due to a distribution to the owner, the business recognises an
expense. We debit the Cost of sales expense account with the cost
price of the inventory sold, the amount by which our assets were
reduced.
1. Recording sales income

a) If the sale was a cash sale:
b) If the sale was a credit sale (the customers still owes you for
the 20 bags):
c) What if the customer who bought the 20 leather bags for
R350 each did not have the money to pay Judy? The
customer owned a new computer that was worth R7 000
that she agreed to give Judy as payment for the 20 leather
bags.
If the inventory was exchanged for another asset:
2. Recording the decrease in inventory

This is the general journal entry to record the decrease in inventory
when a sale takes place.
When we make a sale in a perpetual inventory system, we
immediately update the Inventory account for the decrease in
inventory and recognise the Cost of sales expense at the cost price of
the units sold.
6.3.2.3.2 Recording the sale of inventory in a

periodic system
Let’s see if we can help Judy understand how to record the sale of
the 20 bags in the general ledger.

1. Sales income account
The journal entries are exactly the same as for the perpetual
inventory system in section 6.3.2.3.1 above.
2. Recording the decrease in inventory

When we sell inventory and are using the periodic system, no
journal entry is processed to record the decrease in inventory at the
time of the sale. At the end of the period, we update the Inventory
account and recognise the Cost of sales expense (section 6.3.2.6).
6.3.2.4 Recording sales returns (return inwards)
Judy was just about to close the stall when a worried-looking

customer ran in. The customer exclaimed, “I am so disappointed
because the bag I bought from you last week has just fallen apart at
the seams!”
Judy replied, “I am so sorry about this, but we have had some
trouble with one of the suppliers. I will replace your bag with
pleasure, or would you prefer me to refund you your cash?”
While Judy was talking to the customer she was wondering how
on earth she would record a sales return in her general ledger.
6.3.2.4.1 Recording sales returns in a perpetual

system
Let’s see if we can help Judy understand how to record a sales
return in her general ledger using a perpetual recording method.

When the customer returns the bag, the credit entry for the return
will depend on whether we refund the customer cash or replace the

bag, and whether the payment for the original sale has been received
at the sales return date.
The general journal entries Judy should process are:
a) If Judy received payment and pays the refund on the date the
purchase is returned:
− When we sold the bags for R350 and payment was received:
− When the customer returns the bag:
b) If Judy received the payment and does not pay the refund on
the date the purchase is returned:
− When we sold the bags for R350 and payment was received:
c) If Judy did not receive payment from the customer:
− When we sold the bags on credit for R350:

d) If we exchange the bag:
− There is no change in sales income, so we do not process any
transaction.
2. Recording the increase in inventory

Remember, when a transaction happens that changes the value of
inventory, we update the Inventory account. We increase inventory
to record the receipt of the bag from the customer. We credit the
Cost of sales expense to decrease the expense, as we have not sold
the bag.
When we record inventory returned by a customer, we reverse
the original journal entry used to record the sale of inventory.
a) Recording the return of the bag:
When we sold the bags, the journal entry would have been:
i) If the customer does not exchange the bag:
When the customer returns the bag, we need to put the bag
back into stock and reverse the original sale entry:

ii) If the customer exchanges the bag:
If we replace the defective bag with a new one, we do not
need to process any transaction because the inventory is
unchanged.
When a customer returns a damaged inventory bag, we increase
Inventory because we control the bag’s benefits. If we give the
customer a new bag, we take the new bag out of stock, so we
credit Inventory and debit Cost of sales.
A damaged bag may no longer have the potential to produce

economic benefits. What are Judy's options?
b) What about the damaged bag?
The damaged bag is not an asset if Judy can no longer sell it to
customers. She should try to return the bag to the supplier, but
this is not always possible, as the period in which a return is
allowed may have passed. Judy may be able to sell the bag at a
reduced price.
Let’s look at the journal entries for the different possibilities.
i) If Judy cannot return the damaged bag and cannot sell it in
future: Credit Inventory to decrease inventory and debit
Cost of sales.
Note:
The expense is included in the Cost of sales account even though a sale
has not actually taken place. The bag is no longer an asset, so the cost
of the bag needs to be recognised as an expense. All expenses related to
inventory that occur in the normal course of business are recognised as
part of the COS expense. These expenses occur when the inventory is
sold, damaged or stolen.
ii) If Judy cannot return the damaged bag, but can sell it at a
reduced price in future:
Judy will recognise the expense (Cost of sales) only when
the damaged bag is actually sold. We will look at how we
record a transaction where the selling price of the inventory
has decreased below the cost price in section 6.3.2.7. This is
referred to as an inventory write down.
Something to do 9
Assume that the only transactions during the year were the sale of the
damaged bag and the exchange of the damaged bag for a new bag by the
customer.
What do you think Judy's trading statement will look like if Judy cannot return
the bag to the supplier, nor sell it at a reduced price?
Check your answer
Sales 350
Cost of sales (400)
Bag taken out of stock with the original sale (200)
Damaged bag returned to stock 200
New bag given to the customer (200)
Cost of the damaged bag written off as no longer an asset (200)
Gross loss (50)
Judy has made a loss as she has had to reduce her inventory by two bags (one sold
and one damaged), but has received money for only one bag.
6.3.2.4.2 Recording sales returns in a periodic

system
If the customer returns the bag and receives a refund, the sales
income needs to be reduced. The journal entries are the same as for
the perpetual inventory system 2(a) and (b) in section 6.3.2.4.1. If the
customer exchanges the bag for a new one, no journal entry needs to
be processed, as the sale income remains the same.
2. Inventory account
Using the periodic method, we do not record the changes in
inventory for the sale of the bag and therefore no entries are
required when the bag is returned. Remember that the cost of sales is
calculated only by doing a physical stock count at the end of the
period.
a) If Judy cannot return the bag to the supplier (whether she can
sell it or not):
The effect will not be recorded on the return date. With the
periodic system, the total expense for the year (Cost of sales) is
determined only at year-end.
b) If Judy returns the bag to the supplier:
This is a purchases return so the Purchases or Purchases returns
account is credited. The journal entries for purchases returns are
shown in section 6.3.2.2.2.
6.3.2.5 What if Judy took inventory for her personal

use?
On 5 December Judy purchased 100 leather bags for R200 each to

sell to customers in the stall. Judy had a very busy day on Christmas
Eve, and when she was about to leave for Christmas dinner with her
friends, she remembered that she had not bought Christmas
presents for any of them. She saw the leather bags hanging up for
sale and knew they would make wonderful Christmas presents. Judy
took five of the bags to give to her friends as presents.
6.3.2.5.1 Perpetual system

When Judy bought the 100 leather bags on 5 December, these were
recorded as inventory. On 24 December Judy no longer planned to
sell all the bags as part of normal business activities, but decided to
give some of them to friends as gifts. From the date that Judy
changed her plans, the bags were no longer part of inventory.
Remember that we debit Cost of sales if inventory is sold,
damaged or otherwise lost during normal business activities. Giving
bags to friends is not part of Judy’s normal business, so we cannot
debit Cost of sales with the cost of the five bags.
Judy took the bags for her own use. This is a withdrawal by an
owner, as opposed to an expense. An expense is a reduction in the

net assets of the business other than those arising from withdrawals
from the business by the owner.
6.3.2.5.2 Periodic system

If Judy takes the bags for her own use, this is a withdrawal by the
owner, and drawings must be increased (debited). With the periodic
method, we record the purchase of inventory during the period as a
debit to the Purchases account. Therefore, we credit the Purchases
account with the amount of drawings.
6.3.2.6 Adjusting entries at the end of a period
James passes Judy's stall and sees that she is busy counting her
stock. “Hey, Judy! Are you also doing your year-end stock count
today?” he asks.
“Yes, I am actually very busy, but my accountant insisted that I
must do it today, because it is 31 December, and that is my year-end.
But it is giving me quite a headache. How am I going to record the
stock count once it is done? And then my bookkeeper also told me to
watch out for damaged and obsolete stock. I found some stock that
is no longer in fashion and can be sold only at a reduced price. Do I
have to show that in my books? I have no idea how to do that,” she
replies.
Let’s help Judy understand which adjusting journal entries to
process at year-end using the perpetual and periodic inventory
system. Remember that adjusting entries are processed so that the
correct expense and income amounts can be closed off to the Profit
or loss account, and the correct asset and liability amounts can be
recognised on the statement of financial position.
6.3.2.6.1 Perpetual system
6.3.2.6.1.1 Calculating cost of sales

In the perpetual system the Cost of sales account is updated every
time inventory is sold, returned by a customer, or damaged/stolen
(when the business identifies the damage or loss). The business does
not need to calculate the cost of sales expense at the end of the
period as this amount will be taken from the Cost of sales expense
account.
6.3.2.6.1.2 Physical stock count

What does Judy’s inventory account in the general ledger look like at
the end of a period?
Her inventory account balance shows a balance of R13 000. The
general ledger balance is the value of inventory we expect to have on
hand at the end of the period and is called the theoretical closing
inventory.
Theoretical inventory amount: R20 000 (inventory purchased) − R2
000 (returned to supplier) − R4 000 (sold to customers) − R1 000
(taken for personal use), assuming that the sales return was an
exchange.
At the end of the period Judy had an inventory list that showed
actual inventory on hand of R12 000 (60 bags at R200 per bag). We
know the closing balance of inventory must be R12 000, because
Judy counted the physical inventory in the warehouse and included
consignment stock and inventory not yet received but sent FOB
shipping point.
How should Judy record the R1 000 difference?

Using the perpetual method, we are able to compare the actual (R12
000) and theoretical (R13 000) amount of inventory. Judy has less
inventory on hand than is shown in the general ledger. This could be
because inventory has been stolen, damaged or removed. An
expense needs to be recorded and, as we expect a certain amount of
damage or theft to occur in the normal course of business, the Cost
of sales account needs to be debited.

With the perpetual inventory method, at the end of the period we
compare the theoretical inventory on hand (the balance shown in the
general ledger) with the actual inventory counted. We process a
journal entry to record any difference so that the final balance on the
inventory account agrees with the physical inventory counted.
6.3.2.6.2 Periodic system
6.3.2.6.2.1 Calculating cost of sales

When the periodic system is used we do not have a cost of sales
account that is updated during the year. At year-end we will need to
calculate the cost of sales expense.
COS Opening inventory + Purchases of inventory during the
expense = year − Closing inventory
We transfer the balance of the inventory we had at the beginning of
the period to the Cost of sales expense account.
We also transfer the inventory we have purchased during the year
from the Purchases account to the Cost of sales expense account.
Judy has R17 000 in the purchases account (R20 000 (section 6.3.2.1)
− R2 000 (section 6.3.2.2) − R1 000 (section 6.3.2.5)).

The Cost of sales account now shows the cost of all inventory that
was available to sell. We need to see what portion of this cost relates
to inventory that has been sold (shown as an expense), and what
portion relates to inventory still on hand (shown as an asset).
We know the unsold inventory on hand at the end of the period
from doing a physical stock count − counting the inventory on the
premises and adding other inventory controlled by the business (for
example, consignment inventory and inventory sent FOB shipping
point that has not yet been received by us). The inventory is
summarised on an inventory list, and in Judy’s case this amounted
to R12 000.
If we had inventory of R17 000 available to sell and of this R12 000 is
left, we must have sold or lost bags with a cost of R5 000. This is the
Cost of sales expense amount because it is the cost of the inventory
we have sold (used). The inventory on hand at the end of the year
should amount to R12 000.

After processing the adjusting journal entry, the Cost of sales
account shows the cost of inventory that has been used. The
Inventory account correctly reflects the balance of inventory we still
have left to sell.
Remember the business could calculate the gross profit in the
trading account or directly transfer both sales and cost of sales to the
profit or loss account at year-end.
6.3.2.6.2.2 Physical stock count, periodic system

At the end of the period, the general ledger does not give us any
information about the inventory we expect to have on hand. We
have to count the inventory physically in the warehouse to know
what the closing balance on the Inventory account in the general
ledger should be. There is no theoretical closing inventory with a

periodic recording method.
The inventory on hand at the end of the year should reflect a
balance of R12 000. To record the cost of inventory still on hand we’ll
process the following entry:
The inventory loss of R1 000 is already included in the R5 000 Cost of
sales expense. This is because we use the physical inventory counted
at the end of the period to calculate the inventory on hand. The stock
stolen or lost would not be in the warehouse and would not be
included in the physical inventory count. The total Cost of sales
expense is worked out from this closing inventory and therefore
includes the inventory losses.

If Judy uses a periodic inventory recording method, she will count
her inventory at the end of the year and work out by how much
inventory has decreased during the year. She will not know which
part of the decrease in the inventory has occurred because she sold
the inventory and which part relates to stolen inventory. When we
use a periodic system, it is impossible to identify stock losses and
theft from the recording system. To assist the business to identify
and manage these losses, we can compare the expected gross profit
(mark-up) with the gross profit achieved. We will look at this
concept again later in the chapter.
6.3.2.6.2.3 Import duties and transport costs on

purchases returned
The import duties and transport costs are part of the cost of
inventory because they are necessary to get the bags to the location
and conditions required to sell the bags.
What entries would be processed if Judy returned 10 of these bags
to the supplier (10/50 = 20%)?
The transport costs and import duties are transferred to the Cost
of sales account at the end of the period. Once all the costs have been
transferred to the Cost of sales account, we identify what portion of
these costs relates to inventory on hand (asset) and what portion of
these costs has been used, wasted or lost (Cost of sales). If we
assume that the remaining 40 bags are still on hand at the end of the
period, the adjusting journal entries for the periodic system would
be as follows:
* assuming these amounts were not initially recorded directly in the
purchases account.
The value of the closing inventory is calculated as follows:
Purchase cost of 40 bags at R200 = R8 000
Transport cost for 40 bags = R60 × 40 bags = R2 400
Import duties for 40 bags = R20 × 40 bags = R800
This results in a total value of closing inventory of 40 bags of
R11 200.
R800 is recognised as a Cost of sales expense. This is correct, because
the R800 is in respect of the transport costs (R60 × 10 bags) and the
import duties (R20 × 10 bags) that relate to the 10 bags returned to
the supplier. This portion of the transport costs (R600) and import
duties (R200) is reflected as an expense − cost of sales − because
these are direct inventory costs incurred during the course of normal
business activities and they no longer meet the asset definition.

6.3.2.7 Inventory write-downs
After the stock count Judy visited her accountant and told him that
she found some inventory that was no longer fashionable, “I bought
10 bags for R200 each a few months ago when they were a high-
fashion item. Unfortunately, the trend now is very different, and I'll be
able to sell these items for only R50 each.”
The accountant asked Judy, “Have you adjusted the inventory
account in the general ledger for the drop in selling price?”
“Of course not!” replied Judy, “I know inventory is recorded in the
general ledger at cost price.”
Let’s help Judy understand what entry she should process in the
general ledger for the 10 old bags mentioned above.
Inventory is an asset and is initially recognised at cost. What
happens if, at a later measurement date, we think that the historical
cost of the inventory will not be recovered, i.e. the inventory may
have been damaged or the market for the inventory may have
changed?
No asset can be reported on the statement of financial position at
an amount greater than the recoverable amount of the asset.
Inventory is normally recognised at cost, but if the selling price of
the inventory less any disposal costs (recoverable amount) has
dropped below cost, the inventory will be recognised at its net
selling price (selling price less disposal costs).
The general journal entry to record this information is:

What is the cost of the bags?
= 10 × R200 = R2 000
What is the net realisable value of the bags?
= 10 × R50 = R500
Inventory is shown at the lower of cost and net realisable value, as
required by IAS2, the inventory accounting standard.
Net realisable value = Selling price − any selling costs
Net realisable value is a calculation of the recoverable amount

expected when the inventory is sold.
Something to do 10
Calculate the net realisable value of the 10 old bags if Judy has to pay the sales
staff a 5% commission on all sales. Help Judy to prepare the general journal to
record any entries that may be required.
Check your answer
Cost = 10 × R200 = R2 000.

Net realisable value = Selling price − any selling costs
= R500 (10 bags at R50) − R25 (10 × R50 × 5%)
= R475
The 10 bags have an expected recoverable amount of R475. The inventory cannot be
recognised at a cost greater than the recoverable amount. Inventory is written down to
net realisable value (R2 000 (10 bags at R200) − R475 = R1 525).
The general journal entry is:
This implies that when the inventory is sold next year, there will be no profit.
Sales (10 × R50) R500
Less: Cost of sales (R475)
Less: Commission − selling expense (R25)
Pro t R0
6.3.2.8 Closing journal entries

At the end of the period we transfer the Sales account and the Cost
of sales account to a Profit or loss account or to the Trading account.
Remember the Trading account could be used to calculate the gross
profit (gross profit = sales − cost of sales). This allows us to calculate
the profit for the period and clear out the income and expense
accounts to a zero balance. The Trading account highlights how
much of the profit is from the main activity of the business, for
example, selling goods or providing a service. The business could
also transfer the sales and cost of sales directly to the profit or loss
account when preparing closing entries.
Gross profit is the portion of the sales value that is left once you have
deducted the cost of inventory sold.
Profit for the period is the amount a business makes after all other
expenses have been deducted from gross profit and all other income
(income from activities that are not part of its normal business
activities) has been added .
Something to do 11
Prepare the closing journal entries for the following post-adjustment trial
balance using both inventory systems, assuming the business uses a trading
account to calculate gross profit.
Inventory: R12 000
Sales: R7 000
Cost of sales: R6 000
Purchases: Nil
Check your answer
The journal entries at the end of the period will be the same for the perpetual method
and the periodic method. This is because both methods have the same final post-
adjustment trial balance.
6.3.2.9 Pre-adjustment and post- adjustment trial

balances
When using the periodic method, the balance on the inventory
account in the pre-adjustment trial balance will be the inventory on
hand at the beginning of the period. This account will not have been
adjusted for any increase (from purchases) or decrease (sales and
purchases returns) during the period. However, if we look at the
post-adjustment trial balance, the balance on the Inventory account
will be the inventory on hand at the end of the period.
Extract from pre-adjustment trial balance
Extract from post-adjustment trial balance
The balances on the general ledger accounts, regardless of the
recording method used, will be the same after recording the
adjusting journal entries at the end of the period. The perpetual and
periodic methods are just different ways of recording the same
transactions.
6.3.2.10 Reviewing the periodic and perpetual

inventory recording systems
Judy spent the weekend reading about the periodic and perpetual
inventory recording methods. Although she understood most of the
information, she still had a few questions. She decided to write these
down so that she would not forget to ask her accountant later in the
week.
Here is Judy's list of questions:

1. What element is the Purchases account?
2. Why would I choose to use the perpetual method of recording
inventory?
3. Why would I choose to use the periodic method of recording
inventory?
Let's look at the answers
1. The Purchases account can be an expense or an asset account.

When we use a periodic method of recording inventory, we debit the Purchases
account with the inventory purchased during the period. The total in this account
at any time will be the total inventory we have purchased during the current
period. When we sell inventory, we do not update the Purchases account.
Even though inventory purchased is an asset, we cannot say that the
Purchases account is an asset account, because some of the inventory in the
Purchases account may already have been sold. Of the total inventory bought
during the year, some is still on hand and some has been sold at some point in
time.
Some of the cost in the Purchases account relates to inventory sold (an
expense) and some of the purchase cost relates to inventory still on hand (an
asset). The Purchases account cannot be described as just one element. It does
not really matter as the adjusting entries at the year-end will correct the split
between the assets (inventory) and expenses (cost of sales).
2. If we own a large business with a large number of sales and purchases, we will
have a large quantity of inventory, and we will want to have control over inventory
in order to protect our investment. It is therefore important to know how much
inventory we hold at any time.
If we use a perpetual recording system, the Inventory account in the general
ledger provides us with the necessary information. This method gives us better
control over inventory because it allows inventory theft and losses to be identified
in good time and provides current information about inventory on hand that
assists in day-to-day decision-making.
3. If we own a small business that does not have a huge number of sales and
purchases each year, the periodic method may be preferable. The owner of a
small business is usually more involved in the day-to-day administration of the
business and so can have better control over the business assets than the owner
of a big business would have.
In a small business, the small volumes of inventory make it possible for the
owner to look in the warehouse if he wants to know what inventory is on hand
when making purchase decisions. In a bigger business, this is not possible, so the
accounting records are the only source of finding out this information.
To a small business, the benefit of knowing how much inventory is on hand is
probably not enough to outweigh the significant cost of administering the complex
accounting system needed to implement a perpetual inventory recording method.
Something to do 12
When is inventory no longer an asset?
Check your answer
An item of inventory is derecognised when:

• Inventory is damaged and cannot be sold.
• Inventory is already sold and cannot be sold in the future.
• Inventory is stolen and cannot be sold in the future.
• The market has changed and the inventory cannot be sold in the future.
With all of these examples, the inventory is no longer an asset and the cost of this
inventory becomes an expense. The inventory (asset) has been used (in the case of
inventory already sold to the customer) or lost (in the case of damaged or stolen
inventory).
6.4 Cost allocation methods −
subsequent measurement of
inventory
In anticipation of a busy Christmas season, Judy has bought more
bags for her stall. On 30 November X1, she purchased 50 bags at
R200 each and on 5 December X1, she received a further 60 bags at
R250 each. By now Judy knows a lot about recording purchases in a
perpetual recording system and she has no difficulty recording these
purchases in her general ledger.
On 7 December X1, a customer walked in and bought 70 bags,
paying the selling price of R350 each. Judy is excited by this huge
sale, but unsure how to record the sale in her general ledger. Judy
knows how to record the sales income. She also knows that she has
to debit Cost of sales with the cost price of the bags she has sold, but
is wondering what cost price to use. She thinks, “How do I know if
these bags are from the first order, costing R200 each, or from the
second order, costing R250 each? All the bags look the same to
me.”
Businesses could sell items such as a vehicle or a camera that has a
serial number or some other method that makes it easy to identify
the particular item. When this item is sold, the business can easily
identify the specific camera or vehicle that has been sold. The
business is then able to allocate the cost of that item to the profit
calculation as cost of sales (specific cost identification method).

However, many businesses sell identical items of inventory, for
example, one white t-shirt or a chocolate bar (for example, Crunchie)
looks exactly like all the other white t-shirts or Crunchies that are on
the shelf or in the warehouse. When one of the t-shirts are sold, the
business does not have a serial number per t-shirt to be able to
allocate its exact cost to the profit calculator. Businesses selling

identical items would use a cost allocation method to be able to solve
this issue in a cost effective manner.
Just as a business can choose which inventory recording method
to use, it can also decide which cost allocation method would best
suit the business to calculate the identical cost of goods sold. The
choice of cost allocation method affects the amount recognised as
cost of sales and the amount shown as inventory at period end. The
choice of method (known as our accounting policy) will result in a
statement of financial position and profit or loss, with different
portions of the inventory treated as expense (cost of sales) and as
assets (inventory). The results for the two methods will differ but
will be fair, provided that whichever method is used is consistently
applied. Remember that inventory when purchased is initially
recognised at cost. The cost allocation methods are applied when
you sell identical goods and need to allocate cost of sales, or you
need to allocate a cost per item to the inventory on hand (and the
inventory items are identical).
Let's help Judy calculate the cost of the 70 bags she has just sold.
Judy does not actually know which bags cost R200 and which cost
R250, as they are all identical. Ideally, she should work out the actual
cost of what she has sold and what she has left; this is called the
specific identification method. Judy could do this by marking each
bag with its cost price, but for businesses like hers that sell a large
number of similar items, that is not practical.
There are two methods of calculating the cost of a sale. These cost
allocation methods are called the FIFO (first-in-first-out) method and
the weighted average method.
Note:
You may have heard something about the LIFO method. This method is based on the
assumption that the inventory that was purchased last will be sold first. As this
method is not allowed by the accounting standards and is unlikely to give a good
estimate of Cost of sales, we do not discuss it further.
Go and watch Understanding cost allocation: FIFO and Weighted average:
This video explains the inventory cost allocation methods FIFO and Weighted
average.
Let’s help Judy understand the FIFO cost allocation method.
With this cost allocation method, we assume that the bags we
bought first (First In) are the bags we sell first (First Out). We make
this assumption to help us calculate a cost price to allocate to the
bags being sold.
So what has Judy purchased during the period?
30 November 50 bags at R200
X1: each
5 December 60 bags at R250
X1: each
If we use a FIFO cost allocation method, we assume the cost of the 70
bags sold to be R15 000, calculated as follows:
50 bags at R200 = R 10 000 (the 50 bags purchased on 30
November)
20 bags at R250 = R 5 000 (20 of the 60 bags purchased on 5
December)
The cost of the 70 bags is R15 000 (cost of sales) and Judy has
inventory worth R10 000 at the end of the year (40 bags at R250). The
inventory on hand is assumed to be the items purchased last.
6.4.1.1 FIFO and a perpetual recording method

Let’s prepare the general journal entries to record the purchase of
the bags in November and December using a perpetual inventory
method. Then let’s prepare the general journal entry to record the
sale of the 70 bags using the FIFO cost allocation method.
Assume that Judy counted 40 bags in the stall on 31 December X1.
The actual inventory balance on hand agrees with the theoretical
balance, and therefore no adjusting journal is required to recognise a
write down of inventory.
a) 30 November X1:
b) 5 December X1:
c) 7 December X1:
The cost of sales expense was calculated using the FIFO method in
section 6.4.1.
Judy will have 40 bags left at the end of the year. The cost of the
bags in closing inventory will be the cost of the last purchases made,
which is R250 per bag.
Inventory recognised on the statement of financial position will be
R250 × 40 = R10 000.
6.4.1.2 FIFO and a periodic recording method

the bags in November and December using a periodic inventory
sale of the 70 bags using the FIFO cost allocation method.
a) 30 November X1:
b) 5 December X1:
c) 7 December X1:
Note:
1. Purchases account instead of inventory account used when inventory is
bought.
2. The inventory account is not adjusted when inventory sold, i.e. no cost of
sales is calculated on the date of the sale.
d) 31 December X1 (the financial year-end):
Under the periodic system cost of sales is calculated at year-end.
The business will process adjusting entries to calculate the cost
of sales.
Judy counted 40 bags in the stall on 31 December X1. Using the
FIFO cost allocation method, we assume that the 40 bags left in
the stall would be the items that cost Judy R250 each. The cost of
the closing inventory is R10 000 (40 bags for R250 each).
Remember FIFO assumes that the first items in, i.e. at R200,
were the first items sold.

Remember that when we use the periodic recording method, we
calculate the cost of sales only at the end of the period. The cost
of sales is the difference between the goods that were available
for sale during the period, amounting to R25 000 (the amount
purchased during the period, as there was no inventory at the
beginning of the period) and the inventory of R10 000 on hand
at the end of the period. Therefore, we sold or lost inventory
with a cost of R15 000. This is the amount that will be
recognised as the cost of sales expense.

The weighted average method is another way to calculate how much
of the total cost of inventory is allocated to each sold unit. We
calculate an average cost over all the inventory purchases made,
weighting each purchase cost with the number of units purchased.
The greater the number of units purchased on an order, the greater
the weighting the order’s unit purchase cost will have in the
calculation of the average cost. Every time we make a purchase this
would change the weighted average purchase cost. Remember that if
“other costs” such as transport are incurred for a particular
purchase, these transport costs should be included in the calculation
of the total unit cost for that purchase.
The weighted average purchase cost for our example is calculated
as follows:
Because there were no other purchases before the sale of the 70 bags
on 7 December, we use the weighted-average cost of R227.27 to
allocate a portion of the total purchase cost of R25 000 to the 70 bags
sold.
The cost allocated to the sale of 70 bags at R227.27 = R15 909.
The inventory left after the sale will be 40 bags at R227.27 = R9
091.
Do you see that the cost of sales expense of R15 909 and inventory
on the statement of financial position of R9 091 add up to the total of
R25 000 that was spent on inventory?
Using the FIFO method, the split of the R25 000 between Cost of
sales expense (R15 000) and Inventory (R10 000) was different − the
two methods produce financial statements with different amounts
allocated to inventory and cost of sales.
6.4.2.1 Weighted average and a perpetual recording

method
the bags in November and December, using a perpetual inventory
sale of the 70 bags using the weighted average cost allocation
method.
The actual inventory balance on hand agrees with the theoretical
balance and therefore no adjusting journal is required to write down
inventory.
a) 30 November X1:
b) 5 December X1:
c) 7 December X1:
The cost of sales expense was calculated using the weighted average
method.
When we use the perpetual method, we recognise the cost of sales
expense every time we make a sale as the inventory asset account is
adjusted perpetually. When we use the weighted average method in
a perpetual recording system, we call it a moving weighted average.

The weighted average cost is recalculated with each purchase. We
need to know the weighted average cost throughout the year in
order to calculate the cost of each sale that happens.
6.4.2.2 Weighted average and a periodic recording

method
the bags in November and December using a periodic inventory
sale of the 70 bags using the weighted average cost allocation
method.
a) 30 November X1:
b) 5 December X1:
c) 7 December X1:
Note:
We do not adjust the inventory account at the time of the sale.
d) 31 December X1 (the financial year-end)
Assuming that these were the only transactions for the year:
We know that Judy counted 40 bags in the stall on 31 December
X1. Using the weighted average cost allocation method, we
calculate the cost of the 40 bags on hand. We allocate a cost to
the inventory left at the end of the year by calculating the
weighted average cost of all the purchases made during the
year. The weighted average cost per unit is R227.27. The cost of
the closing inventory is R9 091 (40 bags at R227.27 each). The
journal entry would be:
Cost of sales amounts to R15 909, which is R25 000 inventory
available to sell, less the R9 091 inventory on hand at the end of
the year.
When we use the periodic recording method, we calculate the cost
of sales only at the end of the period. We calculate the average
weighted cost only once, at the end of the year, and as it does not
keep changing during the year, it is called a simple weighted

average.
Something to do 13
Assume that Judy sold the remaining 40 bags the next year (1 January X2 to 31
December X2), and that this was the only transaction during that year (there
were no other sales, purchases or returns).
1. Explain whether there would be any difference in the accumulated profit on
the statement of financial position as at 31 December X2 if Judy had used a
FIFO cost allocation method instead of the weighted average method.
2. Prepare the trading statement for the years ended 31 December X1 and 31
December X2 to support your explanation.
Check your answers
1.
FIFO Weighted average
Accumulated pro t 31 December X2 13 500 13 500
The accumulated profit as at 31 December X2 is the same whether

we use the FIFO method or the weighted average method. Once all
the units in inventory have been sold, the accumulated profit will be
the same for both methods. This makes sense, because the total
sales and the total purchase cost are the same. Once all of the
units are sold, we can allocate to cost of sales the total purchase
cost of R25 000.
2.
Trading statement X1
Sales (70 bags at R350) 24 500 24 500
Cost of sales (15 000)1 (15 909)2
Gross profit 9 500 8 591
Trading statement X2
Sales (40 bags at R350) 14 000 14 000
Cost of sales (10 000)3 (9 091)4
Gross profit 4 000 4 909
1. 70 bags at R200
2. 70 bags at R227.27
3. 40 bags at R250
4. 40 bags at R227.27
Judy was thinking about the different cost allocation methods and
felt better because she knew how to record the sale of the 70 bags
in her general ledger.
A few days later the customer came running back into the stall
and said, “Judy, I have to return 10 of these bags as they are simply
not big enough!” Judy knew the customer well and wanted to make
sure she came back to her stall, so Judy replied, “Well, that is not a
problem. Do you want me to refund you your cash or are you going to
look for something else in the stall?”
Judy wondered how she was going to record this sales return. She
knew that she had to increase inventory but she did not know what
cost price to use for these 10 bags.
Let’s help Judy understand how to record a sales return when using
the FIFO or weighted average method.

Cost allocation methods − sales returns in a
6.4.3.1
perpetual system
When we have a sales return we increase inventory and decrease
cost of sales, reversing the original entry made when we sold the
inventory.
The adjustment to Cost of sales from a sales return must be
recorded at a cost equal to the original cost we debited to Cost of
sales when we sold the inventory. When we have a sales return and
we are using FIFO or weighted average, we have to find out when
we made the original sale.
We will use the weighted average price on the date of the original
sale or the relevant purchase price allocated on the date of the sale in
the FIFO system when recording the sales return.
Note that this sales return will trigger a recalculation of the
weighted average cost price − the inventory on hand is increased by
units at a cost price equal to the weighted average cost at which they
have been booked out.
For the FIFO method, the return is also treated as a purchase on
the return date, when determining the first-in-first-out order.
6.4.3.2 Cost allocation methods − sales returns in a

periodic system
Remember that in a periodic system, we do not adjust the inventory
for changes during the period. We do not record any inventory-
related entry for a sales return (if the client does not exchange the
item, we would record the decrease in sales income), because we
calculate the cost of sales expense only at the end of the period.
6.4.4 Cost allocation methods − purchases returns

Would the choice of cost allocation method affect the amount at
which we record a purchases return?
When we have a purchases return, we have to reduce the Inventory
account (perpetual method) or reduce the Purchases account
(periodic method). But what cost do we use as the cost for the item
we are returning?
We use the actual purchase cost paid when we originally
purchased the inventory from the supplier. The supplier will be
prepared to refund us or reverse only what we actually paid or
owed him in respect of the inventory we are returning.
We will be able to find the amount on the invoice. Therefore, it
does not matter which cost allocation method is chosen − the
purchases return amount is the same.
If a purchases return is made, it triggers a revision of the
weighted average cost or of the FIFO cost allocation if the perpetual
method is used (this would occur when the cost of the item that has
now been returned is allocated to a sale of inventory). If a periodic
system is used, no additional adjustment is required, because the
cost of sales expense is calculated only at year-end.

When do we derecognise inventory as an asset?
This will happen when:
• Inventory has been sold and cannot be sold again the future
• Inventory is stolen and cannot be sold in the future
• The market has changed and the inventory cannot be sold in the
future
• Inventory is damaged and cannot be repaired and sold.

6.6 Disclosure of inventory in the
financial statements
Judy was waiting for her accountant to deliver the annual financial
statements for her business. She was excited to see how the
business had done and was interested to see the value of her
inventory on hand at the end of the year. “I wonder where in the
financial statements I'll find how much my inventory was worth at
the end of the year?” she thinks.
Something to do 14
Do you know where Judy should look in the financial statements to find how
much her inventory was worth at the end of the year?
Check your answer
Inventory is an asset and will be on the statement of financial position. Inventory is

classified as a current asset because we intend to sell inventory and receive the selling
price or a promise to pay from customers within a year from the statement of financial
position date.
Remember that inventory should always be shown at the lower of cost or net
realisable value in the financial statements.
6.7 Selling price and cost price in more

detail
Go and watch Understanding mark-ups: This video explains the difference
between a mark-up stated as a percentage of the cost price and a mark-up
stated as a percentage of the selling price.
Businesses need to manage their sales and profits. Once again a
trade-off occurs. A higher selling price usually increases the gross
profit and therefore also the profit. However, at the same time, the
sales volume is likely to decrease − clients, for most normal
products, purchase more when goods are cheaper.
Judy did not buy any new inventory during the month because she
expected a slow month. She was very surprised when she sold all the
bags, suitcases and briefcases in the stall.
Tracey, passing by, asked Judy, “Why are you looking so worried?
You must have made a lot of sales because there is no stock left to
sell!”
Judy responded: “But what am I going to do when customers
come in tomorrow? The bags sold much more quickly than I thought,
and I did not buy new inventory.”
Tracey looked puzzled: “Oh no, how could that happen? Maybe
your selling prices are too low and people thought they were buying a
bargain? How do you determine your selling price?”
“Well, it is pretty much a guessing game − I add a certain amount
to the cost of the inventory to ensure that I make a profit. I also look
around and see what other businesses are selling their bags at and
try to keep my selling price below their price,” Judy replied.
6.7.1 Understanding the difference between the

stated mark-up and the actual gross profit
Gross profit is the actual difference between the total sales value and
the total cost of sales expense for the year. We would expect the
gross profit amount to equal the stated mark-up, as these are both
calculated as the difference between the cost price of inventory and
the selling price. The difference is that the mark-up is worked out on
a normal per unit cost price and results in a normal per unit selling
price. Gross profit is the difference between the actual total sales
value and the actual cost of sales expense for the year.
The total sales value may include sales of units not sold at the
normal selling price. Judy could give a trade discount or have a
seasonal sale, and sell bags at a lower selling price than the normal
selling price.
The total cost of sales for the year includes the cost of stolen and
damaged inventory. Cost of sales has increased by the cost of this
inventory, but because it was not sold, there is no increase in the
total sales value.
For these reasons, the difference between total sales and total cost
of sales in the statement of profit or loss and other comprehensive
income (the gross profit) is not necessarily the same as the difference
between the normal cost price per unit and the normal selling price
per unit (the mark-up).
The actual gross profit is not always the same as the gross profit
we expect from the stated mark-up we used during the year. The
first uses the actual amounts for sales and cost of sales at year-end,
while the second uses theoretical amounts for these items.
Something to do 15
A business has a normal mark-up percentage on selling price of 33.33% (this
is the same as a 50% mark-up percentage on cost price).
The following information is applicable for the financial year:
• Sales: 100 000 units (selling price per unit, R150 (excluding VAT))
• Units stolen: 1 000 units
• Units purchased during the year: 101 000 units
• Opening and closing inventory: Nil
Calculate the unit cost price and the gross profit percentage.
Check your answers
a) Calculation of unit cost price
Selling price per unit 150

Less: Mark-up (33.33% of the selling price = R150 × 33.33%) (50)
Cost price per unit 100
b) Calculation of gross profit percentage

• Gross profit calculation:
Sales (100 000 × R150) 15 000 000

Cost of sales (101 000 × 100) (10 100 000)
Gross profit 4 900 000
• Gross profit percentage calculation:
Gross profit = gross profit / sales

percentage
= 4 900 000 / 15
000 000
= 32.67%
The gross profit percentage shows that 32.67% of the total sales made during the year
remained as profit after deducting the total cost of the inventory sold. We expected to
make a gross profit of 33.33% because we used a mark-up percentage of 33.33% on
sales (50% on the cost of inventory) when setting the normal selling price per unit. Why
is the actual gross profit percentage lower than the expected gross profit percentage?
The cost of the units stolen (1 000 × R100) was allocated to Cost of sales,
increasing the total cost of sales with no increase in the total sales value. This lowers
the gross profit percentage by
0.67% (100 000 / 15 000 000), which equals the difference between the gross profit
percentage and the mark-up percentage on selling price.
6.7.2.1 Cost plus method

The most common method of calculating a selling price is the cost
plus method. The owner calculates what it costs the business to
purchase inventory. Any cost closely linked to preparing the
inventory for sale or placing the inventory at the location of sale is
part of the cost of inventory. We use the total cost of inventory to
calculate a selling price, using a mark-up percentage. Once the total
cost is known, Judy decides how much gross profit is needed to
cover all the other operating expenses and still have a profit that is
an acceptable return on the time and capital invested in the business.
The cost price will then be “marked up” to a selling price that will
cover the expenses and provide this profit. Another factor to take
into account when setting the selling price is how much the public is
prepared to pay for the item being sold.
Mark-up is the difference between the normal selling price per unit
and the normal cost per unit.
Mark-up percentage is the percentage that is added to the cost price

of inventory to calculate the selling price.
The mark-up the owner calculates can be expressed as a percentage
of the sales amount ( mark-up on sales) also refered to as the gross

margin or as a percentage of the cost price of inventory ( mark-up on
cost).
Mark-up percentage on cost = (selling price − cost price) / cost price

× 100%
Mark-up percentage on selling price = (selling price − cost price) /
selling price × 100%
The mark-up on cost quotes gross profit as a percentage of the cost
price. Mark-up on selling price quotes gross profit as a percentage of
selling price.
Let’s look at an example.

What is the ratio between selling price, cost price and gross profit
for the following:
1. A mark-up on cost of 40%
2. A mark-up on selling price of 40%
Answer:
1. SP 140%
CP 100%
GP 40%
2. SP 100%
CP 60%
GP 40%
Can you see that in the first example, cost is 100% (as mark-up is
quoted on cost). In the second example, selling price is 100% (as
mark-up is quoted on selling price.)

Something to do 16
Let's see how Judy calculates the selling price of her bags, suitcases and
briefcases now that she understands the cost plus method.
Judy calculated the following mark-up for each product line by looking at what
running costs she has to cover and how much profit she would like to earn from
the business for the year:
• Bags: 75% on cost
• Suitcases: 50% on cost
• Briefcases: 60% on cost
The cost of each of Judy's products is:
Bags: R200 each
Suitcases: R400 each
Briefcases: R250 each
Calculate how Judy uses her mark-up policy to set the selling price for each
product.
Check your answers
Using her mark-up percentages, she calculates the selling prices as:
• Bags: 200 + (200 × 75%) = R350
• Suitcases: 400 + (400 × 50%) = R600
• Briefcases: 250 + (250 × 60%) = R400
Something to do 17
What if Judy uses the following mark-up percentages?
• Bags: 75% on selling price
• Suitcases: 50% on selling price
• Briefcases: 60% on selling price
What is the selling price per product?
Check your answers
6.7.2.2 Market research

In Japan, business managers use a different method to set a selling
price. They perform market research and find out at what price the
customer would buy their product and not a similar product from
someone else. Once they have established this selling price, the
managers decide what profit would make selling the product a
worthwhile venture. The selling price less this profit results in the
maximum amount that can be spent on inventory costs and running
costs. The managers then focus on controlling the costs so that they
do not spend more than the maximum cost allowed for making the
target profit. This method controls costs better than the cost plus
method of determining selling price. With the cost plus method, we
accept the current costs of the business and then add on the profit
we want. With the alternative method, we decide what profit we

want the business to make and then control the costs so that this can
happen.

• Inventory is an asset that is purchased with the intention of
selling it in the ordinary course of business.
• Inventory is recognised on the date that the asset definition and
recognition criteria are met.
• The cost of inventory includes the purchase cost and any other
cost necessary to get the inventory to the conditions and location
necessary for sale.
• How to account for trade and settlement discount.
• Inventory can be recorded in the general ledger using two
different recording methods: the perpetual method and the
periodic method.
• The inventory account is adjusted during the year for all
movements in inventory when the perpetual system is used.
• The inventory account is adjusted only at the end of the period for
movements in inventory when the periodic system is used.
• Inventory should be shown on the statement of financial position
at the lower of cost and net realisable value.
• The cost of inventory that is allocated to each unit when inventory
is sold is estimated using a cost allocation method.
• The cost allocation methods include FIFO and weighted average.
• Gross profit is the difference between sales and cost of sales, and
profit for the period is the difference between all income received
and all expenses incurred.
• The selling price is usually calculated by adding on a percentage
to the cost price − this is called “mark-up”.

• We know the difference between mark-up percentage on selling
price and gross profit percentage.
What's next?
In the next chapter we will learn about how VAT (value added
taxation) is calculated, recorded and recognised in the financial
accounting records of a business.

QUESTIONS
QUESTION 6.1 (A)

On 1 March 20X2 Green Traders purchased 40 solar powered radios
on credit at R125 each from Keep it Green, an Angolan-based
retailer. Green Traders paid import duties of R20 per radio and total
transport costs amounting to R1 200. The goods arrived at Green

Traders store on 15 March 20X2 and the owner hired a part-time
employee to unload and pack the radios on the shelves. The
employee is paid R1 per radio. If any cost item indicated above is not
included in the total cost calculation, briefly explain why.
1. Calculate the total cost of one radio to Green Traders. (3 marks)
2. On 31 March 20X2, Green Traders sent 20 radios to Solar Savers

on consignment. Green Traders allows for a commission of 15%
on the selling price of the goods. Solar Savers informs Green
Traders of the monthly sales on the last day of each month and
pays Green Traders for any radios sold on the 15th of the next
month. During April 20X2, Solar Savers sold 12 radios for R325
cash each.
a) Prepare any journal entry/ies that would be recorded by
Green Traders on 30April 20X2. Ignore closing entries.

Ignore narrations and dates. (5 marks)
b) What amount, if any, would appear on the statement of
financial position for Solar Savers as at 30 April 20X2 with

respect to the radios indicated in point 2above? Briefly
justify your answer. (2 marks)
QUESTION 6.2 (B)

Mal Wart is a retailer buying and selling hand-made soap bars. The
financial director has adopted a perpetual system to record
inventory and decided to use the First-In First-Out (FIFO) method to
assign costs to the inventory sold. On 28 February X0, Omniscient
Oscar, the bookkeeper, presented the financial director with the
following incomplete general ledger accounts for the period 1
January X0 to 28 February X0.
Additional information:
A physical inventory count performed on 28 February X0 revealed
that only 280 units were on hand.

1. Prepare the cost of sales account, using the FIFO method, as it
should appear in the general ledger for the period 1 January X0
to 28 February X0. (Contra details must be shown.) (5 marks)
2. Calculate the cost of sales if the weighted average method is
used to assign costs. (8 marks)
3. Prepare the general journal entry to bring into account the
difference between the theoretical inventory and the physical
inventory as per the count at 28 February X0 (assuming the
FIFO method was used). (2 marks)
QUESTION 6.3 (C)

Isipho is a gift store that sells goods both for cash and on credit.
Customers are offered a cash discount of 5% on their purchases. To
increase sales, the business has started selling gift vouchers valued at
R100 and R200. The gift vouchers can be redeemed only for
merchandise. The business uses the periodic method to record
inventory and has a gross profit margin of 25% on sales.
The following balances, inter alia, appeared in the books of Isipho

as at 1 January X0:

Inventory 17 200
Capital 57 000
Allowance for Doubtful debts 800
Bank 30 000
The following is a summary of the transactions that occurred during
the year ending 31 December X0:
a) Cash sales for the year (net of discount) amounted to R42 000.
b) Credit sales for the year amounted to R60 000. The business
provides for doubtful debts of 2% of credit sales. Trade
Receivables amounting to R22 000 were outstanding at 31
December X0.
c) Cash purchases amounting to R50 000 and credit purchases
amounting to R45 000 occurred during the year. Trade Payables
amounting to R18 000 were unpaid at 31 December X0.
d) Gift vouchers amounting to R35 000 were purchased by
customers during the year and were recorded as “unredeemed
vouchers” in the general ledger. Vouchers amounting to R22 500
had been redeemed as at 31 December X0.
e) Isipho imports some of the inventory. Import duties amounting

to R14 000 were charged during the year ended 31 December
X0. R4 000 of this amount has, as yet,not been paid.
f) A debtor returned inventory with a selling price of R5 000, as it
had been damaged while being transported. On investigation it
was discovered that the item was of an inferior quality, and
Isipho returned the goods to its supplier and received a credit

note.
g) A physical inventory count indicated that inventory amounting
to R32 575 was on hand as at 31 December X0.
h) A shipment of inventory costing R8 500 purchased on 1
December X0 FOB shipping point is scheduled to arrive at the
warehouse on 4 January X1.

1. Process the journal entries (in general journal format) to record
the transactions occurring in points (a), (b) and (c) above.
2. The owner is unsure how transaction (d) would affect (14 marks)
the financial statements of the business. Explain, in detail, how
the unredeemed gift vouchers should be recorded in the books
of Isipho as at 31 December X0. (9 marks)
3. Prepare the journal entry (in general journal format) to record
the transaction in point (d) above AND record the adjusting
journal entry that would need to be processed as at 31
December X0. (4 marks)
4. Prepare the Statement of profit or loss and other comprehensive
income of Isipho for the year ended 31 December X0 in order to

calculate gross profit. (12 marks)
5. Isipho has been offered a consignment of goods for R20 000 (this
is a 50% discount on the normal price of the goods). Isipho
would have to pay cash for the consignment. Other expenses
amounting to R32 000 were paid in cash and only the telephone
and electricity of R1 000 for December X0 were outstanding.
Calculate whether Isipho is able to take advantage of the above

offer. (11 marks)
Judy's application for a loan was successful. She has moved to the stall at
the Waterfront and her business has been growing steadily. She is making
a good profit and her turnover (sales) has increased. She is a little
concerned about a tax called value added tax (VAT) that she has heard
other stallholders talking about. Judy has a number of questions regarding
VAT that she would like to have answered. “Will VAT affect my business? I
am not sure what VAT is all about! How is VAT calculated? Is it yet another
tax that my business must pay?”
Learning objectives
• Understand Judy's problem
• Understand what VAT is
• Know how to record VAT in the books of the business
• Understand how VAT affects the financial statements of a business.
How are we going to help Judy solve her problems?

Let’s start by answering Judy’s questions about VAT.
7.1 What is VAT?

The VAT system is a consumption tax. It is charged on the majority of goods
and services used by consumers. VAT is collected throughout the
production and distribution channel and is included in the marked selling
price.
All businesses, including manufacturing and distribution businesses,
must register for VAT if their earnings are high enough. This is an effective
tax collection system which enables the government to reduce other taxes
that individuals and businesses are required to pay. As of 1 April 2018 the
value added tax (VAT) rate increased by 1%. VAT is currently charged at
15%. We will look at how VAT is collected later on in the chapter (section
7.4).
As individuals, we pay VAT whenever we purchase goods and services.

Look at the till slip below.
The difference (R26.99) between what the customer pays (R29.69) and the
VAT amount (R2.70) belongs to the business. This amount (R26.99) will be
recognised as sales income.
7.1.1 Tax invoice

The source document below is another example of a tax invoice. This
invoice shows that VAT is charged on the service provided or the goods
sold. A tax invoice is a source document that shows the value of an
exchange (including VAT).
If we compare this source document to others we have dealt with, certain
additional information will appear on the tax invoice:
1. The VAT number of the company issuing the source document.
2. The current VAT rate ( 15% in South Africa at present).

3. The VAT added to the value of the transaction.
NOTE: 15% VAT INCLUDED IN ALL ITEMS
The tax invoice (source document) above shows that VAT is calculated by
multiplying the amount being paid for the advertisement (R300) by the tax
rate (15% or 15 ÷ 100).
The amount that the customer must pay equals R300 + (300 × 15%) = R300 +
R45 = R345 or R300 × 115%
The client in the above example will pay The Daily Reviewer R345.
The Daily Reviewer keeps the R300 (the amount charged for the service) and
pays the R45 (VAT) to SARS.
Did you know?

Food items we don't pay VAT on are called zero-rated or exempt supplies. Here is a
list of those foods.
Zero-rated and exempt supplies

The following goods and services are zero-rated:
• Exports
• 19 basic food items
• Illuminating paraffin
• Goods which are subject to the fuel levy (petrol and diesel)
• International transport services
• Farming inputs
• Sales of going concerns, and
• Certain grants by government.
Basic foodstuffs zero rated in South Africa:
• Brown bread
• Maize meal
• Samp
• Mealie rice
• Dried mealies
• Dried beans
• Lentils
• Pilchards/sardinella in tins
• Milk powder
• Dairy powder blend
Source: [onnline]. Available at: <www.moneywebtax.co.za/moneywebtax/view/
moneywebtax/en/page267?oid=14223&sn=Detail>
Government has proposed that white bread, cake flour and sanitary pads
should be included in the basket of zero-rated VAT items. There has also
been considerable pressure to include chicken products in the basket of
zero-rated items as chicken is an important source of protein for families.
7.2 When does a business register as a VAT

vendor?
Did you know?

A business can voluntarily register to become a VAT vendor if the business has a turnover
of more than R20 000 in the last 12-month period. This minimum requirement will be
lifted to R50 000 in 2010.
If your business turnover (sales amount) is likely to be more than R1 million
per year, by law you have to register for value added tax (VAT).
Judy’s business has grown, and her income from sales (turnover) is more
than R1 million in a year. This means that she will have to register her
business with SARS as a VAT vendor and she will be issued with a VAT
registration number. She will have to complete a VAT return every four
months. Once registered, Judy will have to charge customers VAT on the
goods she sells. This means that the price Judy sells her goods at will
increase because she will have included the VAT amount. The prices
marked on goods in a shop usually include VAT calculated at the standard
rate of 15%. Judy’s business will collect VAT from the customers when they
pay for the goods or services she provides. She will have to pay the VAT
over to the South African Revenue Service (SARS).
Did you know?

SARS announced a new tax system for small businesses at the beginning of March 2009.
This system aims to eliminate the time, costs and frustrations small businesses experience
with tax returns. The new system will be applicable only to those entities whose turnover is
up to R1 million. This tax will be known as turnover tax and will replace income tax,
provisional tax, capital gains tax, secondary tax on companies, and value added tax.

When the business sold shampoo for R20.70 this amount is VAT inclusive,
which means that the selling price includes VAT.
Let's calculate the VAT portion of the sale.

The VAT inclusive selling price is 100% of what we wish to earn plus VAT.
R20.70 = 115% (100% sales + 15% VAT)
VAT = R20.70 × 15/115 = R2.70
Sales = R20.70 × 100/115 = R18.00
Amount business recognises Amount SARS receives Amount

as sales as VAT customer pays
100% + 15% = 115%
R20.70 × 100/115 R20.70 × 15/115
R18.00 + R2.70 = R20.70

Value added tax is charged at each point in the production and distribution
channel. In the example below there are three businesses that have to collect
VAT on behalf of SARS. They are the fisherman, the fish factory and the fish
shop. For this example, we are assuming that all the businesses are VAT
vendors and that VAT is 15%.
1. The fisherman wants to earn R100 for the fish he sells to the factory. As
he is a registered VAT vendor, he has to add VAT at 15% on to his
price. This means that the factory pays R115 (R100 + 15% = R115). The
fisherman will record the transaction in his books by debiting Bank
with R115 (the amount of money he has received), crediting Sales with
R100 (the amount of money he has earned) and crediting SARS with
R15 (the fisherman has collected R15 on behalf of SARS). The VAT does
not belong to the fisherman and is owed to SARS. The fisherman will
recognise the R15 VAT amount as a liability until it has been paid over
to SARS.
SARS receives R14 in VAT from the fisherman.

2. The factory purchased the fish for R115. The actual cost to the factory of
the fish is R100. As the factory is registered as a VAT vendor, the
factory will initially pay VAT when it buys the fish, but will claim the
VAT back from SARS. When the fish is purchased, the factory will
record the transaction in its books by crediting Bank with R115 (the
amount of money paid to the fisherman). It will debit Inventory with
R100 (the actual cost to the factory) and debit SARS with R15 (although
the factory has paid the VAT, it will claim the VAT back from SARS).
The SARS account is debited because it is an asset to the business, as the
R15 will be recovered (claimed back) from SARS.
3. The factory processes the fish (and in so doing adds value to the
product). The fish is sold to a fish shop for R230. The factory will debit
Bank with R230 (the amount received from the fish shop), credit Sales
with R200 (the amount the factory actually earned − R230 × 100/115),
and credit SARS with R30 (the R30 is owed to SARS so it is a liability to
the factory − R230 × 15/115 or R230 − R200). The factory received R30
on behalf of SARS and paid R15 VAT during the production process.
The factory will pay R30 − R15 = R15 to SARS. The R30 is known as
output VAT as it is based on the sales (output) of the business. The R15 is
known as input VAT as it is based on the costs incurred (inputs used) in
producing the output.
SARS receives R15 in VAT from the factory.

4. The fish shop purchased the fish for R230. The actual cost to the fish
shop is R200. The additional R30 paid is VAT. When the fish is
purchased, the fish shop will record the transaction in its books by
crediting Bank with R230 (the amount of money actually paid to the
factory). It will debit Inventory with R200 (the actual cost to the fish
shop) and debit SARS with R30 (the fish shop will claim back the VAT
paid).
5. The fish shop adds value to the product and sells it to a customer for
R345. The fish shop will debit Bank with R345 (the amount received
from the customer), credit Sales with R300 (the amount the fish shop
actually earned), and credit SARS with R45 (the R45 is owed to SARS,
so it is a liability to the fish shop). The fish shop received R45 on behalf
of SARS and has paid R30 VAT during the production process. The fish
shop will pay R45 − R30 = R15 to SARS.
SARS receives R15 in VAT from the fish shop.

6. Once the fish has been sold to the customer, SARS has received total
VAT of R45 (R15 from the fisherman + R15 from the factory + R15 from
the fish shop). VAT has been received at each stage of the process. The
VAT received at each stage is based on the value that has been added − the
difference between the sales price (output) and the cost of sales (input).
As R100 value was generated at each stage, R15 VAT was paid to SARS
at each stage. If one of the businesses mentioned above was not
registered for VAT, SARS would still receive a portion of the VAT
owing. If the fish shop was not registered, SARS would have received
only R30.
What would the profit calculation for the factory look like?
Sales 200.00
Cost of sales (100.00)
Pro t 100.00
What do we notice? Neither the income nor the expense includes VAT.
VAT return − factory
Output VAT 30.00

Input VAT (15.00)
Amount paid to SARS 15.00
7.5 Is VAT another tax that my business must

pay?
Provided that the business is registered for VAT, VAT is not a tax on the
business. The business is acting only as a collection agent for SARS.
Although the selling price and the cost price of most goods and services
purchased and sold include VAT, the VAT is paid over to or claimed from
SARS. So although a VAT vendor will pay input VAT when purchasing
inputs, this is claimed back from SARS and output VAT collected from
customers is paid over to SARS. In reality, the business completes a VAT
return form and pays or claims the difference between the output VAT
collected and the input VAT paid.
You and I as consumers who are not registered as VAT vendors are
actually paying the tax (the fish that we bought from the fish factory for
R345 would have cost R300 if VAT had not had to be paid).
VAT return − fish shop
Output VAT R45.00

Less Input VAT (R30.00)
Amount paid to SARS R15.00
Something to do 1
If a restaurant registered for VAT purchased fish for R345 from the fish shop, what is
the cost incurred by the restaurant?
If you bought fish for R345 from the fish shop and cooked it for a dinner party at home,
what is the cost to you of the fish?
Briefly explain why the amounts in the answers differ.
Check your answer
The restaurant is a registered VAT vendor and will claim back VAT amounting to R45. The
balance (R300) is the cost to the business.
You and your friends are the final consumers of the fish. As you are not registered for VAT
purposes, you will not be able to claim back the VAT paid and therefore the full R345 is a cost to
you.
The two amounts differ as the restaurant is a registered VAT vendor, and is not the final
consumer of the fish, whereas you are not registered for VAT and you are the final consumers of
the fish (you do not plan to resell the fish).
7.6 How does VAT affect the records of a

business?
A business could use two accounts, input VAT and output VAT accounts, or
the business could use a single SARS (VAT) account to record the various
input VAT and output VAT transactions.
The balance of R15 is owed to SARS. The VAT account is a current
liability and will appear on the statement of financial position.
For a VAT-registered business the VAT paid or received is neither an
expense, nor an income.
Something to do 2
Assume VAT of 15%.
The following transactions occurred during April X1. Prices that are quoted are
inclusive of VAT unless otherwise stated:
• Purchased inventory on credit from Clothes Suppliers Ltd, R1 403, paid by cheque
• Paid wages, R4 560
• Sold inventory for cash, received R1 771
• Purchased stationery for R575, paid by cheque
Record the transactions in the general ledger of Jessica Stores.
Check your answers
VAT calculations
1. 1 403 × 100/115 = 1 220 [inventory amount]
1 403 × 15/115 = 183 [VAT amount] − cash paid is inclusive of VAT
2. VAT is not paid on wages. The amount of R4 560 therefore excludes VAT
3. 1 771 × 100/115 = 1 540 [sales amount]
1 771 × 15/115 = 231 [VAT amount] − cash receipt is inclusive of VAT
4. 575 × 100/115 = 500 [stationery expense amount]
575 × 15/115 = 75 [VAT amount]
We can see that VAT has not been charged on wages. This is because employees
pay personal income tax on the wages they earn.
Let’s see what Judy’s records would look like if VAT of 15% had been charged on
all goods and services. These transactions are the same as those used at the
beginning of Chapter 2, except that where relevant the amounts include VAT.
Something to do 3
Compare this information to the information given at the beginning of Chapter 2.
1. Identify which amounts have changed.
2. Identify which amounts have not changed.
3. Explain why you think the amounts identified in point 2 above have not changed.
4. Do you think that Judy is earning more money on the sale of her goods? Explain
your answer.
Check your answers
1. Sales, Cellphone, Trestle table, Inventory, Rent, Talk-time, Stationery, Drawings. These are
most of the goods and services that were either purchased or sold.
2. Capital, Loan, Petrol, Wages
3. The loan and capital represent money invested in the business and do not represent the
purchase of goods or services, so VAT is not charged on these transactions. Petrol is a zero-
rated product, so no VAT is charged on the purchase of petrol. Employees pay personal
income tax on the wages that they earn, so no VAT is charged on wages.
4. No, Judy will earn exactly the same amount of money on each sale. Look at the transaction
on 2 January. Judy sold 2 briefcases and received R690. This amount includes the output
VAT she is collecting on behalf of SARS. The VAT amount equals R90 (690 × 15/115) and
the sales amount is still R600 (690 × 100/115).
7.7 Recording VAT
Something to do 4
1. Record the following transactions in the general journal. 1 Purchased 30 large
briefcases with front pouch 4 140.00
2. Record Judy's information given above in the general ledger and balance all the
accounts.
3. Extract a trial balance.
4. Prepare the statement of comprehensive income for Handbags for Africa for
January X2.
5. Prepare the statement of financial position for Handbags for Africa for January X2.
Check your answers
See sections 7.7.1, 7.7.2, 7.7.3, 7.7.4 and 7.7.5 below for the answers to the five questions above.
What do we notice in the journal entry above?

The cost of the inventory purchased of R3 600 is recorded exclusive of VAT.
The VAT is recognised as an asset when the inventory is purchased because
even though the business (Handbags for Africa) pays VAT when they
purchase the briefcases, they will claim the VAT back from SARS. The bank
amount is inclusive of VAT because the business initially pays the VAT
inclusive amount and then claims VAT back at a later stage. Remember that
VAT is not an expense (cost) to the business. The inventory will be
recognised at R3 600 as this is the actual cost to the business of purchasing
the briefcases.

The sales income of R600 is recorded exclusive of VAT. The VAT is
recognised as a liability when the inventory is sold. Although Handbags for
Africa receives R690, R90 is owed to SARS. Remember that Handbags for
Africa, as a VAT vendor, is an agent of SARS and they collect VAT from
their clients (on behalf of SARS) and pay the VAT over to SARS. Handbags
for Africa earns (and recognises as sales) the R600 − the VAT-exclusive
amount.

The cost of the inventory purchased (R600) is recorded exclusive of VAT.
The VAT is recognised as an asset when the inventory is purchased even
though the business (Handbags for Africa) owes the creditor the VAT they
will claim back from SARS. The trade payables amount is inclusive of VAT
because the business will pay the VAT-inclusive amount and then claim
VAT back at a later stage. Remember that VAT is not an expense (cost) to
the business. The inventory will be recognised at R600 as this is the actual
cost to the business of purchasing the handbags.

The sales income of R1 380 is recorded exclusive of VAT. The VAT is
recognised as a liability as soon as the inventory is sold. Although
Handbags for Africa is owed R1 587, R207 of this is owed to SARS.

Remember that Handbags for Africa, as a VAT vendor, is an agent of SARS
and they collect VAT from their clients (on behalf of SARS) and pay the
VAT amount over to SARS. Handbags for Africa earns (and recognises as
sales) the R1 380 − the VAT-exclusive amount. The business will also
recognise the trade receivables at R1 587, as this is the amount the debtors
will need to pay (the sales amount and the VAT).
Did you notice?

The cost of the cellphone and trestle table recognised as an asset is the VAT
exclusive amount:
Did you know?
Instead of having a single SARS (VAT) account, the business could have separate input
VAT and output VAT accounts that are closed off to the SARS (VAT) account.
Did you notice?

All the income and expense accounts are VAT-exclusive. The VAT amount received or
paid is neither income nor an expense.
What do you notice?

1. Judy cannot claim input VAT back on the clothing she bought for
herself (drawings), as she is the final consumer of the clothing.
2. Judy can claim input VAT back on the rent, talk-time and stationery.
Although she is using them, they are being used in running the
business and this means that she is not the final consumer.
3. When Judy pays interest on the loan, VAT will not be charged. This is
because income tax is paid on interest earned. A portion of the interest
earned by individuals is free of tax. This is to encourage individuals to
save.
4. The income accounts, expense accounts and assets that were purchased
are recorded in the ledger at the VAT exclusive amounts. VAT does not
increase the cost of assets or of expenses as the VAT can be claimed
back. VAT does not increase the income earned as the VAT amount has
to be paid over to SARS.
5. The SARS (VAT control) account has a debit balance. It will appear on
the statement of financial position as a current asset. This means that
Judy’s business has paid more input VAT than it has received in output
VAT.

Capital 8 000.00
Drawings 783.00
Loan 2 000.00
Cellphone/Equipment 1 200.00
Trestle table/Furniture 950.00
Trade payables 1 380.00
Bank 3 384.65
Stationery on hand 200.00
Prepaid petrol 300.00
Prepaid talk-time 440.00
Deposit 120.00
SARS (VAT) 263.85
Inventory 1 860.00
Sales 6 711.00
Cost of sales 2 940.00
Rent expense 1 000.00
Wages 600.00
18 211.00 18 199.00
ended 31 January X1
7.7.5 Statement of financial position as at 31 January X1

Assets
Non-current assets
Furniture and Equipment 950.00
Cellphone 1 200.00
Current assets
Inventory 1 860.00
Bank 3 384.65
SARS (VAT) 263.85
Equity
Capital 8 000.00
Accumulated pro t [1 231.00 − 778.80] 386.20
Non-current liabilities −
Loan 2 000.00
Current liabilities
Trade and other payables 1 380.00
Deposit for bags 120.00
Note:
Depreciation has been ignored in this question.
Did you know?

To be able to claim input VAT, an invoice must be provided. The invoice must among
other information contain the following:
The words: tax invoice
Name, address and registration number of supplier
•
An individual serial number

•
Date of issue
•
Quantity and description of goods/services supplied

•
Amount of purchase and VAT amount.

•
Something to do 5
Review the questions below and attempt to answer them.
1. What is output VAT?
2. What is input VAT?
3. On what sort of items is VAT levied?
4. Can you think of any items on which VAT is not levied?
5. Is inventory recorded inclusive or exclusive of VAT in the statement of financial
position? Explain your answer.
6. Why are expenses and income recorded as VAT exclusive?
7. Are receivables (debtors) and payables (amounts owed to suppliers) inclusive or
exclusive of VAT?
Check your answers
1. Output VAT is charged by businesses on the sale of goods or services. The tax is collected
on behalf of SARS.
2. Input VAT is paid by businesses to their suppliers. The VAT is charged on goods (inventory) or
services (telephone, electricity). The input VAT is claimed back from SARS.
3. VAT is levied on all goods and services in South Africa unless the item is deemed an
essential product by the government and is therefore zero rated.
4. Government bread, maize, taxis, residential rental, salaries, wages and interest. Salaries,
wages and interest do not have VAT levied on them because personal income tax is levied
on all of them.
5. The actual cost of inventory to a business is the VAT-exclusive amount. The VAT is claimed
back from SARS. Inventory is recorded in the statement of financial position at the VAT
exclusive price.
6. The income and expense accounts that appear on the statement of comprehensive income
of a business are VAT exclusive. Input VAT (charged on expenses) can be claimed back from
SARS, therefore the actual cost to the business is the VAT-exclusive amount. Output VAT
(received on income) has to be paid to SARS, therefore the actual income to the business is
the VAT-exclusive amount.
7. The customer is obliged to pay the marked selling price including VAT, and therefore the
receivables and payables will be inclusive of VAT.
Think about this

Pay careful attention to the way in which information is worded in order to decide whether
the amount includes or excludes VAT. Amounts for sales, costs and expenses exclude VAT,
whereas cash received and cash paid for goods include the VAT portion.
Something to do 6
Indicate which of the following amounts would include VAT:
1. Selling price displayed in a shop
2. Sales disclosed in a statement of comprehensive income
3. The cash paid to a supplier for raw material
4. The figure for trade receivables (also known as receivables)
5. Cost of sales expense
6. Inventory on the statement of financial position
7. Trade payables (also known as payables).
Check your answers
Includes VAT:
1. Selling price
3. Cash paid to supplier
7. Trade payables
Excludes VAT:
2. Sales
5. Cost of sales expense
6. Inventory on the statement of financial position

During lunch Judy chatted to James, one of the other stall owners. “I didn't
realise that my cost of inventory should include transport and other costs.
The bags I purchased in Durban have an inventory cost of R230, because I
paid R30 transport cost in addition to the R200 purchase price. Did you
know that?”
James replied in surprise: “Are you not a registered VAT vendor?”
“Of course I am,” Judy replied. “My business has been performing quite
well and I was required to register.”
“But in that case you should deduct the input VAT you paid on inventory to
arrive at your cost!” James exclaimed.
Let’s help Judy to understand the proper treatment of VAT when
determining the cost of inventory.
Remember that VAT is a tax that a business (if it is registered as a VAT
vendor) collects from customers and pays to SARS. A registered VAT
vendor charges VAT on sales (by including it in the selling price) and pays it
over to SARS ( output VAT). The business can claim back the VAT the
business has to pay on costs and expenses we incur to run the business.
Judy can claim the VAT back from SARS on the date we purchase the
inventory, provided we are in possession of a tax invoice for the purchase.

As the input VAT charged on the inventory is refunded to Judy by SARS,
the VAT portion of the purchase price is not a cost to Judy. The cost of
inventory, shown either in the Inventory account (if unsold) or the Cost of
sales account (if sold), does not include input VAT.
Let's apply this knowledge to Judy's Durban bag example.

If the supplier is a VAT vendor, Judy would have paid VAT on the purchase
price of the bags. Assume that the R200 includes VAT. The amount of input
VAT would have been R200 × 15/115 = R26.09. Judy would also have paid
VAT on the transport cost. Assuming that VAT was included in the
transport cost of R30, it would have amounted to R30 × 15/115 = R3.91.
Therefore, the cost of inventory would be R200 (R230 × 100/115) per bag.
If Judy is not a registered VAT vendor, then she will not be refunded the
input VAT, and the amount paid for the inventory (including the input
VAT) is a cost to her. Therefore, the cost of inventory would be R230 per
bag.
The detail of the required general ledger entries is discussed later in the
chapter.
The treatment of VAT on inventory purchases and sales was discussed
above. Let’s see if you can prepare the journal entries, using both the
perpetual and the periodic systems. Assume that the business is a VAT
vendor and that the VAT rate is 15%.

Prepare the journal entries to record the credit purchase of inventory for
R115 (VAT inclusive), assuming the perpetual method. Assume that the
supplier gives a settlement discount of 10% if the amount is paid within 30
days. Based on past experience, our business would pay within the required
time to qualify for the discount. We paid on 31 January X1.
The inventory was sold for cash at R230 (VAT inclusive).
1. On the date of delivery:

We debit the SARS (VAT) account because input VAT is an asset. The cost of
inventory is R90. When our business purchased the inventory, it was
probable that we would take the discount. The liability is recognised at the
amount of consideration received. The business receives inventory of R90 on
which VAT of R13.50 is charged. A liability of R103.50 is shown. The
inventory is recognised at the cost of purchase (R90) and a VAT asset of
R13.50 is recognised.
2. On the date of payment:
3. On the date of sale:
We credit the SARS (VAT) account because output VAT is a liability
and needs to be paid over to SARS.

Assume the same information as above. Prepare the journal entries,
assuming a periodic method.

1. On the date of delivery:
2. On the date of payment:
3. On the date of sale:
No entry reducing inventory is processed.
If Judy was not a registered VAT vendor, inventory would have been
debited with R103.50. The R103.50 would be the actual cost of
purchasing the inventory as Judy would NOT be able to claim back the
input VAT.

• VAT is charged on most goods and services purchased in South Africa.
Businesses earning more than R1 million are required to register as VAT
vendors and assist SARS in collecting VAT from customers.
• VAT in South Africa is currently levied at 15%.
• Input VAT is charged on most inputs (costs incurred by the business) and
output VAT is charged on most outputs (sales) of a business.
• Income and expense amounts appearing in the statement of profit or loss
and other comprehensive income of a VAT vendor are VAT-exclusive.

This is because a VAT vendor is a collection point for SARS. The vendor
will pay over the output VAT it collects and claim back the input VAT it
has paid.
What's next?
Useful web sites
SARS: <www.sars.co.za>
SAICA: <www.saica.co.za>
Moneyweb: <www.moneyweb.co.za>
(See “When should you be paying VAT, and when shouldn't you?” 3 November 2008, by
Stephen Jones.)
Moneywebtax: www.moneywebtax.co.za/moneywebtax/view/moneywebtax/en/page267?
oid=31598&sn=Detail>
<www.moneywebtax.co.za/moneywebtax/view/moneywebtax/en/page267?
QUESTIONS
QUESTION 7.1 (A)

Assume a VAT rate of 15%.
All parties are registered VAT vendors and assume, where necessary, that
amounts are inclusive of VAT .
Africurios Traders Africurios Traders uses the
buys and sells African crafts.
periodic inventory method to record inventory. On 1 March 20X2, Africurios
Traders had a R79 000 (Cr) balance on its SARS (VAT) account. The
following transactions took place during the month ended March 20X2:
Day
5 Africurios Traders purchased furniture and equipment for R50 000
(excluding VAT) from Clear Design Ltd on credit. Clear Design Ltd
granted a trade discount of 5% on the purchase price.
7 Purchased inventory costing R262 200 from Busquets Ltd and paid by
cheque.
12 The owner took inventory for her own personal use with a marked
selling price of R51 300. The firm has consistently applied a margin on
sales of 25%.
19 The firm received R39 900 from a debtor whose account was written off
as bad in November 20X1.
23 Paid interest expense of R8 400 for the month of February 20X2.
25 Issued a cheque for R79 000 to SARS, in payment of the VAT owing for
February 20X2.
28 Total credit sales of R172 140 during the month of March 20X2.
31 Paid March 20X2 salaries amounting to R63 000 by cheque.

1. Provide all the necessary general journal entry relating to the
transaction on 12 March 20X2. Ignore journal narrations. (3 marks)
2. Prepare the SARS (VAT) account as it would appear in the general
Africurios Traders for the month ended 31 March 20X2. The

ledger of
account must be properly balanced. (7 marks)
QUESTION 7.2 (B)

All parties are registered VAT vendors and assume, where necessary, that
amounts are inclusive of VAT .
Statement of financial position of Skateboard Africa as at 31 December
20X9
Assets
Motor vehicles 18 000.00
Inventory 7 000.00
Stationery asset 5 800.00
Bank 20 200.00
Equity
Capital 22 000.00
Accumulated pro t (net of drawings) 5 000.00
Liabilities
Loan 20 000.00
SARS (VAT) 3 000.00
The following transactions occurred during the month of January 20X0:
1. R. Clayton, the owner, deposited a further R30 000 into the business’
bank account.
2. Purchased inventory on account from Baily Company, R3 990.
3. Cash sales for the week R12 141 (cost of inventory R5 800).
4. Issued cheque for R21 090, for cleaning materials (business records this
as cleaning material).
5. Sold inventory on account to Manny Company, R6 840 (cost of
inventory R3 000).
6. Paid wages, R798.
7. Bought R284 worth of computer paper (business records this as
stationery) by cheque.
8. Purchased inventory from Canny Corporation for cash, R855.
9. Received R3 420 cash from Manny Company (see point 5).
10. Paid wages, R912.
11. Interest on the loan is payable monthly at a rate of 12% per annum.
Interest for January as well as R10 000 of the initial loan amount was
paid on 31 January 20X0.
12. Although the electricity bill for the month of January, amounting to R2
394 had been received, the bill had not been paid by the close of
business on 31 January 20X0.
13. The owner withdrew R1 500 for personal use.
14. On 31 January 20X0 the business had stationery amounting to R4 500 on
hand. On this date, all the cleaning material had been used.
Prepare all the journal entries to record the transactions for January 20X0.
Ignore journal narrations.

Prepare the SARS (VAT) account as it would appear in the general
1.
Skateboard Africa for the month ended 31 January 20X0. The
ledger of
account must be properly balanced.
QUESTION 7.3 (C)

ZigZag Traders is a small business in East London that sells sewing
machines, and is a registered VAT vendor. The business started trading on 1
January X1 and has a year-end of 31 December. It uses the periodic
inventory system to record inventory. The bookkeeper of the business left
on 28 December X1. Before she left, she paid all the accounts up to date and
extracted the following trial balance.
ZigZag Traders
Trial balance as at 28 December X1
Debit Credit
Capital 120 000.00
Furniture and equipment 35 000.00
Purchases 250 000.00
Loan 15% p.a. 30 000.00
Telephone expense 9 765.00
Vehicle 50 000.00
Stationery expense 18 420.00
Returns inwards 12 000.00
Insurance expense 5 445.00
Bank 46 000.00
Drawings 5 000.00
SARS (VAT) 6 000.00
Sales 420 000.00
Rent expense 39 040.00
Interest expense 4 500.00
Repairs expense 6 000.00
Salaries and wages 63 320.00
Electricity expense 11 510.00
601 000.00 601 000.00
The following transactions occurred from 29 December to 31 December X1:
a) Sold sewing machines at a total marked selling price of R15 960 on
credit.
b) Purchased stationery for cash of R912.
c) Paid salaries and wages for December amounting to R6 840.
d) A debtor, S. Warne, is untraceable, and the business has decided to
write the debt off as irrecoverable. He owed the business R4 788.
e) An inventory check done on 31 December X1 showed that the business
had inventory on hand amounting to R62 000 and had stationery on
hand amounting to R3 000.
1. Prepare, in general journal format, the entries to record transactions 1, 3
and 4 above. Omit narrations. (8 marks)
2. Complete the following general ledger accounts for December X1.
Balance or close off the accounts at the end of the month. The business
has a year-end of 31 December.
2.1 SARS (VAT) (5 marks)
2.2 Stationery expense account (4 marks)
3. Prepare the statement of comprehensive income for ZigZag Traders for

the year ended 31 December X1 (13 marks)
4. Indicate whether the following amounts that would appear on the
statement of financial position are VAT inclusive or VAT exclusive and
give a brief reason for your answer.
4.1 Inventory (2 marks)
4.2 Trade receivables (2 marks)

8 Bank reconciliation
statements
Judy was feeling a bit concerned. She had been speaking to some
of the stall owners and had noticed that they were checking the
information they had received from their banks.
When she asked what they were doing, she was told that they
were reconciling their own accounting records with the bank
statement they had received from the bank to check for errors and
to see how much money they actually had in the bank.
“What do you mean, how much money I actually have in the
bank?” Judy had asked, “Surely if I check the amount in my Bank
account in the general ledger it will be the same as the amount
shown in the statement that the bank gives me? I mean, the bank
statement is the bank's record of my transactions with the bank,
and the Bank account (in the general ledger) is my record of the
transactions with the bank. I can't understand why the balances
would ever be different, so what is the bank reconciliation all
about?”
Learning objectives
• Understand why the Bank account balance in the general ledger can differ from the
balance on the bank statement
• Read and understand a bank statement
• Understand the need for reconciling the bank account
• Complete a bank reconciliation statement.

Judy cannot understand why the balance of her Bank account in the
general ledger could differ from the balance on the monthly bank
statement that she receives from the bank.
How are we going to help solve Judy's problem?
Let us look at the relationship between Judy and the bank. Judy
opened a bank account at SBS Bank in the name of the business,
Handbags for Africa. She will also create a Bank account in her
general ledger. This account will record all the transactions with SBS
Bank from Judy’s point of view. Judy will record transactions in her
ledger only when she becomes aware that the transaction has in fact
occurred. SBS Bank will record the transactions with Judy in the
Handbags for Africa account in their book, from their point of view. At
the end of each month, the bank sends Judy a statement. This
statement is a copy of her account in the bank from the bank’s point of
view.
We are now going to look at two transactions and see how they
appear in the books of both Handbags for Africa and SBS Bank:
Capital contribution from Judy

Judy electronically transfers her capital contribution from her
personal account directly into the bank account of Handbags for
Africa. Remember that every transaction we record in the Bank
account in the general ledger is part of a double entry.
We are trying to understand the relationship between Handbags for
Africa and SBS Bank, so we will focus only on the side of the
transaction that affects the bank.
In Judy’s books we debited the Bank account. Judy has deposited
money in the bank. The money still belongs to her, in other words
SBS Bank owes her the money. Therefore, as long as her balance
remains positive, the bank owes her money. In other words, the
bank is her debtor (asset).
SBS Bank credits the account they opened for Handbags for Africa.
Although the money has been paid into the bank, it does not belong
to SBS Bank. They have to repay it to Judy whenever she demands it.
SBS Bank owes the money to Judy, so the bank sees Judy as a
creditor (liability).
Cheque payment
What would happen if Judy wrote out cheque 001 to pay for a
cellphone?
When Judy writes out cheque 001 for R1 200 to pay for the cellphone,
she will credit the Bank account in the general ledger. She has spent
the money so the amount left in the bank will decrease. The asset
(Bank) is decreasing, so the bank account is credited.
When the cheque is paid into the bank, SBS Bank will debit
Handbags for Africa’s account. Once SBS Bank has paid the cheque,
they have less of Judy’s money and therefore owe her less. Judy’s
account (which the bank sees as a creditor) has decreased, so the
bank will debit the account. If an electronic funds transfer (EFT) had
been made, the impact would be identical. However, there will be
less of a time lag for EFTs than there are for cheque payments,
because the funds are transferred from one account (the payer) to the
account of the business receiving the payment more quickly.
What causes differences between the general ledger and bank

statement balance?
By now you may have noted two differences in the way SBS Bank
and Judy record the transactions. Firstly, the timing differs. SBS
Bank records the transactions on receipt of the deposit or cheque,

while Handbags for Africa records it on writing the cheque or
initiating the deposit. Secondly, a debit for Handbags for Africa is a
credit for SBS Bank, and vice versa. This occurs because they are
counterparties to the same transaction and therefore what is an asset
to the one will automatically be a liability to the other.
After realising that these differences exist, you are already in a
position to answer Judy’s question.
If Judy and the bank have exactly the same information available
to them at exactly the same time and neither of them has made any
mistakes, the Bank account and the bank statement balance would
agree. Note that to agree, the general ledger balance would have to
be a debit and the bank statement balance would have to be a credit
of the same amount, or vice versa. In practice, the balance in the
Bank account and the balance on the bank statement at the end of
any given month are very rarely the same. Differences occur because
Judy and the bank do not have access to the information at the exact
same point in time. Why this happens is explored later in the
chapter.

8.1.1 What is the bank statement, and what does it
look like?
The bank statement is a summary of all your transactions with the
bank over a certain period of time. The transactions are recorded
from the bank's point of view. In other words, the bank statement is a
summary of your account in the bank's books .
What do we notice about the bank statement? The bank statement is
generally in the form of a 3-column ledger account and has a debit
column and a credit column. The balance on the bank statement is a
running total and is updated after each transaction. Any credit
transaction will increase the balance (and therefore the amount the bank
owes us), and any debit transaction will decrease the balance the bank owes
us.
Let’s look at the different line items appearing on a bank
statement in more detail.
8.1.1.1 Opening balance

The bank statement starts with an opening balance. This will be the
same as the closing balance on last month’s bank statement. The
bank statement could run from the 28th of one month to the 28th of
the following month − the bank statement will record transactions
for a month. The bank will print the statements on the 28th and send
them to the customers. Any transaction happening on the 29th, 30th
or 31st of that month will therefore appear only on the following
month’s statement. The starting date of the bank statement depends
on the date on which the customer opened their account (for
example, the statement could run from the 20th of one month to the
20th of the following month).
8.1.1.2 Credit transactions appearing on the bank

statement
Deposits
Sometimes the word “deposits” is the only description on the bank
statement, while at other times more detail is available, for example,
the name of the entity depositing the money (for example, Mr
Swart).
Either Handbags for Africa or another party can deposit money
into Handbags for Africa’s bank account. All that is needed to
deposit the money is the account name, account number and branch
code. Deposits into a bank account can be made by:
• going to a branch of SBS Bank, filling in a deposit slip and
handing it in with the cheque/cash
• making electronic fund transfers via Internet banking
• paying stop or debit orders from a customer’s account into
Handbags for Africa’s account
• making credit card payments into Handbags for Africa’s account.

A deposit can result from sales, a debtor paying his debt, a loan
received, refunds from suppliers, or capital contributions.
Interest received
If Handbags for Africa has a credit balance (asset) in the bank’s
books, the bank owes them money. It is common practice to pay a
certain percentage “charge” for borrowing and using someone else’s
money. This is known as interest. This amount is calculated by the
bank at month end and is then recorded on the bank statement. The
interest income will appear on the bank statement as a credit entry
as it increases the amount of cash in the bank account. At the end of
each month, the interest is automatically added (credited) into the
bank account of Handbags for Africa.
8.1.1.3 Debit transactions appearing on the bank

statement
Cheques
An item we often see on the bank statement is “cheque”, followed by
a number. This indicates that one of the cheques written by
Handbags for Africa has been presented to the bank and that the
bank paid it to the payee (person to whom cheque has been paid
out). Cheques can be made out to pay for purchases or other
expenses, pay a debt (creditor), grant a loan, or refund a customer.
Dishonoured (bounced) cheques

A business, for example Handbags for Africa, could receive a cheque
from a customer to pay for goods that they have purchased or from a
debtor to pay an amount owing for an earlier credit purchase. Let’s
assume that one of Judy’s customers, A. Browning, who banks at

ABC Bank, paid her account of R500 by cheque. Judy deposits the
cheque into her account at SBS Bank. SBS bank will approach ABC
Bank to receive payment on the cheque. If A. Browning has funds in
her account, ABC Bank transfers the money to SBS Bank and SBS
Bank pays the money into Judy’s account. If A. Browning does not
have sufficient funds, ABC bank will not transfer the money to SBS
Bank. The cheque will be sent back to Judy with the bank statement
marked R/D (“refer to drawer”). Judy will need to contact her
customer and inform her that her cheque has “bounced”, which
means that the cheque has not been honoured. As Judy has not
received payment, the customer will still be treated as a debtor.
Electronic fund transfers (EFT)

These days many businesses and individuals make payments via
EFT (electronic funds transfer). EFT payments are made via the
Internet or at an ATM (automated teller machine). The purpose of
these payments is the same as for cheques.
Debit card transactions

Another payment method is via a debit card linked to the particular
bank account. To make a payment the card is swiped in the shop.
The card owner, for example Judy, enters a PIN number (PIN =
personal identity number) to verify that the actual cardholder is
using the card, and the bank transfers the funds into the account of
the shop in which the card has been used.
Stop or debit orders

A stop order is an arrangement with your bank where you give the
bank permission to pay someone on your behalf. A debit order is a
similar concept. However, here you grant someone permission to
withdraw money from your account. Usually the permission is

granted for a specified payment amount, or it can be a variable
amount, such as your cellphone bill each month.
A stop order payment is cancelled by approaching your bank and
instructing them to cancel the stop order. A debit order is more
difficult to cancel. If you wish to cancel a debit order, you need to
approach the business with which you signed the debit order. The
business needs to contact the bank and cancel the debit order. The
bank will not cancel the debit order on your instructions alone.
Both payment methods are used for recurring payments.
Examples are cellphone bills, Internet connections, or the payment of
credit card debt.
Cash withdrawal
Every business needs physical cash to pay small expenses. Cash can
be withdrawn from an ATM or obtained from a bank teller in a
branch. The bank is paying back a portion of their liability to
Handbags for Africa and therefore debits the account.
Service fees and bank charges

SBS Bank will charge Handbags for Africa for various services they
offer. These charges will include the cost of issuing a cheque book,
for processing cheques written by Handbags for Africa, for
withdrawing cash, or for paying a stop order or debit order. These
charges are referred to as bank charges. At the end of the month the
bank calculates a total fee for its services, based on a minimum fee
charged and additional charges for actual services performed. The
bank charges are automatically deducted from (debited to) the bank
account of Handbags for Africa.
Interest paid
The bank will charge Handbags for Africa interest if the account is
overdrawn (has a debit balance − an asset in the bank’s records). The
interest expense will appear on the bank statement as a debit entry.
At the end of each month the interest is automatically deducted
(debited) from the bank account of Handbags for Africa.
8.1.1.4 Error corrections

These can be either a debit entry or a credit entry on the bank
statement and occur if the bank made a mistake on the bank
statement. For example, we would expect to see two debit entries on
the bank statement for the same transaction if the bank erroneously
(in error) subtracted a cheque twice.
8.1.1.5 Closing balance

The balance at month-end will be shown as a closing balance. This
balance will then be the opening balance on the next month’s bank
statement.
8.1.2 An example of how transactions are recorded

in the general ledger and on the bank
statement
General ledger bank account
We can see that the balance on the bank account in the general
ledger amounts to R4 091, whereas the balance on the bank
statement amounts to R5 740.
8.2 Understanding the bank

reconciliation process
Go and watch The reconciliation process: This video explains the reconciliation
process and why reconciliations are necessary, with a focus on debtors,
creditors and bank reconciliations.
At the reporting date Judy will need to prepare a statement of
financial position, which will list all the assets and liabilities of the
business that exist on that date. One of the assets that will appear on
the statement of financial position is the bank account. Judy should
ensure that the amount on the statement of financial position for
bank is correct.
Has the bank account been prepared using all the available
business information? Judy will need to update the bank account in
the general ledger with information relating to bank charges, stop
orders and so on in order to calculate the bank account balance on
To start the reconciliation process Judy will compare the
information on the bank statement with the information in the bank
account in her general ledger. To ensure that all items are checked,
she will tick off the items that appear on both the bank statement
and in the bank account in the general ledger. She will then be able
to identify information that appears in the Bank account but does
not appear on the bank statement, or vice versa. Items that appear
only on the bank statement or only in the bank account will be either
adjusting items or timing items (also referred to as reconciling

items).

Note that the differences can be classified into two categories.
Timing (reconciling) differences occur because of the difference in
time between when Judy records information and when SBS Bank
records the information. Examples are cheques that Judy has written,
but where the recipient (person receiving the cheque) has not
presented the cheque to their bank and/or the recipient’s bank has
not received the money from Judy’s bank. Judy’s bank will know she
has written a cheque only when they receive a copy of the cheque for
settlement. When Judy writes a cheque to a supplier, the supplier
will deposit the cheque at his bank (which could take a few days or a
few months, depending on how soon the recipient deposits the
cheque). If Judy uses EFT, the process happens almost
instantaneously as cheques are not written out, but a direct
instruction is given by Judy (to her bank) to deposit money into her
supplier’s account.
Timing (reconciling) differences do not change the bank account
in the general ledger, but they explain the difference between the
balance on the bank statement and bank account. These differences
are reflected on the bank reconciliation.
Adjusting differences are those differences that relate to
transactions Judy was not aware of before receiving the bank
statement. Examples are interest, bank charges and direct deposits.
These differences need to be corrected by adjusting Judy’s records.
The source document for transactions such as bank charges and
interest received from or paid to the bank is the bank statement.
Information from the bank statement updates the information in the
bank account in the general ledger.
These entries are adjustments in Judy’s accounting process and
will not only update her bank account but will also give rise to
income (interest income) or expense accounts (interest expense or
bank charges) that will affect the calculation of Judy’s profit. As the
bank account will have been adjusted for these amounts, they are
not reconciling items
8.2.2 Identifying reconciling and adjusting items,

and understanding why these differences
occur
8.2.2.1 Deposits
Deposits made by Judy into the bank

The deposit made by Judy on 28 January appears in the Bank
account (Judy recorded this when she deposited the money in the
bank), but does not appear on the bank statement. SBS Bank received
the deposit after the date that the bank statement was sent. The
deposit has been recorded in the general ledger but does not appear
on the bank statement. This means that the balance on the bank
statement is understated by the amount of the deposit. Judy’s bank
account is correct in her ledger. This is a timing difference which will
be reflected on the bank reconciliation.
Deposits Judy's clients make into her bank account

Clients sometimes pay money directly into the bank account, for
example, the deposit shown on the bank statement on 26 January for
R560. Judy will update her records once the bank statement is
received. The bank account will be debited and trade receivables
credited. In this case, the bank account in the general ledger should
be updated, and therefore no reconciling item will appear on the
bank reconciliation.
8.2.2.2 Cheques
In the Bank account in Judy’s books, cheques 001−013 have been
used to make payments and are recorded on the credit side of the
Bank account as they are decreasing the amount in the bank. The
date in the Bank account for each cheque represents the date on
which the cheque was written out by Judy. On the bank statement
only cheques 001, 003, 004, 006, 007 and 009 appear. The bank will
record cheques only when they have been handed to the bank for
payment. The date on the bank statement represents the date on
which the cheque was presented to the bank for payment.
Did you know?

People who receive cheques as payment for goods or services have up to six
months to pay the cheque into their bank account. According to legislation, a
cheque is no longer valid if six months have passed since the date the cheque
was made out. After that the cheque is said to be “stale”.
SBS Bank knows that Judy has written out a cheque only when the
cheque is actually handed in for payment, whereas Judy knows that
the cheque has been written out as soon as she uses a cheque to pay
for something.
The cheques that have been presented for payment will also
appear on the bank statement. The unpresented cheques have been
recorded in the general ledger (they have decreased the bank
account) but do not appear on the bank statement. This is a timing
difference, which will be reflected on the bank reconciliation.
Did you know?

Recording the bank balance in the financial statements
In practice, businesses can choose to reflect on the statement of financial position
the bank balance as it appears on the bank statement. The reason is that the
statement of financial position is a snapshot of the business at a certain point in
time and the entity's right to receive money (from the bank at which is has its bank
account) at that point is limited to the amount shown on the bank statement.
Any adjusting differences such as bank charges or interest income will affect
the bank account in the general ledger but will already have been taken into
account when the bank statement was prepared.
In order for the business to reflect the bank statement balance on the
statement of financial position, the following adjustments would need to be
processed to take into account the timing differences.
Any cheques written out by Handbags for Africa, but not yet presented to the
bank by the payee, are still considered to be a liability (trade payables), as the
business still has an obligation to honour the cheque payment as at year-end. To
adjust for this, the following journal entry is required:
If Handbags for Africa has received a cheque from a debtor, but this cheque has
not been presented to or processed by the bank at year-end, the amount is still
owed to Handbags for Africa at year-end. In other words, it is still a trade
receivable. To understand this concept better, consider what would happen if the
cheque were not honoured by the bank. The debtor would still owe the money, so
the debt is settled only once the actual money has been received. To adjust for
this, the following journal entry is required:
8.2.2.3 Electronic funds transfer (EFT)
Did you know?

An EFT is when money is transferred between bank accounts electronically. For
example, at an automated teller machine (ATM), point of sale (POS), when
purchasing online, or using mobile payment apps such as Snapscan.
Internet banking or ATM (automated teller machines) transaction
When electronic fund transfers (EFT) are used to make payments via
the Internet or at an ATM machine, the bank and Handbags for
Africa should become aware of the transaction at the same time. The
bank account in the ledger is updated when the information relating
to this transaction becomes available. This should be done by using
the payment slip (ATM or Internet banking receipt) as a source
document. If this has not been done, the transaction will be
processed in the general ledger when the bank statement is received.
This will be an adjusting difference. The ledger accounts should be
adjusted and therefore no reconciling item (on the bank
reconciliation) is recognised.
Debit card payments

A debit card payment arises when the bank account holder (for
example, Judy) presents a bank card to pay for goods and services.
This gives rise to a direct transfer from the customer’s account, for
example, from Judy into the supplier’s bank account. The bank
account is updated when the information relating to this transaction
becomes available. This should be done by using the payment slip as
a source document. If this has not been done, the transaction will be
processed in the general ledger when the bank statement is received.
This will be an adjusting difference. The ledger accounts should be
adjusted and therefore no reconciling item (on the bank statement) is
recognised.
8.2.2.4 Stop orders or debit orders

Do you remember what the difference is between a stop order and a
debit order? In both cases, the bank makes the payment directly
from your bank account and you would have notification that this
payment was actually made only when you receive your bank
statement at the end of the month.
The stop orders or debit orders do not appear in the Bank account
but do appear on the bank statement. Judy will need to update her
record in the general ledger of her business for the information
relating to the stop orders or debit orders. The Bank account will be
credited and a second account, usually a creditor or expense, will be
debited. This account will depend on what the stop order or debit
order is paying, for example, insurance, telephone or rent. This is an
adjusting difference and will not be reflected on the bank
reconciliation.
8.2.2.5 Cash withdrawal

The bank is notified immediately when cash is withdrawn from an
account. However, cash can be withdrawn after hours or on
weekends from ATMs and is then processed by the bank only on the
next business day. If such a transaction occurred at month-end, the
withdrawal would appear in the general ledger but would not, as
yet, appear on the bank statement. The balance on the bank
statement would be overstated by the amount. This information
would need to be processed on the bank reconciliation statement as
a reconciling item. No cash withdrawals occurred in Judy’s business.
8.2.2.6 Service fees/bank charges

Judy will know how much the monthly bank charges are only when
she receives her bank statement. The information relating to bank
charges does not appear in the general ledger account but does
appear on the bank statement. Judy needs to update her records and
the information relating to the bank charges must be recorded in the
general ledger of Judy’s business. The Bank account will be credited
and the bank charges account will be debited. This is an adjusting
difference and will not be reflected on the bank reconciliation.

8.2.2.7 Interest income or expense
As with bank charges, interest income or expense is calculated by the
bank each month, and is automatically adjusted to the bank account
of the business. This information does not appear in the Bank
account but does appear on the bank statement. Judy will need to
update her records and the information relating to the interest must
be recorded in the general ledger of Judy’s business. The Bank
account will be debited and the interest income account will be
credited, or the bank account will be credited and the interest
expense account will be debited. This is an adjusting difference and
will not be reflected on the bank reconciliation.
8.2.2.8 Dishonoured (bounced) cheques

When Judy sells her handbags, she may receive a cheque from her
customer, either if it is a cash sale or when her debtors pay her at a
later stage. Let’s assume that one of her customers, A. Browning,
who banks at ABC Bank, paid her account of R500 by cheque. Judy
deposits the cheque into her account at SBS Bank.
A. Browning did not have sufficient funds. When the cheque was
deposited into Judy’s account at SBS Bank on 16 January, SBS bank
credited Judy’s account with R500. The deposit appears as a credit
on the bank statement. When SBS Bank discovers that A. Browning
does not have any money in her account they will debit (see 26
January) Handbags for Africa with the amount of the original
cheque (R500). This will appear as a debit on the bank statement.
SBS Bank has cancelled the deposit by debiting Handbags for Africa.
The initial R500 deposited by Judy into the bank was recorded
both in the general ledger and on the bank statement. However, the
cancelled cheque appears only on the bank statement. Judy will need
to update her records. The bank account will be credited (as Judy
has not received the cash) and the debtor’s account will be debited as
A. Browning still owes the business the money. This is an adjusting
difference and will not be reflected on the bank reconciliation.
8.2.2.9 Errors
Cheque 009 appears in the Bank account as R150 but appears on the
bank statement at R105. When SBS Bank sends Judy her bank
statement, they also send back the original cheques that have been
presented for payment at the bank. So by looking at the actual
cheque, Judy will be able to determine whether she made an error in
her books or whether the bank had made an error.
Let's assume that the bank made the error.

Judy will contact SBS Bank, and the bank and will have to correct the
error. The cash balance on the bank statement has been overstated as
R105 has been debited on the bank statement instead of R150. The
difference, R45, will appear as a reconciling item on the bank
reconciliation. When Judy receives the bank statement for the
following month, she will check that the bank has in fact corrected
the error. Judy has to reconcile to the bank statement as issued by
the bank. She cannot correct the actual bank statement for the errors
made by the bank.
If Judy made the error, she will need to correct it in the general
ledger. Judy will have credited bank and debited a creditor/expense
account with R150, while she should have credited bank and debited
a creditor/expense account with R105. She will need to update her
records. When doing so, she will debit Bank with R45 (as less money
has been paid than was initially recorded) and credit the
creditor/expense account with R45. This is an adjusting difference,
as Judy will adjust her general ledger to correct the mistake. There
will not be a reconciling item in relation to this transaction (it will
not be reflected on the bank reconciliation).
Apart from incorrect amounts, other errors that may occur are
double accounting for a transaction (repeating the same transaction),
debiting an account instead of crediting it (or vice versa), recording a
transaction in Judy’s account when it should have been recorded in
another client’s account, or omitting a transaction. These errors can
be made either by the bank or by Judy, and it is necessary to refer to
the original supporting document, for example, the actual cheque or
deposit slip, to determine who needs to make a correction. It is
therefore important to keep copies of deposit slips, actual cheques,
and other source documents.
8.2.2.10 Stale cheques and cancelled cheques
Stale cheques
When a cheque is given as payment, the person receiving the cheque
has six months to pay the cheque into their bank account and receive
payment. After six months the cheque is said to be stale. This means
that even if it is paid into a bank account, the bank will not honour
the payment.
Something to do 1
Assume that Judy had paid R200 to a stallholder for stationery on 1 January X2.
She is preparing the bank reconciliation statement at the end of July X2. She
realises that the cheque was issued six months ago and has now gone stale. She
has tried to find the stallholder, but he seems to have closed up shop. How would
she correct this?
Check your answer
Judy's Bank account was credited when she wrote out the cheque, and the stationery
account was debited. The bank cannot pay the original cheque of R200 so she will
need to cancel the cheque in her books. She will debit her Bank account and credit the
Stationery account. There is no entry on the bank reconciliation statement. This is
because SBS Bank has no knowledge that the cheque was written out in the first
place. This cheque would be a reconciling item (it would appear in the bank
reconciliation) from the time it was written until it went stale. In other words, the
cheque could appear on the bank reconciliation for a period of six months.
Cancelled cheques
Judy may write out a cheque and then wish to stop payment on the
cheque. This could happen if the goods or services she was paying
for have not been delivered or are substandard. Judy must inform
the bank in writing that they are not to pay out any money if the
cheque is presented for payment. Once she has informed the bank in
writing, she will cancel the transaction in the general ledger in order
to reverse the entry processed to record the initial transaction. To
cancel the transaction, she will debit the Bank account, as the money
will not be paid out of her bank account and will credit the debtor’s
account. She will also reverse the transaction recognising the receipt
of goods or services and the trade payables. The following entries
would be processed:
1. Obtain the balance as at month-end from the bank statement
and the balance on the same date from the Bank account in the
general ledger.
2. Identify differences between the Bank account and the bank
statement. This is done by comparing the entries on the bank
statement to the entries in the general ledger Bank account.
Remember that we compare the debit entries on the bank
statement with the credit entries on the bank account and the
credit entries on the bank statement with the debit entries on the
bank account.
3. Identify which items are adjusting differences, which are items
that will update the general ledger’s bank account, such as bank
charges or interest expense, and which items are timing
differences (items that will appear on the bank reconciliation,
for example, un-presented cheques).
4. Update the general ledger with any adjusting differences.
5. Obtain the bank reconciliation of the previous month and
determine whether any of the differences noted in point 3 are
reflected on the previous bank reconciliation. For example, a
cheque issued in February X1 could appear on the bank
reconciliation for February X1. The cheque appears on the bank
statement in March X1 (it has been presented for payment), so it
will not appear on the bank reconciliation for March X1. The
item (the cheque) has already appeared on the other document
(bank statement or general ledger) in the previous month. Any
items on the prior month’s bank reconciliation that are not
resolved in the current month must be shown on the current
month’s bank reconciliation again. Depending on the nature of
the items and the period they have been outstanding, the
business might need to follow up on these items.

6. Draft the bank reconciliation statement. Remember that only
timing differences will appear on the bank reconciliation. Check
that the bank statement balance plus timing
differences/reconciling items is now the same as to the updated
general ledger bank balance.
Let's use the information above and the six-step approach to

reconcile Judy's Bank account with her bank statement balance.
Step 1
The closing balance from the bank statement of R5 740 and the
closing balance of the bank account of R4 091 are easily obtained.
The R5 740 is the amount on the external documentation received
from the bank, and the R4 091 us the amount in Judy’s ledger prior
to making any adjustments.
Step 2
The differences between the bank statement and the bank account
have been identified. Remember that in practice we would
physically tick off matching amounts on the bank statement and in
the general ledger. The differences will either be adjusting
differences (will be used to update the general ledger) or
timing/reconciling differences (will be used to prepare the bank
reconciliation). Remember that the timing differences explain why
the adjusted bank account balance (in the general ledger) and the
balance on the bank statement differ.
Step 3
Next we need to update Judy’s records with all adjusting differences
we have identified.
The adjusting differences may be taken into account in the
calculation of profit or loss (income and expense account).
Step 4
We know that this bank reconciliation is the first one prepared by
Judy. Also, we assume that before January, no reconciling items
existed (otherwise we would need to prepare reconciliations for the
entire period before the current one).
Step 5
Let’s prepare the bank reconciliation statement. This will take into
consideration all the items we have identified that appeared in the
bank account but have not, as yet, appeared on the bank statement.
Balance according to bank statement 5 740
Add: Deposit not yet recorded 1 161
Less: Unpresented cheques −3 170

002 950
005 300
008 200
010 420
011 150
012 150
013 1 000
Less Error on the bank statement (150−105) −45
Balancing according to the Bank account 3 686
Step 6
The balance on the bank reconciliation statement of R3 686 is equal
to the new balance in the bank account. This means that once the
outstanding deposit, correction of the error, and the unpresented
cheques are taken into account, the bank balance in Judy’s account at
SBS Bank is the same as the bank balance in her general ledger. The
statement of financial position will reflect a bank account asset of R3
686.
8.3 What is the purpose of doing a bank

reconciliation?
By completing the reconciliation process, Judy will be able to update
her records with information from the bank statement that she has
not as yet recorded. Both the Bank account in the general ledger and
the other relevant accounts will be updated. If, after the
reconciliation is complete, the balances do not agree, Judy would
need to check whether any further errors have been made, either by
her or by the bank.
In summary, the purpose of performing a bank reconciliation is
to:
• Update the general ledger bank account with the additional
information from the bank statement.
• Detect and correct errors made by either the bank or the business.
• Provide a control mechanism for management of a business to use
when checking that all the cash received by the business has been
banked immediately.
8.4 Another example

Something to do 2
Judy is reconciling her Bank account with the bank statement as at 28 February.
She has the bank reconciliation statement for January, the Bank account, and her
bank statement for February. Update Judy's general ledger and prepare the bank
reconciliation statement for February.
Bank reconciliation statement for January
The deposit made on 21 February was a direct deposit by a debtor
who repaid his account.

Check your answers
1. The opening balance in the Bank account as at 1 February is different from the
balance on the bank statement. Remember that the ledger accounts in Handbags
for Africa's general ledger are updated during the reconciliation process but that
Judy cannot update the bank statement. The opening balance on the bank
statement for February is equal to the closing balance on the January bank
statement.
2. Cheques 002, 005, 008 and 011 which appear on the February bank statement
do not appear in the February Bank account. This is because they were issued in
January. They will not appear on the bank reconciliation statement for February as
they have been presented for payment.
3. Cheques 010 and 012 appeared on the January bank reconciliation statement
but do not appear on the February bank statement. This means that they still have
not been presented for payment and will appear on the February bank
reconciliation statement.
• We know why the bank account balance in the general ledger
differs from the balance on the bank statement.
• We have learnt how to read a bank statement.
• We have learnt how to prepare a bank reconciliation statement.

• We have learnt how to report the bank balance in the annual
What's next?
In the next chapter we’ll look at trade payables, credit purchases,
and creditor reconciliations.

QUESTIONS
QUESTION 8.1 (A) INCLUDES SETTLEMENT DISCOUNT

Ignore VAT.
The Bookshelf, a local bookstore in your town, urgently needs you to

perform their bank reconciliation for them at 30 June X2. Before you
can do this, you will need to correct the cashbook balance, mainly
because of some erroneous entries passed and some reckless
accounting. The bank balance reflected on the trial balance currently
shows an overdraft of R146 068. This balance was arrived at after
passing the following journal entries in June X2:
a)
*Little Angels pays within credit terms
b)
No entry was passed on 29 June X2, when the manager gave a
supplier a cheque for R423 118, for a bulk order of books to be
delivered on 1 July X2. She said that they would receive the books
only in July, and she wanted to reflect a higher bank balance in the
financial statements at the end of June. The supplier managed to
deposit the cheque only on 2 July X2.
The bank statements reflected interest of R327 earned on the call
account of the business, which is transferred to the current account
on a monthly basis.
The debtors’ clerk receipted R199 957 to a debtor’s account, based
on the remittance advice sent to him by the debtor on 30 June X2.
This amount does not yet appear in the bank statements.
Cheque 378 for R232 050, which was on the outstanding cheque
list at the end of May X02, has still not been processed in the bank
statements in June X2.
1. When does a business perform a bank reconciliation and why?
2. Show all movements that need to be passed to the bank (3 marks)
account in the general ledger, in order to reflect the correct bank
balance at the end of June. (Prepare a T-account for this
purpose, using the closing balance at the date that the
bookkeeper left as your opening balance.) (5 marks)
3. Prepare the bank reconciliation as at 30 June X2. (4 marks)
4. What entry would need to be passed to correct the journal entry
(a)? (2 marks)
5. If cheque 378 has still not been processed through the bank
statement by the end of November X2, what journal entry
should the business pass, and why?

Assume cheque had paid creditors (3 marks)
QUESTION 8.2 (A)
Furniture Frenzy is a furniture business based in George that
purchases and sells both wooden and bamboo furniture and offers a
service that repairs broken wooden furniture. The business uses the
cost model to measure vehicles, the FIFO cost allocation method to
measure the cost of inventory and the perpetual method for
recording inventory. The business has a year-end of 31 March.
Extract: Pre-adjustment trial balance of Furniture Frenzy as at 31

March 20X2
Debit Credit
Bank 45 200
The bank reconciliation process identified the following differences
between the bank account in the general ledger and the bank
statement for March 20X2:
1. Outstanding deposits in the February and March bank account
amounted to R3 900 and R8 400 respectively.
2. On 29 March 20X2 Furniture Frenzy incorrectly entered the rent

expense EFT payment for April 20X2 of R15 000 as R1 500 in the
cash payments journal.
3. The bank statement for March 20X2 included, amongst others,
the following transactions: Bank charges amounting to R478, a
direct deposit by a client for furniture repair income amounting
to R3 663 for work completed on 15 March 20X2 and a
dishonoured cheque for R3 520 that had been received from a
debtor and had been deposited by Furniture Frenzy on 10 March

20X2.
1. Prepare the bank account as it should appear in the general
ledger of Furniture Frenzy on 31 March 20X2.

2. Identify any amounts that have not been used to update the
bank account in point 1 above and explain how these amounts
will be treated in the bank reconciliation process as at 31 March
20X2.
QUESTION 8.3 (C)

Goodlife is a health shop in Bloemfontein selling natural products
that are believed to enhance the body and mind through increased
energy and vitality. Goodlife has a markup of 25% on cost on all
products and uses the perpetual method when recording inventory.
Ms Fanatic is employed by Mr Vibrance to advise customers on
health issues and ensure the smooth running of the store. Included
in Ms Fanatic’s tasks is the preparation of the accounting records of
Goodlife up to and including the trial balance. Mr Vibrance has
realised that Ms Fanatic knows more about health than she knows
about accounting. You have been working for Mr Vibrance each
Saturday morning for the past year to earn extra money. He is aware
that you study financial accounting at university and he has asked
you to check Ms Fanatic’s work. The business has a year-end of 30
September. Mr Vibrance provides you with the following
information:
Goodlife
Trial balance as at 30 September X10
Capital 128 160
Drawings 30 000
Loan: Business Bank 18% 40 000
Vehicles 75 000
Accumulated depreciation: Vehicles 24 000
Inventory 48 000
Bank 5 756
Accrued commission income receivable (1/10/X9) 680
Accrued interest payable (1/10/X9) 750
Sales 271 950
Sales returns 1 970
Cost of sales 170 154
Interest on loan 8 100
Bad debts expense 700
Commission income 6 080
Advertising expense 13 200
Rent expense 52 000
Telephone 15 270
Water and electricity 5 960
Bank charges 2 200
Interest income 900
478 040 478 040
You have identified that NO REVERSALS were processed as at 1
October X9.
1. The loan had been obtained from Business Bank on 1 March X9.
The loan agreement stipulates that the loan will be repaid in
equal instalments over five years commencing on 1 March X10.
Interest is paid in arrears every three months. The first interest
payment was due on 31 May X9.
2. Mr Vibrance took inventory with a selling price of R1 200 for his
personal use. Ms Fanatic thought it intrusive to keep track of the
owner’s actions with regard to the running of the business and
did not feel it necessary to record the transaction.
3. During the year, inventory with a selling price of R400 was
donated to a local gym to be used as a prize in a fitness
competition. This was recorded in the sales journal as credit
sales.
4. A debtor, Mr Unfit, was declared insolvent. He owed Goodlife

an amount of R450. A final dividend of ten cents in the rand was
received from the insolvent estate. The remainder of the debt
was to be written off. Ms Fanatic was unsure how to record the
information, so she banked the money, but she has left the entire
transaction out of the records and marked it for your attention.
5. Bloemfontein is notorious for high rentals. Mr Vibrance is
fortunate enough to have his wife working in the real estate
business and he managed to rent his store from 1 October X9 at
a reasonable rental per month. Rent is paid in advance at the
end of each month. All payments have been made on time.
6. On 10 September X10, Mr Vibrance came to an agreement with
Berry Bush Advertising Agency to launch an intensive
advertising campaign from 3 October X10 to promote the store

and products. A deposit of R1 500 was paid in respect of the
campaign and debited to the advertising expense account.
7. Vehicles have an estimated useful life of five years after which
they will have no salvage value. A second delivery vehicle was
purchased on 1 August X10 for R15 000 and put to use
immediately. Ms Fanatic recorded the purchase of the vehicle in
the accounting records.
8. Stationery is recorded as an expense when purchased. There
was no stationery on hand at the beginning of the year.
According to a physical count, stationery on hand at 30
September X10 amounted to R210.
9. Goodlife earns commission of 5% on goods that are sold on a

consignment basis. Total goods sold on consignment during the
financial year amounted to R120 000. All commission received
during the year is credited to the commission income account.
10. On comparing the bank statement from September X10 with the
bank account in the general ledger and the bank reconciliation
statement for August X10, you identified the following
additional information (see point 4 above):
10.1 Included in the debits on the September bank statement is a
cheque from a debtor amounting to R1 760 returned by the
bank marked “insufficient funds”. The bank’s charges for
this transaction amounted to R50. The debtor is charged for
the bank charges.
10.2 Outstanding deposits on 31 August and 30 September
amount to R9 300 and R4 800 respectively.
10.3 Outstanding cheques at 31 August X10 amount to R6 200.
Of these, cheques amounting to R5 000 were presented for
payment during September X10. Cheque 441 for R700 (sent
to a creditor on 3 April X0) and Cheque 852 for R500
(stationery purchased on 3 July X10) were still outstanding

as at 30 September. Cheques amounting to R5 150 that were
issued during September X10 had, as yet, not been
presented for payment.
10.4 Mr Vibrance has sub-let part of his office at a monthly
rental of R700 as of 1 September X10. A direct deposit of
R700 for rent had been received directly by the bank on 1
September and again on 30 September.
10.5 Ms Fanatic incorrectly entered a cheque for wages
amounting to R427 as R472 in the cash payments journal on
18 September X10.
10.6 The credits on the September bank statement include a
correction in respect of A deposit of R350 that had been
entered on the incorrect side of the August bank statement.
10.7 Bank charges amounting to R350 (over and above the
amount charged in point 10.1 above) and interest income of
R150 appeared on the bank statement.
1. Prepare, in general journal format, the necessary adjusting or
correcting journal entries for points 3, 5, 6, 7 and 9, as at 30
September X10. Dates and narrations are not required. (18 marks)
2. Prepare the Interest expense account in the general ledger of
Goodlife for the year ended 30 September X10 after taking into
account all of the above information. (4 marks)
3. Prepare the statement of comprehensive income for Goodlife as

at30 September X10. (24 marks)
4. Prepare the Equity and Liabilities section of the statement of
financial position of Goodlife as at 30 September X10. (7 marks)

5. Indicate what amount would appear on the statement of
financial position for the following assets:
5.1 Bank (9 marks)
5.2 Trade receivable (3 marks)
5.3 Inventory (2 marks)

9 Introducing credit:
Trade payables
Judy is delighted that she has found a systematic way of
summarising all the transactions that occur in her business into an
easily readable format. She is now able to record each transaction
as it happens and complete both the statement of comprehensive
income and the statement of financial position without having to
refer to each individual transaction. Learning how to use a general
ledger has given her an invaluable tool for translating events in her
business into an acceptable accounting format. Now that she
understands the framework for accounting, she finds it a lot easier
to communicate with people about her business, particularly the
bank manager! In fact, her business has been doing so well that
she is even in a position to expand her operations. Operating from
the Waterfront makes her feel that her business is a lot more
stable and she has decided to expand her network of suppliers to
offer a wider range of leather goods to her customers.
She has seven suppliers offering her high-quality leather
products. She has negotiated a delay in cash payment with all
these suppliers. This means that she will have between 30 and 90
days to pay her suppliers after receiving goods from them. This is a
cheap way of funding her business without having to increase her
bank overdraft. She must record all the transactions with these
suppliers, and although the general ledger has been useful for
keeping track of total purchases, she is not sure how to keep track
of purchases from each supplier. She knows that she will need to
keep a separate record of the details of each supplier so that she
can see how much she needs to pay each one at any point in time.
Let's see if we can help Judy set up a system for controlling her
network of suppliers.
Judy has discussed her new system with Jason Arnold, one of
her suppliers. He manages a business called Leather Man, which
supplies retailers in the Western Cape with handmade leather
handbags and briefcases.
Learning objectives
• Understand why a business would purchase on credit
• Understand why an accounting system that records transactions with each
individual supplier is needed
• Record credit transactions between a business and its suppliers (creditors)
• Maintain a Trade payables ledger and extract a list of individual creditor balances
• Prepare a reconciliation between the Trade payables account in the general ledger
and the list of creditors
• Understand the relationship between the creditor's account in the Trade payables
ledger and the creditor's statement
• Understand why the balance of the creditor's account in the Trade payables ledger
can differ from the balance on the statement received from the creditor
• Understand the need for reconciling the two balances
• Describe the purpose and benefit of preparing a creditors reconciliation statement
• Explain the reasons for the differences between the creditor's account and
creditor's statement balances
• Record all necessary adjustments to the creditor's account to determine the
corrected, adjusted creditor's account balance
• Prepare a creditors reconciliation statement between the creditor's statement and
the creditor's subsidiary ledger
• Prepare a remittance advice.

Before we show Judy how to record the transactions with each
supplier separately, let’s look what we have learnt about purchases
this far.
Something to do 1
What accounting terms do we use to describe the following?
1. Suppliers to a business with whom a delay in cash payment has been
negotiated.
2. Goods purchased from suppliers in a business that uses the periodic
method for recording inventory.
Check your answers
1. Trade payables or creditors. This textbook will use the term trade payables when
all the creditors are being referred to, and will use the term creditor when a single
individual is being referred to.
2. Purchases.
Do you remember what credit purchases transactions took place in

Judy's business in January X1?
Below is an extract of these transactions as they appeared in Chapter
2.
Day Information
5 Purchased 20 small black handbags with single pocket at R30 each −
still owe the wholesaler R600 for the bags
20 Purchased 30 small brown purses at R20 each − still owe the
wholesaler R600
Do you remember how we recorded these transactions under the

accounting equation?
Let’s assume a periodic system is used (if you don’t remember what
this is, refer to Chapter 6).
Let’s look at each transaction in turn:
1. 25 small black handbags with single pocket − still owe the
wholesaler R600
2. 30 small brown purses − still owe the wholesaler R600
Something to do 2
How would we record the cash settlement of the first transactions?
Check your answer
Do you remember why the Trade payables account is a liability?

Before the business can recognise trade payables as a liability in the financial
statements, the trade payables need to fit the liability definition and recognition
criteria.
Judy has purchased goods which have been delivered to the business from a supplier.
Judy's business therefore has a present obligation to transfer an economic resource
(cash) to the supplier. The business has no practical ability to avoid this. The liability
definition is met.
The information about the trade payable is relevant to users and its inclusion will result
in information that is a faithful representation of the business.
The trade payable fits the recognition criteria and should be recognised as a liability.
In the transactions on 5 and 20 January above, we recognised the purchases on the
same day as we recognised the trade payable as a liability.
9.1.2 Recording credit purchases in the general

ledger
Let’s visit the general ledger to see how the transactions in January
X1 were recorded. Again, assume a periodic system is used.

Something to think about
How would the transactions on 5 and 20 January be recognised if the business
was a VAT vendor (VAT of 15%)?
The purchases would be the cost of the inventory (excluding VAT), whereas
the trade payables would be the amount owing to the supplier (including VAT).
The difference would be recognised in the input VAT account.
Definitions of some useful terms

Credit limit: The maximum amount of credit that is granted to a
particular customer. Once customers have purchased goods to
their credit limit, they will be able to purchase again on credit only
once they have made a cash payment.
Credit terms: Credit terms indicate a customer’s credit limit, the
maximum repayment time, any discounts for early payment, and
any penalties that will be incurred on late payments.
Creditworthiness: The ability the business has to make repayments

as specified in the credit terms allowed to the business. This
decision is based on the credit history and credit rating of the
business.
Credit rating: The ability the business has to repay debt. This is
based on the current financial position of the business, its credit
history, and its ability to generate cash in the future.

9.2 Why would a business purchase on
credit?
Negotiating credit (a delay in paying for goods) is often cheaper
than borrowing money to pay cash for the goods. Suppliers can start
charging interest only after the specified credit period that they have
given a business. This is generally 30 days to 60 days but could be
longer. The credit period gives the business time to sell the goods
and use the cash from sales to pay for the purchases. Before a
supplier will grant a business credit the business would need to
prove its “ability to pay”, in other words, its creditworthiness.
Now that we have a better understanding of the need for credit,
let’s look at what information would be useful to help a business
communicate the transactions with its suppliers.
9.3 Source documents relating to credit

sales
The source documents used to record transactions related to credit
purchases are:
• Credit purchases: invoice
• Payments to trade payables: cheque, electronic transfer
instruction, credit card receipt or bank statement
• Returns to trade payables: credit note (initially a debit note)
• Settlement/trade discounts: invoice
• VAT invoice.
Did you know?

Students are often confused by the terms debit note and credit note.
A debit note is a document issued by the customer if he cancels a
transaction. It is a one-sided transaction, and the supplier still needs to give his
consent to the cancellation via a credit note.
A credit note is a document a supplier issues if the other party cancels a
transaction and the supplier accepts the cancellation.
Examples of these source documents are shown on the next page.
Note that the following detailed information is required to record
the transactions accurately:
• Name and address of the supplier
• Amount of the purchase
• Date of purchase
• Type of purchase
• Agreed settlement period (delay in time between purchase and
payment)
• Discount on settlement within agreed period
• VAT information.
Debit note
Credit note
9.4 How do we record credit
transactions?
9.4.1 Why would Jason want information about
individual creditors?
Judy is expanding her business and increasing the number of
suppliers with whom she does business. This will increase the
number of transactions in her business. She needs a system for
recording these transactions so that each supplier is paid according
to the agreed credit terms. If Judy does not pay in time her
creditworthiness may be questioned and she may not be able to get
credit from her suppliers in the future.
9.4.2 Recording credit transactions in specialised

journals
As the number of transactions in the business increased, it became
necessary for Judy to use specialised journals for recording

transactions.
Do you remember what types of specialised journals are used?
Journal Use
Cash Payments Records all cash
journal payments
Purchases journal Records credit
purchases
1. Cash Payments journal − records all payments to trade payables
All transactions relating to trade payables are recorded in the
relevant specialised journals and are then posted periodically to
the general ledger to an account called Trade payables. This
account summarises all transactions with individual creditors
and reflects the total balance owing to trade payables at a point
in time.
2. Purchases journal − records all credit purchases made by the

business; also known as the Trade payables journal
Note that a business can purchase not only inventory, but also
equipment, stationery and similar items on credit. All these
purchases are recorded in the purchases journal.

Goods returned to trade payables can either be recorded as
negative amounts in the Purchases journal i.e. shown in
brackets or recorded in a Purchases Returns journal with the

total returns posted as a debit to the trade payables account in
the general ledger.
What does the Trade payables account look like?
What do you notice?

• All purchases are posted to the credit side of the account from the
Purchases journal. The folio PJ9 indicates that these are the total
purchases for the ninth month, September.
• All payments to trade payables are posted to the debit side of the
account from the Cash Payments journal. The folio CPJ9 indicates
that the information has been posted from the Cash Payments
journal for September.
• The trade payables account in the general ledger gives us
information only about the TOTAL we have purchased from, paid
to and still owe our trade payables.
9.4.3 Creditors or Trade payables subsidiary ledger

The subsidiary ledger keeps a separate record of transactions with
each creditor in individual accounts for each creditor. This allows
the business to manage their relationship with individual creditors.

It is important to realise the subsidiary ledger does not form part of
the double entry record keeping.
Let's look at a transaction to make this clearer.

On 1 January, Judy’s business purchases inventory for R10 000 from
Leatherman on credit.
On 31 January, Judy pays R4 000 to Leatherman as part payment of
the amount owing.
Transaction 1
This transaction will be recorded in the purchases journal, the totals
of which will be posted to the general ledger: Inventory will be
debited and Trade payables will be credited (the double entry).
This information will also be recorded in the subsidiary ledger.
The account of Leatherman will be credited to show that Judy owes
them R10 000.
Transaction 2
This transaction will be recorded in the cash payments journal, the
totals of which will be posted to the general ledger: Trade payables
will be debited and Bank will be credited.
This information will also be recorded in the subsidiary ledger.
The account of Leatherman will be debited to show that Judy paid
them R5 000.
Using the information in the Trade payables account in the general
ledger will not allow us to make easy decisions about individual
entries, so the business also keeps a subsidiary ledger.
The subsidiary ledger is a separate book that has an account for
each creditor. When the business receives the creditor’s statement,

the business can compare the information on the statement
(creditors point of view) with the creditors account in the subsidiary
ledger (the businesses point of view) to check that all the
transactions have been correctly recorded and that the amount
indicated on the creditors statement actually needs to be paid. This
process is called creditor reconciliation and is explained in more
detail later in the chapter.
Let’s summarise the purpose of maintaining a creditors’
subsidiary ledger:
• To record the details of transactions with individual
suppliers.
• To make sure that all transactions with creditors have been
accurately recorded and posted to the general ledger.
• To determine the amount owing to a particular supplier at
any point in time.
• To make sure that the statements received from suppliers
are correct.
We will be looking at creditors reconciliations in more detail
later in the chapter.
In the next example, we’ll show you how to:
• Record all credit transactions with trade payables in the relevant
journals
• Summarise the transactions in the general ledger (trade payables
account)
• Set up a subsidiary ledger that maintains information about
individual creditors.
Note that in practice, if the accounting system is computerised, the
information captured in the journals is automatically posted to the
subsidiary ledger and to the general ledger.
9.4.4 A worked example: Journals, ledger and

subsidiary ledger
We’ll look at the transactions that took place in Judy’s business in
September X2. We’ll do the exercise without VAT, using the periodic
method for recording inventory.
Opening balances
At the beginning of the month Judy owes the following suppliers for
goods purchased in previous months.
Leather Man R4 322.50

Savannah Shoe Manufacturers R968.00
Africa Collectors (Pty) Ltd R5 221.00
Base Metals R3 200.00
Sun and Moon Wholesalers R2 580.00
Accessorize R1 960.00
Plethora of Leather R2 339.00
R20 590.50
Transactions for September:

3 Paid rent for September, R3 840 (Cheque #4567).
4 Purchased leather bags and briefcases costing R8 950, on credit,
from Leather Man (Inv HA001). A settlement period of 60 days
was negotiated, with a 5% settlement discount being offered for

settlement within 20 days. Based on past experience, Judy
normally pays within 20 days.
5 Purchased leather shoes on credit from Savannah Shoe
Manufacturers, amounting to R4 660 (Inv 3452). A 45-day
settlement period was negotiated. No settlement discount is
offered.
7 Paid Accessorize the balance owing on 1 September (Cheque #
4568).
8 Purchased belts and keyrings costing R2 220 from Sun and
Moon Wholesalers, on
credit (Inv C332). No settlement discount is offered.
10 Paid the electricity account for August, R587 (Cheque # 4569).
Paid the Telkom telephone account for August, R889 (Cheque #
4570).
12 Paid Leather Man the balance owing at 1 September (Cheque #
4571).
13 Bought another printer for the computer, costing R2 180
(Cheque # 4572).
15 Purchased leather toys from Africa Collectors (Pty) Ltd, on
credit (Invoice R912). The
goods cost R3 000. No settlement discount is offered.
16 Paid Africa Collectors (Pty) Ltd the amount owing to them, after
receiving a call from their credit control department that the
payment was due on 10 September. No interest has been
charged on the overdue account (Cheque # 4573).
17 Purchased a wooden display unit for the shop, costing R2 799,
from a local furniture retailer, SA Furnishings, on credit (Invoice
SA 555). No settlement discount is offered.
19 Purchased bags from Leather Man, costing R1 430, on credit
(Inv HA005). Settlement discount of 5% still applies.

20 Paid Sun and Moon Wholesalers the balance owing at 1
September, for goods purchased on 25 August (Cheque # 4574).
21 Purchased leather jackets from Sun and Moon Wholesalers on
credit, for R5 600 (Inv C334). No settlement discount is offered.
23 Bought 300 pairs leather sandals from Plethora of Leather on
credit. The sandals cost R10 per pair. No settlement discount is
offered. R3 000 (Inv H112).
24 Paid Leather Man for the goods purchased on 4 September
(Cheque # 4575), i.e. within the 20 day early settlement period.
26 Purchased briefcases from Leather Man, costing R2 565, on
credit (Inv HA 007). Settlement discount of 5% still applies.
27 Purchased a new range of leather bags from Base Metals, on
credit for R1 245 (Inv 1556). No settlement discount is offered.
28 Purchased leather accessories from Accessorize costing R600 on
credit (Inv BB212). No settlement discount is offered.
Returned 10 pairs leather sandals to Plethora of Leather (bought
on 23 September) as the stitches were loose (Credit note CN371).
29 Paid salaries for the month, R8 200 (Cheque # 4576).
30 Purchased 200 pairs leather sandals costing R8 per pair from a
new supplier, for cash
(Cheque # 4577).
We'll proceed as follows:

1. Identify credit purchases and record in the Purchases journal.
2. Record all cash payments in the Cash Payments journal.
3. Record all purchase returns in the Purchase Returns journal
(assume that a separate journal is used by Judy).
4. Post the relevant transactions to the Trade payables account in
the general ledger.
5. Balance the Trade payables account in the general ledger.

Create a subsidiary ledger and open an account for each
6.
supplier in the ledger.
7. Record all transactions with trade payables in the individual
accounts in the subsidiary ledger.
8. Extract a list of balances from the individual accounts in the
subsidiary ledger and calculate the sum of all the individual
balances. Compare the balance on this list to the balance in the
Trade payables account.
1. Purchases/Trade payables journal
Refer to Chapter 6 if you are unsure how a settlement discount
should be recorded.
2. Cash payments journal

3. Purchases returns journal
4 and 5. Trade payables account in the general ledger

6 and 7. Trade payables subsidiary ledger
8. List of balances from the individual accounts in the subsidiary
ledger
Trade payables/Creditors list

Leather Man R3 795.25
Savannah Shoe Manufacturers R5 628.00
Africa Collectors (Pty) Ltd R3 000.00
Base Metals R4 445.00
Sun and Moon Wholesalers R7 820.00
Accessorize R600.00
Plethora of Leather R5 039.00
SA Furnishings R2 799.00
R33 126.25
The total on the creditors list equals the balance of the Trade
payables account. If it does not, it implies that an error has been
made − start checking!
Something to do 3
What differences would you expect to see in the recording process if a
perpetual system is being used?
Check your answer
Instead of debiting “Purchases”, the “Inventory” account would be debited after each
transaction. Purchases returns would result in a credit to the inventory account.

In the previous exercises we have ignored VAT. What if Judy and
her suppliers had been registered VAT vendors?
Note 1: The VAT column has been added to record the VAT
component of all purchases, as this will be taken to the VAT account
in the general ledger.
Note 2: All costs of goods purchased are assumed to be stated at the

VAT inclusive amount.
Note:
The amounts in the VAT Control account are posted from the specialised journals.
9.4.6 Summarising the transaction flow

Credit purchase
Payment of creditor
Return of credit purchase

Judy is amazed at how much her understanding of business has
changed in the last few months and, talking to her accountant at
lunch one day, she remarked, «Finally, there is some order in the
chaos that my business was creating! I am so relieved that I have
managed to control the flow of information. I can now make some
real sense out of the information that the accounting system
generates. I see why everything must be ordered. Without the
structures, the information would have little value.
“I would like to know more about managing information about
transactions. You have shown me how to set up a trade payables
sub-system that helps me to check the accuracy of recorded
transactions. I would like to take this a step further now and look at
how the relationship between my trade payables and me can be
better managed.
“I receive statements regularly from my suppliers, but my picture
of the account in the Trade payables ledger is often different from
the statement the supplier sends me. I can't seem to find anything
wrong with my records, because I now use the sub-system as a
means for checking all transactions. I'm a little confused, because I
don't want to tell the supplier they are wrong, but I also don't want to
pay an amount that I don't agree with! Could you help me to set up a
system that lets me see why these two amounts don't agree, and
also to tell me what amount I should be paying?”
The Trade payables subsidiary ledger provides a useful check on
Judy’s transactions with creditors. The subsidiary ledger is a method
of recording information about individual creditors in the business
records. By duplicating transactions (entering them in two places),
errors in recording and posting can be identified and corrected
before the information is reported.
The creditors list, which is the sum of the individual creditors’

balances in the subsidiary ledger, is regularly compared to the
balance in the Trade payables account in the general ledger to ensure
complete and accurate recording. This information is recorded from
Judy’s point of view. When the creditor sends a statement to the
business, all transactions on this statement are shown from the
creditor’s point of view. Judy can compare her record with the
record kept by her supplier.
9.5.1.1 Debtor and creditor relationship

To begin with, let’s look at the relationship between Judy and the
suppliers to her business. We’ll use the supplier Leather Man to
illustrate how the credit transactions are recorded from the point of
view of the debtor (Judy) and the creditor (the supplier, in this case
Leather Man). Refer to the transactions for the month of September
that we recorded earlier in this chapter.
How are the credit transactions recorded by Judy?

Let’s look how Leather Man’s account would look in Judy’s books:
What do you notice?
• The opening balance is the amount that was owing to Leather
Man at the end of the previous month (purchases that have been
received but have not yet been paid for).
• Goods purchased from Leather Man are credited to the account of
Leather Man in the subsidiary ledger.
• Payments made to Leather Man are debited to the account of
Leather Man in the subsidiary ledger.
• The credit balance at the end of September is the amount that
Handbags for Africa owes to Leather Man.
How are these transactions recorded by Judy's suppliers, such as

Leather Man?
A supplier keeps a record of its transactions with Judy in a
“Handbags for Africa” account in its Trade receivables subsidiary
ledger. Refer to Chapter 10 for more information on recording credit
sales. At the end of each month the supplier sends Judy a statement
which is a copy of its view of the transactions that occurred during
the month. This statement is a copy of Judy’s account in the
supplier’s subsidiary ledger.
This statement is similar in principle to the bank statement Judy
receives from the bank each month. The bank statement is a copy of
Judy’s account in the bank’s records from the bank’s point of view,
while the creditor’s statement is a copy of the account from the
creditor’s (supplier’s) point of view.
It is important at this point to remind ourselves that Judy
considers her suppliers to be her creditors, while Judy’s suppliers
consider her to be a debtor.
Now let’s look at how the same transactions would be recorded in
Leather Man’s Trade receivables subsidiary ledger.
What do you notice?

• Goods purchased by Handbags for Africa are debited to the
account of Handbags for Africa in Leather Man’s subsidiary
ledger.
• Payments received from Handbags for Africa are credited to the
account of Handbags for Africa in Leather Man’s subsidiary
ledger.
• The debit balance at the end of September is the amount that
Handbags for Africa owes to Leather Man.
In this example, the balance at the end of the month is the same in
both ledgers. This is unlikely to be the case in reality. We’ll establish
why a little later. We’ll first look at how Leather Man communicates
with its debtors.

9.5.1.2 Communicating the creditor's perspective
Because Leather Man has allowed Handbags for Africa to purchase
on credit, Leather Man will want to make sure that the credit terms
are met and that the outstanding debts are paid on time.
Do you remember the credit terms Leather Man negotiated with
Handbags for Africa? The credit terms are 60 days with a 5%
settlement discount offered if payment is made within 20 days. This
means that Handbags for Africa should settle the amount owing
within 20 days to take advantage of the settlement discount being
offered and within 60 days to avoid being charged interest on the
overdue amount.
To make sure that payments are made in time, Leather Man needs
to keep in touch with all the debtors of the business. This is generally
done by sending statements of each debtor’s account to the debtors
at regular intervals, usually monthly. These statements provide
information on all transactions that have taken place in the month as
well as the outstanding balance payable at the end of the month.
Something to do 4
Do you receive any communication from businesses that have provided services
to you on credit? If not, can you think of any businesses that commonly
communicate with individuals in households?
Check your answers
Telkom for telephone rental and use

Cellphone service providers for cellphone rental and use
•
The local government authority for rates, water and electricity

•
Retailers such as Woolworths, Edgars, Truworths, for products bought with store
•
cards
•
Credit card companies for credit card transactions
Government with respect to car licence renewals
•
SABC with respect to TV licence payments.

•
The statement sent from one business to another communicates the same
•
information as the statement sent from businesses to individuals.
Creditor statements
The statement sent by the creditor starts with an opening balance.
This will be the same as the closing balance on the previous month’s
statement. The statement date varies from creditor to creditor. There
is no rule that determines when the statement should be sent, but
remember that the sooner statements are sent, the earlier the debtor
(customer) will become aware of the amount that has to be paid. The
creditor (supplier) will record transactions up to the statement date
and then print out and send the statements to customers by the end
of the month. This means that some of the transactions that take
place after the statement date will not appear on the statement.
Now let’s look again at the problem that Judy expressed earlier in
relation to this statement. Judy’s problem is that the balance on the
statement is rarely the same as the balance of the creditor’s account
in the Trade payables subsidiary ledger.

Before attempting to reconcile the supplier’s statement to the balance
in Judy’s subsidiary ledger, Judy must check that the total of the
individual accounts in the subsidiary ledger equals the total in the
trade payables account in the general ledger. When this has been
done, she can be reasonably certain that there have been no mistakes
on her side.
Judy will have her own information about an individual creditor
(in the subsidiary ledger) and she will receive a statement from the
creditor. The information from these two sources could be different,
and Judy will need to find out what amount actually needs to be
paid to the creditor.
We’ll solve Judy’s problem by learning how to reconcile the
statement received from the creditor to the account of the creditor in
Judy’s records.
Do you remember how we dealt with this problem earlier when
statements received from the bank did not agree with the Bank
balance in the business records?
• We adjusted the Bank account in the general ledger for
information that appeared on the bank statement but not in the
business records.
• We prepared a bank reconciliation statement showing why the
balances were different (if the adjusted bank account balance still
differed from the balance on the bank statement).
9.6.1 The creditors' reconciliation process

Let’s see what the creditors’ account in the Trade payables
subsidiary ledger and the statement received from the creditor
would probably look like in practice. We’ll look at the transactions
that took place in October.

Our record in the Trade payables subsidiary ledger
Statement received from the creditor
What do you notice?

• The closing balance on Leather Man’s account in the subsidiary
ledger account is R8 228.

• The closing balance on the statement received from Leather Man
is R15 685.
• On the statement, goods purchased by Handbags for Africa are
shown as debits and payments received are shown as credits. This
is because the statement shows the transactions from the
perspective of the supplier, Leather Man.
In the Trade payables subsidiary ledger account, goods purchased
by Handbags for Africa are shown as credits and payments are
shown as debits. This is because the Trade payables subsidiary
ledger account shows the transactions from the perspective of
Handbags for Africa.
What has caused the difference between the two balances?

We can see that the entries in the creditors subsidiary ledger account
are not exactly the same as the entries on the statement. This
happens because Judy and her creditors do not have access to the
same information at exactly the same time. The creditors'

reconciliation process identifies the reasons for the difference in the
balances.
9.6.2 How do we prepare a creditors' reconciliation

statement?
If we compare the statement from Leather Man and the Leather Man
account in the Trade payables subsidiary ledger above, we can
identify certain differences. We are now going to examine why these
differences occur and how they are treated during the reconciliation
procedure.
Let’s first look at transactions that have been recorded in both the
Trade payables subsidiary ledger and on the statement, but which

show different amounts. Can you identify these?
A. Transactions recorded at different amounts

1. A purchase on 15 October has been recorded as R3 353 in
Leather Man’s account in the Trade payables subsidiary ledger.
The same purchase has been recorded as R3 335 on the
statement.
2. A purchase on 20 October has been recorded as R6 500 in the
creditors’ subsidiary ledger and as R6 175 on the statement.
Now let’s look at each of these transactions and decide where and
how an adjustment should be made.
1. Purchase on 15 October
Some investigation is required to determine which party
recorded the transaction correctly. Let us suppose that after
checking the Leather Man invoice it was discovered that the
amount on the invoice was R3 335. So it seems that Judy has
overstated the purchase amount in the Trade payables
subsidiary ledger by R18 (R3 353 − R3 335). How will this be
corrected?
We need to check whether the same mistake has been made
in recording the purchase in the Purchases journal. If this is the
case, then a correcting journal entry will need to be processed.
The correcting journal entry will look like this:
Did you know?

If the difference between two numbers is divisible by 9, the difference is probably
because the order of two digits has been swapped. In this example, the
difference of 18 arises from swapping the order of the 3 and the 5. This is called
a transposition error.
If the mistake was made only made when the transaction was
recorded in the creditors’ account in the Trade payables
subsidiary ledger, then only the account in the Trade payables
subsidiary ledger needs to be adjusted. Note that in this case,
the error would also have been identified if the total of the
creditors list had been compared to the trade payables account
balance.
There are two options for adjusting the creditor’s account, both
of which are shown below:
a) Simply cross out the incorrect amount in the account and
replace it with the correct one. This means that the balance
at the end of October will change.
b) Start with the closing balance at the end of October and
make the adjustment in the account.

The first method (a) results in the correction being processed
above the line (before we calculate the closing balance) and the
second method (b) in the correction being processed below the
line (after calculating the closing balance).
2. Purchase on 20 October
Again, further investigation is required to check where the purchase
has been correctly recorded. Let us assume that after checking the
invoice we discover that a trade discount of 5% was granted at the
time of the purchase and that the amount that appears on the invoice
is R6 175. If the gross amount of the purchase was R6 500, who has
recorded the amount incorrectly?
The debtor (Judy) recorded the incorrect amount. The amount has
been shown in the Trade payables subsidiary ledger at the gross
amount before trade discount. When trade discount is negotiated at
the time of purchase, the cost of the items purchased is the amount
net of the discount.
How will this be corrected?

Again, we will need to ask whether the mistake has been made in
the Purchases journal as well as in the Trade payables subsidiary
ledger. Let us assume that in this case the mistake was made only in
Leather Man’s account in the Trade payables subsidiary ledger. This
means that the purchase has been overstated in the Trade payables
subsidiary ledger by the amount of the trade of R325 (R6 500 × 5%).
When making the correction, we have the option of adjusting the
amount in the account manually (above the line) or by means of a

new entry in the account (below the line). We add the adjustment to
the other adjustments done below the line.
By completing the reconciliation, Judy will be able to update her
records. The creditor’s account in the Trade payables subsidiary
ledger will be adjusted by including any additional information that
appears on the statement.
Now we look at the information that appears on the statement but
does not appear in the creditor’s account to see whether the Trade
payables subsidiary ledger should be further adjusted.
B. Transactions that appear on the statement but not in the Trade

payables subsidiary ledger
Let’s summarise the transactions that have been recorded only on
the statement:
• Invoice 466 for R2 400
• Invoice 655 for R880
1. Invoice 466 for R2 400

This invoice was processed by Leather Man on 24 October for goods
to be delivered to Handbags for Africa, but does not appear in the
Trade payables subsidiary ledger. Can you think how such a
situation might have arisen?

After the invoice was processed, although the order and the
invoice were prepared for delivery, there might have been a delay in
the actual physical delivery to the customer.
Do you think we should adjust the Trade payables subsidiary
ledger to show this invoice as a purchase?
To answer this question, think about whether Handbags for
Africa should pay for the goods. Remember that the closing balance
in the Trade payables subsidiary ledger is the amount of the cheque
that the debtor will send to the creditor. Would the debtor pay for
goods that have not been received? Is he liable to do so?
The answer is, most likely not. Handbags for Africa will enter the
purchase in the Trade payables subsidiary ledger only when they
actually receive the goods. When the goods are received they will be
checked to ensure that they are of an acceptable quality and that the
invoice accurately reflects the goods that have been delivered. The
invoice will also be compared to the original purchase order to
ensure that the correct goods have been delivered by the creditor.
Until all these details are verified by the debtor, the invoice will not
be processed in its records and the goods would therefore not be
paid for.
Remember that an asset (the inventory) is recognised only when
control over the right to sell the inventory has transferred, which
usually happens at delivery.
As we did not adjust the trade payables subsidiary ledger by the
amount, we need to include it in the creditors’ reconciliation
statement. The statement is shown later in the chapter.
2. Invoice 655 for R880

Upon further investigation it was discovered that this invoice was
sent by Leather Man to Leather Madness for goods sold to Leather

Madness. The statement incorrectly includes this invoice as a sale to
Handbags for Africa.
This is an example of an error made by the creditor. Such
amounts will be included in the creditors’ reconciliation statement,
because the Trade payables subsidiary ledger balance will not
include errors made by the creditor.
C. Transactions that appear in the Trade payables subsidiary ledger

but not on the statement
We also need to determine whether any transactions that are
recorded in the Trade payables subsidiary ledger are not shown on
the statement.
1. Purchases of R980 on 28 October.
2. Payment of R5 000 on 29 October.
3. Purchase returns of R500 on 29 October.
After further investigation we realise that all these transactions were
correctly recorded in the Trade payables subsidiary ledger. The
differences arose as a result of the timing difference between the
statement date and the month end. Therefore, no adjustments to the
Trade payables subsidiary ledger are required. Instead the amounts
need to be included on the creditor reconciliation statement.
(Did you notice that the date on the supplier’s statement was 25
October? That means that no transactions that occurred after that
date will be recognised on the statement. Checking the dates on the
transactions will help you to identify items that should be included
on the creditors’ reconciliation.)
The creditors' reconciliation statement

The process so far is identical to the bank reconciliation procedure
you learnt about in Chapter 8. The Bank account in the general

ledger was updated with information that appeared on the bank
statement but not in Judy’s records. The bank reconciliation was
prepared in Judy’s books. Any entries that appeared in the Bank
account in the general ledger, but did not appear in the bank
statement, were entered in the bank reconciliation statement.
Do you remember that when reconciling the bank balances Judy
did not actually change the bank’s records? The bank reconciliation
served as an internal check on the Bank account. The creditors’
reconciliation statement is also prepared for internal control
purposes. In effect it is an update of the supplier’s statement.
We are in a position to complete a creditors’ reconciliation statement
that will reconcile the balance in the ledger account (in the trade
payables subsidiary ledger) with the statement balance. The
difference between the adjusted Trade payables subsidiary ledger
balance and the statement balance can be explained:
• by looking at the entries that appear in the Trade payables
subsidiary ledger but have not been shown on the statement, and
• by including the entries that are shown on the statement, but not
on the adjusted Trade payables subsidiary ledger balance.
This is similar to the timing differences that were identified when
reconciling the Bank account balance in the general ledger to the
bank statement balance.
Therefore, the trade payables reconciliation statement will contain
timing differences and errors made by the supplier.
We can now reconcile Leather Man's adjusted account balance in the

Trade payables subsidiary ledger with the statement balance.
1. Balance as per statement

What was the balance on the statement at 31 October? We should
check that the creditor has correctly calculated the amounts in the
statement to arrive at the balance at the end of the month. In this
case, the balance is correct.
Leather Man
Trade payables/Creditors’ reconciliation statement at 31 October
X1
Balance per statement 15 685.00
2. Reconciling items
We’ll look at each reconciling item that we identified earlier and
consider the impact on the balance per statement.
a) Invoice 466 for R2 400
This invoice has been processed in Leather Man’s records but
not in Handbags for Africa’s records. In our earlier discussion
we concluded that the invoice would not be added to the Trade
payables subsidiary ledger balance because the goods have not
yet been received by the debtor.
What effect will the item have on the balances from the
debtor’s and creditor’s perspectives?
The invoice will result in the statement balance being higher
than the Trade payables subsidiary ledger balance. In order to
reconcile these two balances, we would need to decrease the
statement balance to bring it into line with the Trade payables
subsidiary ledger balance.
Leather Man
X1
Invoice 466 − goods not received yet (2 400.00)
b) Invoice 655 for R880
This amount will reduce the statement balance because it has
been incorrectly added to the statement.
Leather Man
X1
Invoice 655 incorrectly debited on the statement (880.00)
c) Purchase on 28 October for R980
This purchase was recorded in the debtors’ books (Judy’s books)
after the statement date. As a result it does not appear on the
statement. This purchase represents a timing difference that
arose between the statement date and the month end in the
Trade payables subsidiary ledger. Because the statement does
not reflect this purchase, the statement balance will be
understated.
To reconcile the two balances we’ll add the purchase amount
to the statement balance.
Leather Man
Creditors’ reconciliation statement at 31 October X1
Invoice for goods purchased on 28 October 980.00
d) Payment on 29 October for R5 000
This payment is also a timing difference, as it was paid after the
statement date. Because the statement does not reflect this
payment, the statement balance is overstated by the amount of
the payment. In order to bring the statement balance into line
with the Trade payables subsidiary ledger balance, we’ll deduct
the payment from the statement balance.
Leather Man
X1
Payment made on 29 October (5 000.00)
e) Purchase return for R500 on 29 October
This is also a timing difference, which will require adjustment to
the statement balance. What is the effect of bringing this return
onto the statement? The statement balance will decrease by
R500.
Leather Man
X1
Purchase return on 29 October (500.00)
Balance per trade payables ledger 7 885.00
3. Adjusted balance as per Trade payables ledger

Once all the reconciling items have been included in the
reconciliation statement, the new balance can be calculated. It is
shown in the statement above.
We can see that the final balance on the trade payables
reconciliation statement is equal to the new balance in the Trade
payables subsidiary ledger account. This means that once the
purchases and cheques processed after 25 October and any errors
have been taken into account, the balance in Handbags for Africa’s
account at Leather Man is the same as the balance in Leather Man’s
account at Handbags for Africa. If, after the reconciliation is
complete, the balances still do not agree, Judy would need to check
whether any further errors have been made, either by her or by the
creditor.
When Judy prepares her trade payables list at the end of the
month, the reconciled trade payables balance of R7 885 will be used.

The reconciliation procedure serves as a useful internal control, but
at this point nothing has been communicated to the creditor. In the
example above, the creditor statement indicated that a balance of
R15 685 was owed by Judy. The reconciliation procedure revealed
that an amount of R7 885 should be paid at the end of October. If a
cheque of R7 885 was sent to Leather Man, it would cause a bit of
confusion, unless an explanation was provided as to how that
amount was calculated.

An explanation will have to be sent with the cheque payment to
explain the difference between the statement balance and the
amount paid. This explanation appears on the remittance advice

sent by the debtor (Judy) to the creditor (Leather Man).
The structure of a remittance advice is very similar to the trade
payables reconciliation statement prepared for internal purposes.
The only difference is that the amount of R7 885 is referred to as the
cheque amount (or EFT).
Let’s prepare the remittance advice that Judy would send with the
cheque to settle the October balance.
Remittance advice on 31 October X1

Purchase return on 29 October (500.00)
Amount of cheque/EFT 7 885.00
Notice how the remittance advice sent to the creditor starts with the
amount that the creditor has indicated that Judy owes. This makes it
possible for the creditor to identify quickly why Judy paid a
different amount.
Something to do 5
You have been chosen as a business advisor by your course co-ordinator because
of your outstanding results in the course so far. You will be helping out at the
small business advisory centre set up by your institution. Your first job consists of
reconciling the Trade payables subsidiary ledgers of one of the centre's clients.
The business, Jade Traders, is having trouble working out how much they owe
one of their suppliers, Ruby Wholesalers.
You have been presented with the statements received from Ruby Wholesalers
for the months of March and April X2. You also have a copy of the information
summarised in the journals for March and April.
1. The balance on Ruby Wholesalers’ account in the Trade
payables subsidiary ledger of Jade Traders on 1 March was R3
690. The difference between the statement balance and the
Trade payables subsidiary ledger balance was the result of a
cheque payment made on 27 February not yet received by Ruby
Wholesalers.
2. Invoice BD 247, reflected on the April statement of Ruby
Wholesalers, had not yet been received by Jade Traders.
3. Jade Traders sent a debit note to Ruby Wholesalers in March for
R500, representing the difference between the price they had
verbally agreed on some items purchased and the price that
appeared on the invoice. They have still not negotiated a
compromise.
4. A credit note for goods returned in April appears on the April
statement as R190. This credit note has been correctly recorded
by Jade Traders in April. This is the only entry in the purchases
returns journal for April.

5. Invoice BD254 on the April statement is for Jade Furnishings,
not Jade Traders.
6. An invoice for R658 shown on the April statement was for
jewellery ordered by the owner of Jade Traders for his wife’s
birthday. The bookkeeper had not recorded this transaction at
all, as the owner had ordered the goods in his own name and
not for the business.
1. Prepare the Ruby Wholesalers account in the Trade payables
subsidiary ledger showing all the transactions for March and
April.
2. Prepare a Trade payables reconciliation statement at 31 March
and 30 April.
Check your answers
1. Extract from Trade payables subsidiary ledger

2. Trade payables reconciliation statements for March and April:
Ruby Wholesalers
Trade payables/Creditors’ reconciliation statement at 31 March
X2
Balance per suppliers statement 13 180
Less amount disputed (500)
Balance per Trade payables ledger 12 680
Ruby Wholesalers
Trade payables/Creditors’ reconciliation statement at 30 April X2
Balance per suppliers statement 14 111
Less invoice BD247 − goods not yet received (3 100)
Less invoice BD246 (658)
Less disputed amount (500)
Less invoice incorrectly recorded in Jade Traders account (3 784)
Add invoice BD244 appearing on incorrect side of statement 4 920
Less credit note AS24 understated (720)
Balance per Trade payables ledger 10 269
What do you notice?

The amount in dispute of R500 appears on both statements, because
Jade Traders has not agreed to pay it. Until there is agreement, this
will appear as a reconciling item.
Something to do 6
What will be the effect on May's records for each of the following
scenarios?
1. Jade Traders agrees to pay the amount on the invoice.
2. Ruby Wholesalers agrees to deduct R500 from the invoiced amount.
Check your answers
1. The R500 will be debited to Inventory and credited to the Trade payables account
in the general ledger. Ruby Wholesalers account in the subsidiary ledger will be
increased by R500.
2. The amount (R500) will appear as a credit on the May statement from Ruby
Wholesalers.
Something to do 7
1. The invoice of R658 for goods purchased by the owner of Jade Traders
has been reversed on the statement. Can you explain why?
2. How should this amount of R658 be dealt with in the books of Jade
Traders?
Check your answers
1. This amount relates to a personal, not a business, transaction, and should not
appear as a purchase in the records of Jade Traders or a sale to Jade Traders in
the records of Ruby Wholesalers.
The amount should not be recorded in the books at all as the sale is between
the owner (in his or her personal capacity) and Ruby Wholesalers.
2. The following journal entries would be processed (assuming a periodic system):
a) When the jewellery is received:
b) When the owner takes the jewellery to give to his wife:

• We have learnt why businesses purchase on credit.
• We know how to record credit transactions in specialised
journals.
• We have learnt how to post credit transactions from the
specialised journals to the Trade payables/Trade payables
accounts in the general ledger.
• We know how to prepare the trade payables subsidiary ledgers.
• We have learnt how to account for VAT on credit transactions.
• Creditors communicate with their debtors by means of a
statement.
• The balance of the creditor’s account in the Trade payables ledger
may differ from the balance on the statement received from the
creditor. The two balances may be reconciled by comparing the
two perspectives of the debtor and the creditor.
• A Trade payables reconciliation statement highlights the
differences between the creditor’s account in the Trade payables
ledger of the debtor and the statement received from the creditor.
• Adjustments may need to be made to the creditor’s account before
preparing the trade payables reconciliation statement to
determine the corrected creditor’s account balance.

A remittance advice is prepared to communicate why the amount
•
paid to the creditor is different from the amount on the statement.
What's next?
In the next chapter we look at the recording of credit sales and other
transactions with our debtors and at working capital management.

QUESTIONS
QUESTION 9.1 (B)

Ignore VAT.
Part A
Jingles Ltd sells portable waterproof radios to hypermarkets. You
have been asked to assist in the preparation of the annual financial
statements for the year ended 31 March X2. The following statement
of comprehensive income has been prepared by the bookkeeper:
Retained income 31 March X1 68 200

Sales 200 000
Purchases 79 100
Import duty 12 000
Salaries 25 200
Rent 16 300
Interest 3 000
General expenses 22 700
Pro t 30 500
On investigation of the above statement of comprehensive income,
you discover the following:

The bookkeeper had not journalised the reversing entry for the
i)
accrual at 31 March X1 of rent paid in advance of R3 000 or sales
received in advance of R6 500. Both these amounts related to
April X1. All other reversing entries have been processed.
ii) Interest represents payments of interest for the year on a loan of
R30 000. The interest rate is 15% per annum and there have been
no repayments during the year.
iii) The inventory per the statement of financial position at 31
March X1 was R6 300, which represented 70 radios valued at
R90 each.
iv) There were 72 radios on hand at 31 March X2. Of these, 8 were
considered worthless. Jingles Ltd accounts for inventory on the

periodic method using the FIFO basis of allocating costs.
v) The purchases and purchase returns records for the year were
as follows:
Purchases:
June 280 radios at R100 each
October 320 radios at R110 each
February 100 radios at R120 each
March 30 radios at R130 each (after trade discount)
Purchase returns
July 40 radios at R100 each
March 10 radios at R130 each
vi) A Taiwanese supplier entered the market in late March, and
was selling its radios at R150 each. The normal selling price of
Jingles Ltd was R200.

vii) During March X2 a carton of 10 radios purchased in March was
stolen. Jingles Ltd is not insured for losses of this nature.

viii) No taxation or dividends are payable for the year.
1. Record the journal entries to finalise the books for the year
ended 31 March X2 for items i, ii, vi and vii ONLY. Narrations
are not required. If no entry is required, state this fact and give a
reason for your answer. (9 marks)
2. Prepare the statement of comprehensive income for the year
ended 31 March X2, taking (i) – (viii) above into account.
(12 marks)
Part B (8 marks: 10 minutes)
Jingles Ltd changed to a new supplier, Amaglug-glug Ltd, in
February X2, as Mr Jingles had been able to negotiate a better price
for the radios. The only transaction in February had been the
purchases above. However, Amaglug-glug Ltd had recorded a unit
price of R150 on its invoice, instead of the negotiated price of R120.
A credit note for the difference was sent in April.
In March Amaglug-glug Ltd had agreed to give Jingles Ltd a 20%

trade discount on all purchases. On comparing the balance in the
Creditors ledger at 31 March X2 to the statement from Amaglug-
glug Ltd at the same date, the following discrepancies were found:
i) The invoice for 30 items purchased in March did not reflect the
trade discount of 20% as agreed.
ii) The payment made by Jingles Ltd in respect of February

purchases was not reflected on the statement.
iii) A sales invoice for R6 000 to Jukebox Ltd has been reflected on
the statement in error.

1. Calculate the balance of Amaglug-glug Ltd in the Creditors
ledger of Jingles Ltd at 31 March X2. (2 marks)
2. Prepare the remittance advice to be sent with the cheque to
Amaglug-glug Ltd on 15April X2. (6 marks)
QUESTION 9.2 (B)
The following information was extracted from the books of Christian

Traders in respect of the month of June X9:
1 June X9
Total of individual debit balances in debtors' ledger 10 520
Total of individual credit balances in debtors' ledger 95
Total of individual credit balances in creditors' ledger 6 750
The balances on the trade receivable and trade payables account in
the general ledger on 1 June X9 were in agreement with the totals of
the lists of individual debtors’ and creditors’ accounts at that date.
30 June X9 (summarised gures for the month)

Cash received from debtors 15 046
Allowances made to debtors for goods returned 830
Purchases from suppliers, for cash 4 420
Purchases from suppliers, on credit 6 362
Cash paid to creditors 6 500
Cash sales 6 540
Credit sales 14 250
Interest charged on overdue debtors' accounts 86
Debtors' cheques dishonoured at bank 348
Goods purchased on credit returned to suppliers 800
30 June X9
Total of credit balances in debtors' ledger 38
1. Prepare the Trade receivables account for the month of June X9.
2. Prepare the Trade payables account for the month of June X9.
The other side of
credit: Trade
10 receivables and
working capital
management
Judy has discussed her new system with Jason Arnold, one of her
suppliers. He manages a business called Leather Man, which
supplies retailers in the Western Cape with handmade leather
handbags and briefcases. He has also recently expanded his
business and decided to offer credit to his retail customers in an
effort to rapidly increase his market share. He does not, however,
have an accounting system in place for dealing with the increased
complexity of his business. After talking to Judy, he approached us
for help in setting up a system for controlling his credit customers.
We'll apply the principles we used to record and control Judy's
suppliers to set up a system for Leather Man.
Learning objectives
• Understand why a business would sell on credit
• Record credit transactions between a business and its customers (debtors)
• Understand why an accounting system that records transactions with each
customer individually is needed
• Maintain a Trade receivable subsidiary ledger and extract a list of debtor balances
• Prepare a reconciliation between the trade receivable account in the general ledger
and the total of the list of debtor balances
• Prepare the transactions to record bad debts (with VAT)
• Identify the components of net working capital
• Understand why working capital management is important for a business.

Before we show Jason how to record the transactions with each
customer separately, let’s look at what we have learnt about sales
this far.
Something to do 1
What accounting terms do we use to describe the following?
1. Credit customers of a business.
2. Journal in which all credit sales are recorded.
Check your answers
1. Debtors or Trade receivables. This textbook will use the term “Trade receivables”
when referring to all the debtors, and the term “debtor” when referring to an
individual customer.
2. Sales or Trade receivable Journal.

Do you remember what credit transactions took place in Judy’s
business in January X1?
Below is an extract of these transactions as they appeared in
Chapter 2.
Day Information
6 Sold 4 briefcases and 3 handbags − R1 380 must still be paid
13 Sold 10 briefcases to a tour operator − gave him a 5% trade discount −
must still pay R2 850
Do you remember how we recorded these transactions under the
accounting equation?
Let’s look at each transaction in turn:
1. Sold 4 briefcases and 3 handbags − must still be paid the R1 380
2. Sold 10 briefcases to a tour operator − gave him a 5% trade
discount − must still be paid the R2 850

Do you remember why the Trade receivables account is an asset?
Before the business can recognise debtors as an asset in the financial
statements, the debtor needs to fit the definition and recognition
criteria.
The resource (debtor) is a present economic resource (the right to
receive cash) due to a past event (the purchase − and delivery − of
Leather Man’s bags). The debt is controlled by the business (the
business has the legal right to demand payment on the due date and
would lose money if no payment was made), and the payment of the
debt on the due date will benefit the business. We can see that the
debtor fits the definition of an asset.
Recognising the debtor provides relevant information to users
and faithfully presents the assets of the business.
The debtor fits the recognition criteria and should be recognised
on Judy’s statement of financial position as an asset.
Do you remember how we record the credit sales in the general

ledger?
Let’s visit the general ledger to see how the transactions in January
X1 were recorded. We will assume that a periodic system is used.

By allowing customers to buy on credit, the business hopes to
increase its sales. By allowing the customer to buy on credit the
business is providing the customer with a zero interest loan to buy
the inventory. A customer would rather buy at a place where he or
she can borrow money for free than at a place where he or she has to
pay cash. In this way the customer can use its cash for other
investments (for example, earn interest at a bank), and can pay for
the purchase only once the goods are sold again. Customers who
purchase often during a month or have inventory delivered to
various stores or factories but have the payment made by a head
office would find it more efficient to buy on credit. Increasingly,
customers do not carry around large amounts of cash − electronic
transfers and credit sales are the reality of many businesses.
Therefore the advantages of investing in trade receivables are:
• Increased sales − more people can afford to buy goods now and
pay for them later.
• Increased income from outstanding debtor balances − businesses
can charge interest to customers who do not pay their debts

within an agreed time.
Think about this 1

Can you think of a company that sells a large percentage of its goods on
credit?
Check your answer
Some examples are Edgars, Woolworths or Joshua Doore.

The Woolworths group, for example, had total assets in 2008 of R11 261.8 million
on their balance sheet, of which R4 035.1 million was trade and other receivables (this
amount excludes loans to customers and credit card receivables).
On their income statement they earned R10.7 million other interest income
(excluding bank and financial services asset interest), some of which was interest
earned on their outstanding trade receivable balances.
Now, let's look at what information would be useful to help a business

communicate the transactions with its customers.
10.3 Source documents relating to credit

sales
The source documents used to record transactions related to credit
sales are:
• Credit sales: duplicate invoice (retained copy)
• Payments from trade receivable: duplicate receipt, cash slip,
deposit slip or bank statement
• Returns from trade receivable: credit note
• Settlement/trade discounts: duplicate invoice

• VAT: duplicate invoice.

individual debtors?
When a business has a large investment in debtors, large amounts of
cash could be tied up in the debtors’ balances. The risk of selling on
credit (taking on trade receivables) is the possibility that the debtors
will not pay their debts. Jason needs to know what each individual
debtor owes him at any point in time to make sure that he manages
them effectively (ensures that they pay on time) and to help him to
decide if he is prepared to lend them any more money (sell more
goods on credit). A system needs to be in place for recording and
controlling his customers who buy on credit (also known as his trade
receivables).
Before a business can start selling goods on credit, a credit policy
needs to be decided on by the managers of the business. More detail
on the decisions that need to be made is provided later in the
chapter.
Did you know?

If customers use a credit or a debit card, the business will not recognise the
customer as a debtor. The card system is electronically linked to the bank, so that
when a customer's card is swiped through the speed point, the amount is
electronically transferred to the business bank account. If a credit card is used, the
amount is transferred from the bank that supplied the card. If a debit card is used,
the bank account is the customer's own bank account. The credit card company
usually charges a commission for providing this service. When customers use a
credit card, they are receiving credit from the credit card company, so their
obligation to repay the amount spent is to the credit card company and not to the
business. As the business receives the payment when the customer leaves the
shop, the business does not have a trade receivable.

journals
As the number of transactions in the business increase, it becomes
necessary to use specialised journals for recording transactions.
Do you remember what types of specialised journals are used?
Journal Use
Cash Receipts Records all cash
journal receipts
Sales journal Records all credit sales
We are going to show Jason how to record all the transactions with
his credit customers in a specialised journal and ledger.
Which of these will be useful in helping Jason record his debtors?
1. Sales journal − records all credit sales made by the business,

also known as the Trade receivables journal (for the obvious
reason that the debit arising from the credit to sales is trade
receivable).
Goods returned by the debtor can either be recorded as negative
amounts (shown in brackets) in the Sales journal or recorded in
a Sales returns journal, with the total sales returns posted as a
credit entry to the trade receivable account in the general ledger.

Cash receipts journal − records all cash received from debtors in
2. respect of credit sales made in an earlier period.
All credit sales are recorded in the relevant specialised journals
and are then posted periodically to the general ledger to an
account called Trade receivable. This account summarises all the
transactions with individual debtors and reflects the total
balance owed by customers who purchase on credit at a
particular point in time.
What does the Trade receivables account look like?
What do you notice?

• All sales are posted to the debit side of the account from the Sales
journal. The reference SJ5 indicates that these are the total sales
for the fifth month, May.
• All cash receipts from trade receivables are posted to the credit
side of the account from the Cash receipts journal. The folio CRJ5
indicates that the information was posted from the Cash receipts
journal for May.
10.4.2.1 Settlement discounts

To encourage our debtors to pay the amount owing earlier the
business can offer a settlement discount, for example the credit terms
offered to our debtors could be 2%, 10 days or net 30 days. What do
these credit terms mean. If the debtor pays within 10 days of
purchasing the inventory they will receive a settlement discount of
2%; in other words, they will pay 2% less to settle their debt. If they
do not pay within 10 days they will have to pay the full amount
within 30 days.
Let’s look at settlement discounts offered to our credit customers.
If your business sells on credit and offers a settlement discount, the
amount recorded for the debtor (trade receivable) depends on your
estimate (based on past experience) of whether the debtor will take
advantage of the discount or not.
1. If it is probable that the discount will be taken:

• We will recognise sales net of the discount as this is the income
we anticipate earning. Remember that if the amount is net of the
discount, it means that it is less the discount amount.
The trade receivable amount recognised will be net of the discount
(it will exclude the discount).
2. If it is probable that the discount will NOT be taken:

• We will recognise sales of the FULL amount, as this is the income
we anticipate earning.
• The trade receivable amount recognised will be the FULL amount
of the sale.
Something to do 2
On 1 June X1, Jason sells inventory to a customer for R100 and offers a 4%
settlement discount, i.e. the following settlement terms: 4%, 10 days or net 30
days.
How would you record the transaction, if Jason:
1. Assumes customers will take advantage of the settlement discount.
2. Assumes they will not take advantage of the settlement discount.
Check your answers
1. If Jason assumes customers will take advantage of the settlement discount, the
sale must initially be recorded as follows (assume a perpetual recording system):
a) In Jason's books (Seller):
1/6/X1
b) In Purchaser's books (if the debtor also assumes that he will take advantage
of the settlement discount):
1/6/X1
2. If Jason assumes the customers will not take advantage of the settlement
discount, the sale must initially be recorded as follows:
a) In Jason's books (Seller):
1/6/X1
b) In Purchaser's books (if the debtor also assumes that he will NOT take
advantage of the settlement discount):
1/6/X1
Something to do 3
1. How would you record the transaction, if Jason assumed the customer
would take advantage of the settlement discount, but the customer paid
only after the settlement period, i.e. on 30 June X1?
2. How would the customer record the transaction if he had made the same
assumption?
Check your answer
1. In Seller's books
10/6/X1
The seller recognises that the debtor owes the settlement discount that has not
been taken up and recognised the full sales amount, i.e. no settlement discount.
30/6/X1 (Assuming payment received)
2. In Purchaser's books
10/6/X1
Both the liability to the supplier and the cost of the inventory have increased in the
buyer's books.
30/6/X1 (Assuming payment received)
Something to do 4
1. Jason assumed the customer would NOT take advantage of the settlement
discount, but the customer paid within the settlement period. How should
Jason record the payment?
2. How would the customer record the transaction if he had made the same
assumption?
Check your answers
1. In Seller's books
10/6/X1
The seller recognises that the debtor does not owe the 4% settlement discount
and that the business has not earned the R4 as sales revenue.
2. In Purchaser's books
10/6/X1
The buyer recognises that the cost of the inventory purchased has an actual cost
of R96 as the settlement discount of 4% was taken up.

In the next example, we’ll show you how to do the following:
• Record all credit transactions with debtors in the relevant
journals.
• Summarise the transactions in the general ledger (Trade
receivable account).
• Set up a subsidiary ledger that maintains information about
individual debtor balances.
We’ll look at the transactions that took place in Jason’s business in
September X2, and then we’ll do the exercise without VAT, using the
periodic method for recording inventory.
Opening balances
The following debtors had balances (included in the trade receivable
balance in the general ledger) owing at the beginning of the month:

Based on past experience, Jason’s debtors normally pay in time to
benefit from the discount.
Transactions for September

3 Total cash sales, R3 550.
Sold briefcases on credit to Golden World Retailers, for R3 600
(Invoice HA000).
Sold leather bags and briefcases for R8 950, on credit, to
Handbags for Africa (Invoice HA001).
5 Purchased leather products costing R12 500 from Universal
Leather Suppliers. Paid by cheque #222.
Received a cheque for R2 550 from African Expedition in
settlement of the amount owing by them at 1 September.
7 Golden World Retailers returned two of the bags sold to them
on 3 September. Issued a credit note (CN443) for R100.
Sold leather bags to Leather Madness, on credit, for R3 540
(Invoice HA002).
10 Received a cheque from Handbags for Africa to settle the
balance owing at 1 September.
Sold 15 briefcases to Jacob’s Ladder Clothing, on credit, for R4
500 (Invoice HA003).

Sold bags to Handbags for Africa, for R1 430, on credit (Invoice
HA004).
Received a cheque from Golden World Retailers, for the balance
owing at 1 September.
Sold bags and briefcases to African Expedition, on credit, for R5
670 (Invoice HA005). Received a cheque from Handbags for
Africa for the goods purchased on 4 September.
25 Sold goods on credit to Golden World Retailers for R5 550
(Invoice HA006). Received a cheque from Leather Madness, to
settle the amount owing on 1 September.
26 Sold briefcases to Handbags to Africa, for R2 565, on credit
(Invoice HA007).
27 Paid salaries for the month, R15 000 (Cheque 227).
Received a cheque from Jacob’s Ladder Clothing, to settle the
amount owing at 1 September.
We'll proceed as follows:

1. Identify credit sales and record in the Sales journal.
2. Record all sales returns in the Sales journal (assume no separate
Sales Returns journal is used by Jason).
3. Complete the Cash Receipts journal to show all cash receipts.
4. Post the relevant transactions to the Trade receivable account in
the general ledger.
5. Balance the Trade receivable account in the general ledger.
6. Create a Trade receivables subsidiary ledger and open an
account for each debtor in the ledger.
7. Record all transactions with debtors in the individual accounts
in the subsidiary ledger.

Extract a list of debtor balances from the individual accounts of
8.
debtors in the subsidiary ledger and calculate the sum of all the
individual balances. Compare this balance with the balance in
the Trade receivable account in the general ledger at the end of
September.
1 and 2. Sales/Trade receivables journal
3. Cash receipts journal

4 and 5. Trade receivables account in the general ledger
6 and 7. Trade receivables subsidiary ledger

8. Debtors list
Trade receivables/Debtors list

African Expedition R5 670.00
Handbags for Africa R3 795.25
Leather Madness R3 433.80
Jacob's Ladder Clothing R4 275.00
Golden World Retailers R9 050.00
R26 224.05
The total of the individual debtors’ accounts on the Trade
receivables/Debtors list equals the balance of the Trade receivable
account in the general ledger.

The Trade receivables subsidiary ledger was created to keep an
independent account of all transactions with each debtor in an
individual account. This allows Jason to keep track of the
transactions with individual debtors and means that the business
can send statements to its individual debtors requesting payment.
The statement will be a picture of the debtor’s account in the
subsidiary ledger. It will reflect all transactions with the debtor from
the business’ point of view. This will also give a perpetual record of
the amount owed by an individual customer and make it easy for
Jason to decide whether to lend more to that customer by selling
goods on credit.
The purpose of maintaining a trade receivables subsidiary ledger is:
• To record the details of transactions with individual debtors.
• To ensure that all transactions affecting the trade receivable
account have been accurately recorded and posted to the general
ledger.
• To enable statements to be sent to debtors, informing them of all
amounts due.
• To determine the amount owing by a particular debtor at any
point in time in order to facilitate credit granting decisions.

In the previous exercises we have ignored VAT. What if Jason is a
registered VAT vendor?
Let’s look at the example again and see how the results would
change, if we assume that the business was liable for VAT. We also
assume that the amounts (for goods sold) in the example are stated
exclusive of VAT.
What do you notice?

1. The opening balance for Trade receivables remains the same,
because we assume that VAT was correctly treated in the
previous period.
2. Sales is adjusted by the VAT component, in other words, by
adding 15% of the sales amount. The amounts have been
increased, as the customer has to pay an amount including
VAT. The sales income remains unchanged, but the amount
owing by the debtor increases with VAT. Refer to the adjusted

sales journal below for a detailed calculation of the debtor
amount relating to sales.
3. The bank payments need to be adjusted, because one of the
payments (by Handbags for Africa) does not relate to the
opening balance (which includes VAT), but relates to a purchase
during the month, which excluded VAT.
In the Sales journal, the amount recorded in the Trade receivables
column is the VATinclusive amount (sales amount × 1.15).
Let’s analyse the sale on 4 September. The VAT exclusive price is R8
502.50. The journal entry is:
In the Cash Receipts journal, the amounts received for cash sales are
calculated by adding VAT to the sales amount.
On 3 September, for example, the amount in Bank is R3 550 × 1.15
= R4 082.50. The amount recorded in the VAT column is R3 550 ×
15/100 = R532.50, or R4 047 × 15/115.

Finally, let’s look at the SARS (VAT) account in Leather Man’s
ledger. The amounts in the SARS (VAT) account are posted from the
adjusted specialised journals. The amounts are credited to the SARS
(VAT), as they are output VAT that needs to be paid over to SARS.
10.4.5.1 VAT on bad debts expense
Assume VAT of 15%.

Golden World Retailers, a debtor owing R3 600 ( VAT exclusive) for
credit purchases made in the current year, has been declared
insolvent. No entry has been recorded to process the bad debt.
What was the original sale entry?

What journal entry should we record when the debtor is declared
insolvent?
What do we notice?
We reduce the trade receivables by the full amount of R4 340,
because we will not receive any payment from the debtor. When we
made the sale we recognised output VAT of R540 (R3 600 × 15/100).
In other words, we owed SARS R540. Now that we are not being
paid the amount owing (including this VAT), we need to reverse the
VAT liability recorded when the sale was made. Trade receivables
therefore decrease by R4 340 and the VAT liability decreases by
R540, resulting in a decrease in net asset value of R3 600. This
reduces the net asset value of the business, and is not due to a
transaction with the owner, so we recognise an expense − bad debts
expense.
10.4.5.2 VAT and allowance for doubtful debts

There is no VAT effect when recording an allowance on doubtful
debts because SARS does not cancel the output VAT on a sale until
there is evidence that an identified debtor has gone insolvent.
10.4.5.3 VAT and bad debts recovered

What would happen if we wrote Golden World Retailers off as a bad
debt and the next year the company managed to pay us (in other
words, we recover the bad debt)?
• When we receive the money, the debtor no longer appears in the
subsidiary ledger. (We would have removed the debtor after the
debt was written off.)
• It is often a good idea to reinstate the debtor in the subsidiary
ledger. We could use this information when deciding whether to
offer the debtor credit in the future, as it shows that the debtor has
paid his or her debt.
The required journal entries are as follows:
We owe SARS the output VAT from the original sale, so we credit
VAT. There is an increase in net assets of R3 600, and as this is due to
a transaction not with the owner, we recognise income (bad debts
recovered).
Credit sale
Receipt of payment by debtor

Return of credit sale

Working capital includes the current assets of the business. The
typical components of working capital are trade receivables,
inventory and cash.
Net working capital is current assets (for example, trade
receivables, inventory and cash) less current liabilities (for example,
trade payables).
10.5.2 Why is working capital management

important?
Three assets, which are inventories, trade receivable and cash, form a
large part of the total investment in assets of a business. Businesses
can have from 50% up to 70% of their cash tied up in investments in
working capital. Together with the non-current assets and other
investments in a business, they account for the total assets that must
be used productively to ensure a maximum increase in wealth to the
owners of the business. The success of a business is measured by the
capacity of management to invest in assets that generate the highest

return to the owners. If these investments are not managed carefully,
the result may be the failure and bankruptcy of the business.
10.5.3 The financing of working capital

The financing of working capital is an important part of working
capital management. Creditors largely fund working capital, with
the balance funded by short-term interestbearing loans from the
bank, such as overdrafts.
10.5.4 Managing the various components of net

working capital
The risks of investing in working capital (such as trade debtors
failing to pay) must be balanced by the return of such an investment
(more sales, and interest income). Risks can result from an over- or
an under-investment in net working capital.
If the investment in net working capital is too high (there are too
many current assets):
• The cash may earn more money in the bank as a long-term
investment.
• Inventory may become obsolete or old-fashioned.
• Trade receivables may not be recoverable (a debtor may not pay).
If the investment in net working capital is too low (there are too few
current assets):
• There may be insufficient cash to pay the running costs of the
business.
• Inventory stock-outs may occur and sales may be lost.

• If the credit terms for debtors are too strict, customers may be able
to obtain a better deal elsewhere and sales may be lost.
The total investment in net working capital, as well as the portion
invested in its various components, needs to be managed. For
example, cash is more liquid than inventory and is needed to ensure
that short-term obligations are met.
Let's look at each component of net working capital.
10.5.4.1 Current assets
Level of cash
If cash levels are too low, there is a risk that the business will not be
able to pay its obligations i.e. pay creditors or operating expenses
(liquidity problems). This will influence the creditworthiness of a
business, since “ability to pay” is seen by lenders as a key factor of
the risk of such loans. On the other hand, the higher return earned
on a fixed or longterm investment will be lost if cash levels are too
high.
Level of inventory
If inventory levels are too high, inventory could become obsolete (go
out of fashion) or could be damaged if it remains in the warehouse
too long. If inventory levels are too low, the business may not be
able to fill customer orders, the reputation of the business may be
damaged, and customers could go to other suppliers.
Level of trade receivable

If the criteria for deciding whether to grant credit (allow customers
to purchase on credit) are too strict, potential customers may be lost.
If, on the other hand, the credit policy is too lenient (not strict
enough), the level of trade receivable may be too high and the level
of bad debts may increase.
10.5.4.2 Credit policy

1. Credit terms
• How much time do customers have before their invoices fall
due? (When does payment have to be made?)
• Are customers offered a settlement discount for paying their
debts before or on the due date? This provides them with an
incentive to pay early, but it is a cost to the business.
• After what time period should the business charge interest on
the unpaid amount?
2. Creditworthiness
• What criteria are applied when deciding to issue credit to a
customer?
This is an important decision, because it will affect the
percentage of bad debts, in other words, amounts never
recovered from customers.
Considerations such as the customer’s credit history, present
state of wealth, current salary, attitude towards debt and
security provided would be taken into account. The general
economic outlook is also considered.
3. Collection policy
• What procedures are applied for collecting debts, for
example, letters, phone calls, an attorney?

• When is credit to a particular customer stopped?
• How are long-overdue accounts dealt with?
10.5.4.3 Level of creditors

Trade payables are a cheap financing method (especially as a form of
financing working capital). Remember that your suppliers could
offer you certain credit terms, for example, 30, 45 or 60 days. During
this period the creditor cannot charge interest on the amount you
owe them. Your suppliers could also offer you a settlement discount
if you pay the amount owing within a specified period. Therefore,
having a high level of creditors is beneficial to a business. However,
if the business has too many creditors, the business may not be able
to repay all the debts as they fall due. The business would lose its
good reputation with its suppliers. Suppliers may stop offering
credit and insist that you pay COD (cash on delivery) for all the
inventory or your business could be forced to file for bankruptcy.
Also, high debt levels negatively affect loan application decisions.
Managers need to plan their cash cycles carefully before buying
goods on credit to make sure that there will be enough cash
available to pay their suppliers when the debt falls due. When
planning how much inventory to purchase, it is important that there
is a match between the inflow of cash flows from selling the
inventory and the payments to be made to the suppliers for the
inventory.

• We have learnt why businesses offer credit to customers.
• We know how to record sales credit transactions in specialised
journals.
• We have learnt how to post credit transactions from the
specialised journals to the Trade receivable account in the general
ledger.
• We know how to prepare the Trade receivable subsidiary ledgers.
• We have learnt how to account for VAT on sales credit
transactions.
• We have learnt how to account for VAT on bad debts.
• We have learnt how to identify the components of net working
capital.
• We have learnt why working capital management is important for
a business.
What's next?
In the next chapter Judy decides to purchase machines and
equipment so that she can start manufacturing leather products.
We’ll consider all the accounting implications of buying and using
these types of assets.

QUESTIONS
QUESTION 10.1 (A)

The accountant of your company, Tshwane Delights, tried to perform

a debtors’ reconciliation for the month of March X5 and was unable
to reconcile the ledgers. The information available is as follows:
a) Total of the debtors list on 31 March X5 is R450 000.
b) The closing balance on the trade receivables control account in
the general ledger on 31 March X5 is R404 175.
c) When checking the ledgers you found the following:
i) The account of A. Smith in the debtors ledger had been
incorrectly added. The closing balance was overstated by
R600.
ii) A sale return from M. David had been recorded on the
incorrect side of the ledger account for M. David in the
debtors ledger. The transaction had been correctly
processed in the general ledger. The inventory returned
had a selling price of R22 800 and a cost price of R11 400.
iii) The accountant has incorrectly recorded the sale to a debtor
where a discount was allowed. The original sale was for R7
500 and the debtor, Miss Xolile, was allowed a 5%
settlement discount. Tshwane Delights anticipated that the

debtor would take advantage of the discount. The
accountant had processed the entry below to record the sale

in the general ledger. The correct amount owing by Miss
Xolile had been recorded in the Debtors ledger. Tshwane

Delights received payment from Miss Xolile, and the
payment was correctly recorded.
1. Prepare the correcting general journal entry(ies) to correct the

general ledger in respect of the payment received from the
debtor Miss Xolile. (3 marks)
2. Prepare the debtors reconciliation as at 31 March X5, after
taking into account the information provided above. (7 marks)
QUESTION 10.2 (B)

Extract from the pre-adjustment trial balance of Windy Seas as at

30 April 20X2
Trade receivables 1 355 000
Allowance for doubtful debts (01/05/X1) 103 500
The following information became available to the accountant on 30
April 20X2:
Note: This information has as yet not been processed in the books of
the business.
1. When posting the totals from the sales journal to the general
ledger at the end of April 20X2, the sales column was posted as
R1 750 000 instead of R1 705 000.
2. A sale return made by debtor P. Storm on 15 April 20X2 had
been recorded in debtor F. Storm’s account in the debtors’
ledger.
3. The April bank statement included transactions up to and
including 27 April 20X2.
4. The April 20X2 bank statement reflected a dishonoured (R/D)
cheque for an amount of R25 600. This cheque had been
received from debtor D. Cloud on 5 April 20X2 and had been
deposited in the bank account on the same day. It is the policy
of Windy Seas to allocate all charges relating to dishonoured

cheques to the individual debtors concerned. The dishonoured
cheque above resulted in additional bank charges of R375.
5. Bank charges (excluding those indicated in (4) above)
amounting to R1 200 were reflected on the April 20X2 bank
statement.
6. Debtor B. Calm was declared insolvent during 20X2. The total
debt owing by B. Calm on 30 April 20X2 was R18 500. This
amount related to sales made to the debtor during the current
financial year. B. Calm’s lawyer confirmed that Windy Seas

would receive 35c for each rand owed to the business. On 30
April 20X2, a cheque was received from B. Calm. At 30 April
20X2, Windy Seas decided to write the remainder of B. Calm’s

debt off as irrecoverable.
7. At 30 April 20X2, debtors to whom sales amounting to R85 000
had been made in the previous financial year were considered
irrecoverable and the decision to write off these debtors had
been made.
8. Windy Seas reliably estimated that it was unlikely that 6% of
outstanding debtors on 30 April 20X2 would be collected.
1. Prepare the general journal entry/ies that would have been
processed to record the information in points (1) and (2). If NO

general journal entry/ies are required, provide reasons for your
answer. Ignore dates and narrations. (4 marks)
2. Refer to point (6):

Prepare the general journal entry(ies) necessary to process the
information provided in point (6). Closing entries are not
required. Ignore dates and narrations. (4 marks)
3. Refer to points (1) to (8):

Prepare the trade receivables account as it would appear in the
general ledger of Windy Seas for the year ended 30 April 20X2.
Balance or close off the account appropriately. (7 marks)
4. Calculate the amount that will appear in the statement of
comprehensive income of Windy Seas for the year ended

30April 20X2 as bad debts expense. (3 marks)
QUESTION 10.3 (B)

The new bookkeeper of MBA Traders had completed the following
Trade receivables account for the month of December X0 and is a
little concerned about the credit balance on the Trade receivables
account.
After reviewing the above account, you realise that he needs
guidance on posting information to the ledger. He has provided you
with the following information that has been extracted from the
journals.
1.
Trade receivables column in Cash Receipts journal 66 000

Sales column in Sales Returns journal 9 120
VAT column in Cash Receipts journal 6 100
Purchase Returns column in Purchases Returns journal 3 990
Sales column in Sales journal 110 000
Trade payables column in Cash Payments journal 40 000
VAT column in Cash Payments journal 9 920
Purchases column in Cash Payments journal 60 000
Sales column in Cash Receipts journal 45 000
Purchases column in Purchases journal 51 300
2. Included in the general ledger at 31 November X0 were the
following balances:

SARS (VAT) Cr Balance 62 500
Inventory 80 000
Purchases 243 000
3. VAT amounting to R20 000 was paid to the Receiver of Revenue
during December X0.
4. The following additional information appeared on the bank
statement and has, as yet, not been processed in the books of
MBA Traders:
4.1 The bank had returned a dishonoured cheque from Anita
Naidoo, a debtor. The cheque of R567 had been intended to
settle a debt of R600.
4.2 Bank charges for December X0 amounted to R171.
4.3 Interest of R114 earned on the current account was credited
on the bank statement.
1. Prepare a corrected Trade receivables account for December X0.
2. Prepare the Trade payables account for December X0. (6 marks)
3. Prepare the Purchases account for December X0. (4 marks)(5 marks)
4. Prepare the SARS (VAT) Control account for December X0.
5. Briefly explain what the balance on the SARS (VAT) (10 marks)
means. (1 mark)
11 Property, plant and
equipment
Judy's business has grown steadily over the last few months and
although the increase in sales has been good for business, she
has also had to deal with a number of new problems. The most
important of these is that her suppliers are often late with the
delivery of her orders of leather bags, suitcases and briefcases.
She has also found it difficult to obtain leather goods that are of a
good quality.
Judy was talking to her friend Tracey one Saturday morning
about all these problems when Tracey remarked, “Judy, why don't
you think about making the leather goods yourself? You know
some reliable suppliers of raw leather, some very good designers,
and a few competent seamstresses.”
Judy smiled and said, “I have been thinking about starting to
make my own leather products, but I'll have to buy machinery and
equipment, not to mention renting or buying a factory building to
house the manufacturing operations. All of these purchases will
need a large amount of cash, which I simply do not have at the
moment.”
Tracey replied, “Why don't you draw up a budget of the
estimated sales this new manufacturing business could generate?
You could include an estimation of the costs of the new business
and show the estimated profit this venture could produce. If you
had to take a realistic budget to your bank manager, I am sure
that you could get a loan from the bank to buy the machinery,
equipment and buildings you would need.”
Judy thought this was a good idea, so after drawing up a budget
she went to see her bank manager. After a few weeks Judy was
told that the loan had been approved.
It was a month later when Judy phoned Tracey and said, “I've
bought a number of machines, various equipment and a factory
building over the last few weeks. I have to record these assets in
my general ledger, but have no idea how to go about doing so. Do
we apply the same accounting concepts as those we learnt about
when discussing inventory?”
Tracey replied, “There's a whole lot more to these assets, like
‘depreciation’, ‘revaluation’ and `impairment' which didn't apply
to inventory. These will all need to be considered when you are
recording and reporting assets like equipment and machines.”
After their conversation Judy was worried because she had no
idea what Tracey was talking about. She had to record the
purchase of the machinery, equipment and building and did not
know how to go about it. As a registered VAT vendor, Judy was also
wondering whether the VAT principles for property, plant and
equipment were the same as those she applied to her other
purchases.
Learning objectives
• Understand what is meant by the term “property, plant and equipment”
• Know when to record the purchase and disposal of property, plant and equipment
• Record the purchase and disposal of property, plant and equipment
• Understand what the term “depreciation” means and how to calculate and record
depreciation
• Understand when and how to adjust the carrying value of property, plant and
equipment for changes in value that occur after the assets have been purchased
(revaluation and impairment)
• Record further expenditure that may be incurred on items of property, plant and
equipment once they have been purchased
• Calculate and disclose the effects of a change in estimate used when calculating
the depreciation charge
• Present information about the property, plant and equipment in the annual
financial statements in terms of generally accepted accounting practice.
• Understand that accounting for properties that are held as investments may be
different than accounting for property, plant and equipment.

Judy has bought machines, equipment and a factory building to
manufacture her own leather goods, but she has no idea how to
account for these purchases.
How can we help Judy solve her problem?

Before we can help Judy understand more about property, plant and
equipment, we need to understand the type of assets this term refers
to. We should also find out if there is a GAAP standard that can
provide us with some guidance regarding the issues of recognition
and measurement of property, plant and equipment.

11.1 What does the term “property, plant
and equipment” mean?
The first important meaning attached to this term is that property,
plant and equipment consists of tangible assets. So in order to
satisfy the definition of property, plant and equipment, an item must
first meet the definition of an asset.
The assets that form part of property, plant and equipment have
to betangible assets.
Tangible assets are assets that have physical substance; you can
touch and see them.
The factory machine is an asset because it is a resource controlled
by the business, used to produce inventory that are expected to be
sold. The cash received from the sale of inventory is the expected
future economic benefits. This asset has physical substance and is
therefore a tangible asset.

Property, plant and equipment is defined as a tangible asset that is:
• Held to use in the production or supply of goods or services, for
rental to others, or for administrative purposes, and
• Expected to be used during more than one period.
What do we mean by one period? This refers to a financial year or
trading period. A business will decide on its financial year which is
the period of time chosen for regular reporting to the various
stakeholders of the business. In the first financial year that a business
operates and in any year that the financial year is changed, it is
possible to have a financial reporting period of more or less than 12
months in this transitional period.

The term “ one period” therefore refers to one financial accounting
reporting period, which is usually a financial year. Property, plant
and equipment is used over more than one financial reporting
period.
Did you know?

An asset can also be intangible, which means it has no physical substance; you
cannot touch or see it.
An example is a copyright. A copyright is a contract that prohibits other people
from using something that you have created. This could, for example, consist of
written material, or a piece of music.
Copyright is an asset. The best way to discuss this is by using an example. Let's
imagine you think that you have a great singing voice and would have won the Idols
competition if you had entered. You have come up with an idea to make a lot of
money. You are going to make a music CD on which you want to sing all of the
Madonna songs from the album Like a prayer. Can you go ahead and just make
this CD? The answer is no, because this music legally belongs to Madonna, and the
use of the music is subject to a copyright agreement. It is illegal for you to use this
music to make money unless you obtain permission from Madonna or her agent,
who will charge you a fee for using it.
The copyright is an asset for Madonna because it is a present economic
resource she controls because of the past event of registering the copyright with
the appropriate legal authorities. The copyright is the right to use or offer for use
intellectual property that is not publicly available.
The asset is the present right to receive payment for the use of the material
(music). A copyright is something that you cannot see or touch and which therefore
has no physical substance. Copyright is therefore an intangible asset.
Let’s apply the requirements for assets to be recognised as property,
plant and equipment to a few examples.
Think about this 1

Judy buys leather to be used in making a range of leather goods. The leather is a
raw material because it is an input into the manufacturing process. Do you think
this leather should be classified as part of property, plant and equipment?
Check your answer
The leather is an asset bought with the intention of reselling it (as part of a finished
leather product) in the course of ordinary business operations. Do you remember from
Chapter 6 that this is the definition of inventory? The leather is therefore an asset that
is classified as inventory.
Let’s see whether the leather purchase also meets the definition of
property, plant and equipment. The leather is a tangible asset but it
is not held by the business with the intention of using it in the
production process for more than one financial period. The intention is
to sell the leather in the ordinary business operational cycle. The
intention of the business with respect to the leather means that we
cannot classify this asset as property, plant and equipment.
11.1.2 Classifying assets as inventory or property,

plant and equipment
Let's look at another example.

Consider two different businesses. Company A buys machines in
order to resell them at a profit as part of its core business activity.
Company B buys machines to use in the factory to produce leather
goods, which it then sells at a profit. Should these machines be
classified as inventory or property, plant and equipment?
The answer depends on how the business intends to use the
assets. Company A intends to resell the machines immediately as
part of its daily business and therefore the machines bought by
Company A are classified as inventory. Company B intends to use
the machines over a longer period to make goods that can be sold, so
these machines can be classified as property, plant and equipment.
The intention of the business is therefore very important.
Why is the classification of the asset so important?

If an asset meets the definition of inventory, we apply the
recognition and measurement principles set out in IAS 2, the GAAP
standard on Inventory.
However, if an asset meets the definition of property, plant and
equipment, we apply the recognition and measurement principles
set out in IAS 16, the GAAP standard on Property, Plant and
Equipment.
The classification of an asset is important because it affects the
way in which we recognise, measure and disclose the asset in the
Let’s assume that Judy made the following purchases:
Machinery R1 437 500 (including
VAT)
Equipment R862 500 (including
VAT)
Factory R2 300 000 (including
building VAT)
Judy has purchased machinery, equipment and a factory building to
use for a period of time to produce leather goods. All three criteria
are present for these purchases to be classified as property, plant and
equipment: tangible assets, intention to use in production of goods,
and used for more than one accounting reporting period.

Initial recognition of property, plant
11.2
and equipment
11.2.1 When is property, plant and equipment
recognised?
Property, plant and equipment is recognised as an asset when the
transaction meets the asset definition and recognition criteria.

In order to recognise an asset, there has to be a present economic
resource controlled by the business due to a past event. Control over

property, plant and equipment is the present ability to direct the use
of the economic resource, i.e. the property, plant and equipment. It is
therefore essential to identify the date on which control is
transferred to the business (buyer).
What do we mean by control? Imagine we purchase a motor
vehicle under a hire purchase agreement. We repay the purchase
price of the vehicle over an agreed period of time, at an agreed
interest rate. At the end of the repayment period, we become the
legal owners of the vehicle. During the repayment period, the bank
is the legal owner of the vehicle.
Remember that information is accounted for on the basis of the
economic substance (economic reality) and not only the legal form
of the transaction. This principle allows the financial statements to
represent transactions faithfully (show transactions as they have
occurred in reality). This means that we look at who in the economic
reality of the situation has the present ability to direct the use of the
economic resource. Where the person who has control is different
from the person who legally owns that asset, we use the economic
reality (i.e. control) as the basis for accounting for the transaction.
If we consider the economic reality of this agreement, we see that
while we are repaying the purchase price, we have unrestricted use
of the vehicle and are responsible for any necessary repairs to the
vehicle during this period of use. We are liable for any costs related
to the use of the vehicle (running costs and repair costs) and we
benefit from using it. Although we are not the legal owners, we
control the vehicle because in reality we are able to direct the use of
the resource.
In this example control was transferred on the date that the
vehicle was delivered to the business.
11.2.1.1 FOB and control

“FOB shipping point” and “FOB destination” are contracts or
agreements which stipulate who controls the present economic
resource. FOB shipping point means that the supplier no longer

controls the goods once the goods are loaded onto the transport. If
the ship sinks, the buyer would be responsible (liable) for the loss of
the goods. If the selling price of the goods trebles while they are
being shipped, the buyer will benefit, because control over the goods
transferred on the date that the goods were loaded onto the ship
(FOB shipping point).
FOB destination point means that control over the goods is

transferred when the goods arrive at the destination point .
If the supplier had entered into an agreement with Judy stipulating
that the sale was to be FOB destination, this would mean that
delivery was part of the responsibility of the supplier and that the
sale transaction was complete only on the date of delivery. The
control over the goods would transfer only when the supplier had
completed all of his responsibilities fundamental to the sale, which
in this case is when the ship arrived in Cape Town harbour.
11.2.1.2 Payment and control

How does payment by the buyer affect control of the asset? The fact
that Judy paid for the equipment on 30 April X2 may not result in
her having control of the equipment. We would have to see whether
the economic reality of the situation results in Judy having control,
i.e. the present ability to direct the use of the equipment on the date
of payment.
If the prepayment does not transfer control of the item then the
equipment is still part of the seller’s inventory. Although Judy’s
business has made a payment, the equipment is not an asset as she
does not control the equipment. The amount paid would be
considered an asset, i.e. a right to receive goods or services and it
will be reflected as a prepayment (a receivable) and not an item of
property, plant and equipment.
What happens once the equipment is ready for collection? Does
Judy have control of the equipment? We have to look at the
agreement with the supplier.
Let’s assume that Judy was responsible for collecting the
equipment. In this case, the supplier has met all his requirements for
the sale, and the sale transaction has been completed. Control of the
equipment has transferred so, if the value of the equipment were to
treble during November, Judy would be the person who stood to
benefit from this increase.
Let’s look again at the recognition criteria, because both the asset
definition and recognition criteria have to be met before we can
recognise the asset. It is important to note that the recognition
criteria in IAS 16 differ from the recognition criteria in the

conceptual framework. Remember that the information provided in
the conceptual framework does not override specific information in
a standard. The information in IAS 16 is used when reporting on
An item of property, plant and equipment is recognised if the
future economic benefits expected to be produced by the asset are
probable − and it must also be possible to reliably measure the cost
or the value of the asset.
Think about this 2

Imagine that Judy buys a huge air filter for the factory to ensure that safety
regulations concerning air quality for the workers are met. Do you think this asset
will meet the recognition criteria of probable future economic benefits?
Check your answer
When we purchase an asset such as a machine, it is expected to generate future

economic benefits because we intend using the machine to make inventory or
products which we intend selling to customers (future economic benefit). Without the
air filter, the workers will not be able to work on the machines and produce leather
goods to sell to customers. The air filter is not directly involved in the production of the
goods or services, but it is necessary if the business is to use the machine. This type of
support asset is recognised as an asset because it allows related assets, such as
machinery, to generate economic benefits in the future. To recognise an asset as
property, plant and equipment, the recognition criteria in IAS16 indicate that we need
to show that it is probable that economic benefits are generated in the future. As there
is no indication that the business is unable to use the machines or that the market for
the goods no longer exists, it is probable (more likely than not) that the use of the air
filter will lead to an inflow of future economic benefit. The cost of the asset (air filter) is
reliably measurable as there is a source document indicating the cost of the air filter
(and any related installation costs).
11.2.2 At what amount do we initially recognise
property, plant and equipment?
When the asset definition and recognition criteria have been met, we
can recognise property, plant and equipment. The next consideration
is the amount at which we recognise the item of property, plant and
equipment.
IAS 16 is the GAAP standard that deals with the recognition and
measurement of property, plant and equipment. This statement has
specific guidelines on the initial measurement of property, plant and

equipment (meaning the amount used to measure the asset when it
is initially recognised). In terms of IAS 16, property, plant and
equipment should be initially recorded at cost when it is initially
recognised.
11.2.2.1 What is cost?

Cost is the consideration or payment given for the asset.
If you paid cash for an asset on the purchase date, assuming the
payment occurred more than a year later, the cost is the amount of
cash paid (given). If you paid for the asset after the purchase date,
known as a deferred payment, the amount that you pay consists of
the cost of the asset and interest. The present value of the deferred
payment is the cost at which we measure the asset. The interest
portion of the payment is recognised as an interest expense.
When we purchase property, plant and equipment with cash the
cost is the consideration, i.e. the cash paid. Where we give up some
other asset, the cost of the equipment is the fair value of the asset
given up.
11.2.2.2 What is included in the cost of property,
plant and equipment?
Any expenditure incurred to bring the asset into a working
condition so that it can be used as intended by management is
included in the initial cost of the asset. In other words, these costs
are capitalised, or we could say that the property, plant and
equipment account is debited.
Let's look at an example to illustrate this concept.

Judy purchased equipment for R862 500 (VAT inclusive) with the
intention of using it to produce leather goods to sell to customers.
The supplier is in Pretoria, and Judy had to pay for transport from
the supplier to her factory in Cape Town. This cost R11 500 (VAT
inclusive). The workers had to offload the equipment and carry it to
the correct location; wages paid for this task were R500.
Something to do 1
Calculate the total cost of the equipment we would use to debit the
Machinery account.
Check your answer
The purchase cost of R750 000 (R862 500 × 100/115) is regarded as part of the cost
of the asset. Judy is a registered VAT vendor and can claim the input VAT of R112 500
from SARS. The VAT portion of the purchase price is not a cost to Judy because it is
refunded to her.
Any other cost that Judy incurs to bring the equipment into a working condition for
the purpose for which it was bought will be a part of the cost of the equipment. The
transport cost of R10 000 (R11 500 × 100/115) is part of the cost of the equipment
because it was a cost incurred in order to bring the equipment to the factory. Once
again, the VAT portion of the cost is not included because it will be refunded to Judy.
The wages of R500, the payment for offloading the equipment, can also be
considered to be part of the equipment cost. The cost of bringing the equipment into
working condition includes costs incurred in getting the equipment into the exact
location where it can be used. We have not adjusted for VAT because wages represent
a supply of services that is exempt from VAT.
The equipment will be recognised at an initial cost of R760 500 (R750 000 + R10
000 + R500).
This cost classification applies only to costs that are incurred before the asset is
ready for use. This makes sense, because we refer to all costs that are incurred in
order to bring the asset into working condition. Once the asset is ready for use, any
costs in connection with the asset cannot become part of the cost of the asset on the
basis of the initial classification criteria. (For expenditure incurred once the asset is
ready for use, we refer to the principles for subsequent expenditure that are discussed
in section 11.4.)
11.2.3 Recording the purchase of property, plant and

equipment
Let's prepare the journal entries, assuming Judy paid in cash for all
purchases and expenses.
Judy purchased equipment and increased the assets of the business.
To record this, debit the asset account (Equipment) in the general
ledger. Judy also paid cash for the equipment, and this reduced her
Bank account. This reduction in assets is recorded by crediting the
asset account Bank. Judy has increased and decreased the assets of
her business by the same amount and there is therefore no effect on
the net asset value of the business.
Included in the price was input VAT of R114 000 (R112 500 + R1
500). Judy will record the input VAT as an asset.
We can now prepare the journal entry for the initial recognition of
the equipment.
There are a few points worth emphasising about this journal entry.
The transport costs of R10 000 and the wages of R500 are included in
the cost of the asset. Expenditure or costs that relate directly to the
cost of acquiring and installing an asset are debited directly to the
asset account.
We capitalise these costs (or make these costs part of the cost of
the asset) to the extent that they are related to bringing the asset into
the condition and location for its intended use, so these costs are
classified as an asset.
Did you know?

A public company registered in the United States, called WorldCom, was
investigated for fraudulently overstating the company's profits. How did they show
the profit at more than the company had earned? The directors capitalised general
expenses to an asset account in order to reduce their expenses and so increase
their profits. Expenses can be capitalised to an asset account only if they meet the
definition and recognition criteria of an asset, as is the case with the installation
costs of property, plant and equipment.
11.2.3.1 Correcting journal entries

What would happen if Judy had treated the wages and transport
costs as expenses?
Let’s say that Judy prepared the following journal entry to record
wages and transport expense:

These costs are part of bringing the equipment to a working
condition so should have been recognised as an asset and not an
expense.
We have to correct the journal entry that Judy has already
processed. The journal entry we prepare to correct this entry is called
a correcting journal entry.

Whenever we have to prepare a correcting journal entry, we must
look at what has already been processed to the general ledger. This
is the starting point. Then we decide what should have been
processed to the general ledger. The correcting journal entry is the
adjustment that takes us from the starting point to what we want the
general ledger to show.
Did you notice that the correcting journal entry did not affect the
VAT control account or the Bank account? This is because these

parts of the original entry were correctly recorded.
11.2.3.2 Costs that can be capitalised to property,

plant and equipment
There are several costs that can be incurred in getting property, plant
and equipment ready for its intended use. These costs include:
• Initial delivery costs and handling costs
• Installation costs
• Estimated costs of dismantling and removing the asset to the
extent that these qualify as a liability
• Overhead costs (such as depreciation of the machinery, water and
electricity used in the factory) if the item of property, plant and
equipment was manufactured by the enterprise. This would
include only those overheads incurred before we started using the
asset.
11.3 Decrease in the carrying value of

property, plant and equipment owing
to use of the asset
Judy purchased machinery for R1 437 500 (VAT inclusive) on 1
January X2 to make leather products for 5 years. The machine is
expected to be used evenly over a 5-year period.
We recognised the machine at its cost of R1 250 000 (R1 437 500 ×
100/115).
At the end of the first year we have used the machinery for 1 of
the 5 years of its anticipated usage. We have used 1/5 of the asset’s
estimated useful life, so at the end of the first year the machine has a
remaining useful life (the period it can be used by the business to
produce bags) of 4 years.
The statement of financial position and the statement of profit or
loss and other comprehensive income are prepared according to the
accrual concept. The accrual concept indicates that expenses must be
recognised in the financial year to which they relate, i.e. the year in
which the asset/liabilty changes. If you bought an asset to use for 5
years, the cost of consuming the asset should be recognised as an
expense over the 5-year period − in that way the costs will be
recognised in the same financial year as the asset is consumed
through use.
The allocation of the cost of the machine over the period that it is
expected to be used is known as depreciation. If the machine is used

evenly each year for 5 years, the depreciation will be 1/5 of the cost
of the machine each year (unless the machine is expected to still have
some value at the end of the 5 years). This is known as a “ residual

value”.
The depreciation expense of this machine each year will be R250
000 (R1 250 000/5). Depreciation is an expense that is shown in the
profit or loss calculation.
Something to do 2
Prepare the journal entry to record the cost of using the machinery during the
financial year ended 31 December X2.
Check your answer

Did you notice that the asset account was not credited directly, but an account called
Accumulated depreciation was credited? Why? IAS 16 requires a record of the asset's
original cost or revalued amount. The purpose of the Accumulated depreciation
account is to reduce the carrying amount of the asset it is linked to, such as
machinery. In the statement of financial position the carrying amount of the asset is
shown as R1 million (R1 250 000 less R250 000). The carrying amount of the asset is
the difference between the amounts in two different general ledger accounts, namely
the asset (cost/revalued) account and the Accumulated depreciation account.
What is meant by the term “carrying value”?

The carrying amount is the amount at which the asset will be carried
(shown) in the statement of financial position. It amounts to the cost
less the accumulated depreciation (total depreciation) at the financial
reporting date. If the asset has been impaired we would also subtract
any accumulated impairment written off on the asset. Carrying
amount is sometimes referred to as “book value”.
The depreciation account shows the portion of the asset that has
been used in the current year and is shown in the profit calculation
as an expense. As with all expense accounts, the depreciation
account will be closed off at the end of the period to the profit or loss
account, reducing the retained earnings on the statement of financial
position.
The Accumulated depreciation account will increase each year as
the current year’s depreciation expense is added to the opening
balance. At the end of 5 years the balance of the Accumulated
depreciation account of this machine should be R1 250 000. This is
because the cost of the asset would have been used in full. The
carrying amount of the asset on 31 December X6 would be nil.

Let’s see how the machine will be shown in the statement of
financial position at 31 December X4 (at the end of the third year).
Statement of financial position as at 31 December X4

Non-current assets
Machinery − carrying value (Note 1) 500 000
Notes to the statement of nancial position

Note 1
Machinery − cost 1 250 000
Machinery − accumulated depreciation (250 000 × 3) (750 000)
Carrying value 500 000
11.3.1 Depreciation
Depreciation is the systematic allocation of the depreciable amount
of an asset over its estimated useful life. This is consistent with the
accrual concept, where we recognise expenditure as an expense in
the same period that we use this expenditure to produce economic
benefits.
We depreciate assets with a limited useful life, where the life of
the asset is reduced as we use it to produce benefits. If the asset had
an unlimited useful life, there would be no cost to using the asset, as
the asset’s ability to generate benefits would not be reduced.
Let's consider some assets and see if they have limited or unlimited
useful lives.
A machine has a limited time during which the business will be able
to use it for the purpose for which it was bought. A building also has
a limited lifetime. Although this period may be a great deal longer
than the useful life of a machine, the building should still be
depreciated. The only time that a building may not be depreciated is
if it is classified as an investment property. If a building is an
investment property, we have the option not to depreciate it.
Land does not have a limited useful life; there is no limit to the
period over which we can use it for the purpose we acquired it.
Therefore it makes sense that we do not depreciate land.
However, what if the land belongs to a gold mine which is
currently being mined for gold to sell? In this example, the land has
a limited period over which it will be useful to the company. After a
period, all the gold will have been extracted and it will no longer be
able to be used by the business for the purpose it was acquired. In
this case the land belonging to the mine would be depreciated over
its useful life − the period over which the land was expected to
produce gold.
When we buy property we allocate the purchase cost between the
cost of the land and the cost of the buildings. The cost of the land
and the cost of the buildings will be shown as separate assets
because each component has a different useful life − remember we
will depreciate buildings but not land.
11.3.1.2 Residual value

Judy knows that after using the machine for 5 years, she expects to
sell it to a scrap dealer for R60 000 on 1 January X7. However, in
order to remove the machine from the factory and transport it to the
dealer, she will pay R15 000 to a transport company.
The net benefits are R45 000 (R60 000 − R15 000). These future net
benefits are called the residual value of an asset.

The residual value is used only for the purpose of the
depreciation calculation. The residual value is used to calculate the
portion of the cost or value of the asset that is going to be consumed
over the useful life (residual value) (called the depreciable amount).
As the estimate of the proceeds on disposal is likely to change,
GAAP requires the residual value to be estimated at each year-end
and the revised estimate used to calculate depreciation. The
accounting implications of a change in estimate are discussed in
section 11.9.
If the machine has a residual value of R45 000, we use only R1 205
000 of the purchase cost of the machine (R1 250 000 − R45 000) for
the purpose of calculating depreciation. The R1 205 000 is the
depreciable amount, because it is the portion of the asset cost that
must be expensed over the useful life of the asset.
11.3.1.3 Useful life of an asset

The machine in our example has a useful life for Judy’s business of 5
years. This term does not mean the physical life of an asset, which is
how long the asset will last, but rather refers to the period of time
that the business expects to use the asset. A business has to estimate
the useful life of every asset and does this based on its experience
with similar assets. If a business has never used a similar asset, then
this estimation of the asset’s useful life is more difficult. It may be
necessary to obtain information from other sources outside of the
business.
The useful life of an asset can be based either on the time period
that an asset is expected to be used for (5 years, in Judy’s business)
or the number of units that are expected to be produced by the asset.
The estimation of the useful life of an asset is made at the date of
acquisition of the asset. If the estimate of the useful life of the asset
changes during the life of the asset, it is called a change in an
estimate. As you can imagine, changing the estimate of the useful
life will change the amount recognised as the depreciation expense.
We discuss the implications in more detail in section 11.9.
11.3.1.4 Depreciation methods

Allocating the depreciable amount over the useful life of the item of
property, plant and equipment is achieved by various depreciation
methods.
The method of allocating the depreciable amount over the useful
life should reflect the pattern in which the asset’s economic benefits
are consumed.
Depreciation is the cost of consuming the asset’s economic
benefits. The cost of the asset is therefore expensed at the same rate
at which the economic benefits are consumed.
11.3.1.4.1 Time basis

Straight-line depreciation method
When we expect the economic benefits to be consumed evenly over
the useful life of an asset, we expect equal amounts of the asset to be
consumed each year. This method of allocating the depreciable
amount between periods of use, or calculating depreciation, is called
the straight-line depreciation method.

Let’s look at an example. We calculated the depreciable amount of
the machine Judy purchased as R1 205 000 (cost less residual value).
The useful life of the machine is 5 years and the benefit is consumed
evenly over the 5-year period (the asset is used evenly over its useful
life). The depreciation expense in the current year would be R1 205
000/5 = R241 000. At the end of the first year, the carrying amount of
the equipment is R1 009 000 (cost less depreciation of R241 000).
(Note that the residual value only affects the depreciation
calculation.)
Diminishing balance depreciation method

We may expect to consume more of an item of property, plant and
equipment in the beginning of its useful life than towards the end of
its life. To show this pattern we recognise more depreciation in the
beginning of its useful life and a smaller proportion towards the end
of its life. This is referred to as the diminishing balance method.

The diminishing balance method assumes that the business
consumes a smaller proportion of the total economic benefits the
older the asset becomes.

Assume that the purchase cost of the machine was R1 250 000 and
that the machine has a zero residual value. This means that the
depreciable amount for this machine is R1 250 000. The machine was
purchased on 1 January X1, and the asset is depreciated at 20% on
the diminishing balance method. The depreciation expense per year
is as follows:
• Cost of using the machine 1 January X1 to 31 December X1:
R1 250 000 × 20% = R250 000

R1 250 000 − R250 000 = R1 000 000 × 20% = R200 000

R1 000 000 − R200 000 = R800 000 × 20% = R160 000

R800 000 − R 160 000 = R640 000 × 20% = R128 000

R640 000 − R128 000 = R512 000 × 20% = R102 400

With this method of depreciation we calculate the current year’s
depreciation on the carrying amount of the asset (cost less
accumulated depreciation) to reflect the fact that the proportion of
the asset that is used each year becomes smaller over its useful life.
When calculating depreciation for this method we do not reduce the
cost by the residual value as the percentage used will reduce the
carrying amount to the estimated residual value.
What do you notice?

Do you see that the depreciation charge is a smaller amount each
year, showing that the proportion of the use of the asset is reducing
over the life of the asset?
11.3.1.4.2 Unit basis

The estimated useful life can be stated in terms of units, for example,
the number of units produced by a machine or the number of
kilometres driven by a vehicle.
The annual depreciation expense is based on the number of units
used in the period as a percentage of the total units available. For
example, assume a machine, with a cost of R1 250 000 and a residual
value of R45 000, would be used to produce 400 000 units. In the year
ended 31 December X1 the business produced 80 000 units. Can you
see that the business has consumed
of the estimated useful life of the machine? The annual depreciation
would amount to
20% × R61 205 000 = R241 000.

Points to note:
If the estimated useful life is unit-based the depreciation charge is
not affected by time. For example, if the machine indicated above
had been purchased on 1 June X1 (and the year end was 31
December X1) we would NOT multiply the R241 000 by 6/12. The
deprecation expense is only determined by the number of units
produced and NOT by the amount of time the asset is used.
11.3.1.4.3 The component approach
Think about this 3

What would you think would be an appropriate depreciation rate for an
aeroplane where the body is expected to last 25 years, the engines 10 years,
and the seats 5 years?
Check your answer
The aeroplane should be treated as three seperate components, each with its own cost
and each component depreciated over its individual useful life. This is known as the
component approach. A component is a significant part of the asset, with a different
useful life. IAS 16 requires companies to use the component approach where an asset
has seperately identifiable components with different patterns of usage. This would
apply to the aeroplane.
11.3.1.5 When do we start depreciating an asset?

Depreciation is calculated from the date that the asset is ready for
use. The date from which the asset is ready for use is therefore the
critical date when calculating depreciation.

11.3.1.6 Some disclosure
The managers of the business choose the depreciation method and
the depreciation rate. They identify whether the asset will be used in
a pattern best reflected by a time or units basis. This determines their
depreciation method, which can differ between companies and even
for different assets in the same company. In the notes to the financial
statements the business has to show the users of the financial
statements which method and rate they selected for each class of
depreciable asset. An example of this note is set out below.
Handbags for Africa Limited

Notes to the financial statements at 31 December X6
1. Accounting policies
1.5 Property, plant and equipment
The cost less the residual value of property, plant and equipment is
recognised in profit or loss as depreciation over the period that
management expects to benefit from the use of the assets.
Property, plant and equipment are depreciated on the straight
line basis at rates that will reduce the cost to estimated residual
values over the anticipated useful lives of the assets as follows:
Plant and equipment 5 years
Vehicles 4 years
Something to do 3
What happens if we use the asset for only a part of a year? Remember this is only
relevant if the business uses time to indicate the estimated useful life of an asset.
Let's consider the purchase of the machine, which was expected to be used evenly
for 5 years. The depreciation method is the straight-line method. We purchase the
machine on 1 January X1 but the machine is only ready for use on 1 April X1. The
current financial year ended on 31 December X1. The cost of the machine was R1
250 000 and the residual value was R45 000.
Can you calculate the depreciation charge for the current year?
Check your answer
First, we have to calculate the depreciable amount for the machine. The depreciable
amount is R1 250 000 − R45 000 = R1 205 000.
The depreciation expense for the current year is R1 205 000 × 20% × 9/12 = R180
750. We multiply the amount by 9/12 because we have used the machine for only 9 of
the 12 months.
11.4 Treatment of subsequent

expenditure on property, plant and
equipment
The term subsequent expenditure refers to any expenditure we incur
on property, plant and equipment after we have started using it.
If expenditure is incurred in connection with an item of property,
plant and equipment once we have started to use it, we have to
consider whether this expenditure should be capitalised (included in

the cost of the asset) or expensed (taken to the profit calculation in
that period).
If the subsequent expenditure meets the asset recognition criteria
(future benefits are probable and cost reliably measurable), the
benefit is expected to last more than one financial period, and the
expenditure is not considered to be part of day-to-day expenditure,
the expenditure is capitalised. This means that the expenditure is
debited to the property, plant and equipment account.
If the expenditure is part of the day-to-day activities, the
expenditure is recognised as an expense.

Think about this 4
Let's look at an example of subsequent expenditure.
Judy started to use the equipment on 1 January X3. During the year X3 Judy
incurred two different items of expenditure.
On 1 April X3 Judy incurred expenditure of R11 500, including VAT, because
she had to clean and oil the machinery.
On 1 December X3 Judy incurred a further R17 250, including VAT, for a new
part for the equipment that contributes to the production of the leather bags.

Let’s look at the expenditure on 1 April X3 to replace the part for R11
500.
Judy is a registered VAT vendor. Therefore R1 500 of the purchase
price is not a cost to Judy because she will receive a VAT refund
from SARS. The portion of the expenditure we recognise as either
equipment or an expense is R10 000 (R11 500 × 100/115).
We will capitalise the expenditure if it meets the asset recognition
criteria and is not part of the day-to-day expenditure. The
expenditure incurred on 1 April X3 is for regular maintenance, i.e. is
part of the day-to-day activities. The R10 000 will be expensed.
Depending on whether cash has been paid or payment will occur
later (liability), assets have decreased or liabilities increased, which
would lead to a decrease in the net asset value (equity) of a business
not due to a distribution to the owner. The subsequent expenditure
is recognised as an expense and the journal entry will be as follows:

Recognising subsequent expenditure as an
11.4.2
asset (capitalised)
Let’s now consider how to recognise the transaction on 1 December
X3. Judy purchased a part for R17 250 that contributes to the
production of the leather bags.
Judy is a registered VAT vendor, and she can claim back R2 250
(R17 250 × 15/115) as input VAT. The actual cost to Judy for this part
is therefore only R15 000 (R17 250 − R2 250) or R17 250 × 100/115).
The question to ask is whether this expenditure meets the asset
recognition criteria. The part is more likely than not to lead to an
inflow of future economic benefit and has a cost that can reliably be
measured, and is not part of day-to-day expenditure. This
expenditure should be capitalised.
The journal entry for the subsequent expenditure on the part
purchased on 1 December X3 for R17 250 would therefore be as
follows:
If Judy were not a registered VAT vendor, she would not be able to
claim the R2 250 as an input VAT refund from SARS. The full
expenditure incurred by Judy would then be R17 250, and this
amount would be debited to the asset account.
11.4.2.1 Component approach and subsequent

expenditure
In section 11.3.1.4.3 mention was made of the component approach,
where an asset consisted of seperately identifiable components each
of which has its own cost, with each component depreciated over its
own useful life.
An example of this is a tank in which fuel is stored. The tank will
have two components − the main structure, which could last 50
years, and the lining, which would last 5 years. As the lining is a
major component with a significantly different useful life, it should
be depreciated as a separate component. After 5 years, when the
lining is replaced, the existing lining component should have been
depreciated to nil and any remaining balance written off. The
replacement lining is treated as a new asset, which would be a
component of the storage tank.
11.5 How to measure property, plant and

equipment
Property, plant and equipment is initially recognised at cost. At each
reporting date, the business checks that only items that meet the
asset definition and recognition criteria are recognised as assets. It is
important to remember that an asset cannot be shown at a value that
is greater than its recoverable amount.
Remember recognising depreciation expense allows the business
to allocate the cost of consuming the asset over its estimated useful
life.
Pre-adjustment trial balance 31 December X2

Property, plant and equipment 100 000
Accumulated depreciation (1/1/X2) 40 000
The business intends using the asset evenly over 5 years.
As at 31 December X2, the business will recognise a depreciation
expense of R20 000 (100 000/5) to account for using the asset for the
year.
The carrying amount at which the asset would be reflected on the
statement of financial position amounts to R40 000 [R100 000 − [R40
000 + R20 000]].
If there is any indication that the asset has been damaged, the
business would need to do an impairment test.

The impairment test identifies the recoverable amount of the asset.
So, what is the recoverable amount expected from property, plant
and equipment? Property, plant and equipment generates economic
benefit either from use (value in use) or from sale of the property,
plant and equipment (fair value less disposal costs).
Using the asset

The benefits generated from use is the cash from selling the goods
produced by that asset and the net cash from disposal at the end of
its useful life. The present value of the future net cash received from
using the asset as planned is called the value in use (VIU). This
calculation can be quite technical and at this level only a basic
understanding is necessary.
Selling the asset

The benefits generated from selling the asset, is the fair value of the
asset, less the disposal costs.
Recoverable amount
The recoverable amount of the asset is the higher of the value in use
and the fair value less disposal costs. This is called the recoverable
amount.
If the current carrying amount is greater than the recoverable
amount, the carrying amount of the asset must be written down to
the recoverable amount. The asset is said to be impaired. The portion
written down is an impairment expense. An impairment expense
meets the expense definition as the decrease in the asset results in a
decrease in the net asset value − not due to a distribution to the
owner.
If the carrying amount is lower than the recoverable amount,
assuming the business uses the cost model to measure assets, the
business will continue to recognise the asset at the current carrying
amount (on the statement of financial position).
Impairment of assets is dealt with in a separate statement of
generally accepted accounting practice (IAS 36).
The carrying amount that is compared to the recoverable amount
is after the current year’s depreciation expense has been recognised.

An asset with a carrying amount of R900 000 is expected to generate
cash in present-day terms (the cash in the future years is discounted)
of R840 000, i.e. VIU. The asset could be sold for R650 000 after
paying all the selling costs (fair value less costs to sell).
The recoverable amount of an asset is the greater of the value in
use (R840 000) and the fair value less costs (R650 000). The
recoverable amount is therefore R840 000, and the current carrying
amount is R900 000. R60 000 should be recognised as an impairment
expense.
To increase expenses, we debit the impairment expense account.

Accumulated impairment general ledger account
To record the write-down to the recoverable amount, we need to
reduce the asset by R60 000. Instead of crediting the asset account
directly, we credit a negative asset account called Accumulated

impairment.
This account is a negative asset, because it reduces the carrying
amount of the asset when reported in the statement of financial
position. The PPE asset account is not credited directly because we
need a record of the original cost of the asset. When we recognise the
asset in the statement of financial position, we show the net effect of
these two general ledger accounts, the asset cost account and the
asset Accumulated impairment account. Therefore R840 000 (900 000
− 60 000) will be recognised on the statement of financial position.
This is similar to the Accumulated depreciation account we learnt
about earlier.
11.5.1.2 Reversal of impairment expenses

When the circumstance that led to the impairment of the asset no
longer exists and the recoverable amount increases, the effect of the
impairment is reversed. The Accumulated impairment account is
debited, increasing the carrying amount of the asset, and an income
account (called Reversal of impairment) is credited. The amount we
can reverse is limited by what the carrying amount would have been
had there been no impairment (but taking depreciation into
account).
11.5.2 Increases in value of property, plant and
equipment after acquisition
The GAAP standard dealing with property, plant and equipment,
IAS 16, allows two different methods to measurement after
acquisition, namely the cost model and the revaluation model.

A business selects a model as its accounting policy and applies
that model to all assets in the same asset class. (Classes of assets
include motor vehicles or furniture and fittings or buildings − assets
that are of the same type.)
Judy purchased a piece of land on 1 January X2 for a purchase
price of R2 280 000 (VAT inclusive). The journal entry to recognise
this purchase is as follows:
1 January X2
Let’s assume that on 1 January X3 we could sell the land to another
person, who is a willing buyer and knows about the property
market, for R3 450 000 (R3 million + VAT of R450 000). This selling
price is called the fair value of the property. Will we recognise the
increase of R1 million (R3 million − R2 million)?
11.5.2.1 The cost model

On this model the asset is carried at cost less accumulated
depreciation and accumulated impairment. In other words, we do
not adjust the carrying amount of an item of property, plant and
equipment for increases in its fair value. The carrying amount will
increase only in the case of a reversal of impairment and not above
what it would have been if there had been no impairment. The asset
is initially recorded at cost. The carrying amount will be reduced
though (depreciated) or if the asset is impaired.
The cost basis ignores all increases in fair value of the asset once
the asset is recognised. If we use the cost model for our example
above, the cost of the land will remain at R2 million.
11.5.2.2 The revaluation model

On the revaluation model the asset is carried at its fair value less
accumulated depreciation and accumulated impairment. In other
words, the revaluation model allows for the change in the carrying
amount of property, plant and equipment when the fair value of the
asset changes. If we use the revaluation model, the carrying amount
of the item of property, plant and equipment increases when fair
value increases after the initial recognition of the asset. We would
also be required to decrease the carrying amount for any decreases
in fair value.
Fair value is the amount for which an asset could be exchanged
between knowledgeable, willing parties in an arm’s length
transaction.
If we use the revaluation model, we need to revalue the assets
often enough so that the carrying amount stated does not differ
materially from the fair value. This means that if the fair value of an
asset does not change significantly, we would probably revalue the
asset only every two to three years. However, if the fair value
changes more rapidly, we would revalue on an annual basis.
If we choose the revaluation model for one building, we have to
use the revaluation model for all buildings. We can choose to use the
cost model for motor vehicles, because this is a different class of
Once we have selected an accounting policy, i.e. the cost model or

revaluation model, we cannot change the policy each reporting
period. This is because of the qualitative characteristic requiring
information in financial statements to be comparable over time. (Go
back to Chapter 4 to read about this if you need to.) A company is
allowed to change an accounting policy if a GAAP standard requires

a new policy or because the new policy would produce financial
information that provides more relevant information for users. If a
company changed its accounting policy it would need to disclose
this in the financial statements.
11.5.2.3 Revaluation surplus

If we had used the revaluation model in our land example, the
carrying amount of the land will increase to R3 million. The Land is
increased by R1 million. To increase an asset account, we debit the
asset. What do you think the credit entry should be? The net asset
value of the business has increased. If the increase in the net asset
value is not due to a transaction with the owner, the increase is
generally recognised as income and is shown in the profit or loss
calculation. If the increase in net asset value is due to a transaction
with the owner, we recognise it as a capital contribution.
We always follow the general principles set out in the IASB
framework unless a GAAP standard deals with the specific issue
and sets out a specific treatment for a particular transaction.
IAS 16 specifically tells us not to credit profit or loss with the R1
million increase in asset value. The statement requires us to
recognise this increase in other comprehensive income (OCI) and to

accumulate the increase in equity under a revaluation surplus. In
other words, the change that occurs during the year or revaluation
gain is recognised as OCI and the net effect of all revaluations is
shown in the revaluation surplus account (and disclosed on the
statement of financial position). (For more detail regarding the
nature of the revaluation surplus, read section 12.8.)
The revaluation surplus is an equity account in the same way that
Retained profit (accumulated profit) is an equity account. By
crediting equity, we are increasing the equity or the net asset value
of the business without showing this increase in equity as part of
profit or loss. We do this because IAS 16, the standard governing
how to measure and report property, plant and equipment, specifies
that gains and losses due to revaluations are recognised as other
comprehensive income on the statement of profit or loss and other
comprehensive income.
The journal entry to record the increase to fair value for land on
the revaluation model is as follows:
The closing entry at the end of the financial year is as follows:
Where do we disclose the revaluation gain?

The revaluation gain is recognised on the statement of profit or loss
and other comprehensive income as other comprehensive income
and not profit or loss.

Where do we disclose the increase in the revaluation surplus?
The revaluation surplus is an equity account on the statement of
financial position, and results from closing off the gain recognised in
other comprehensive income. The revaluation surplus also appears
on the statement of changes in shareholders' equity. This statement
is discussed in detail in section 12.11.1.
Something to do 4
Can you name two equity accounts you have learnt about so far?
Check your answers
The Retained/Accumulated Profit account and Revaluation surplus.
When the fair value of the asset increases after the initial recognition,
we adjust the carrying amount of the asset if we are using the
revaluation model. When an asset is impaired, we recognise the
impairment expense on both the cost and revaluation model.
Something to do 5
Imagine we bought land for R1 million on 1 January X2. On 1 January X3 the fair
value of this land was R1 500 000. On 31 December X3 the recoverable amount
of the land was estimated at R900 000. We have chosen the revaluation model.
Answer the following questions concerning this information:
1. What do we mean by the recoverable amount of the land?
2. Prepare the journal entry for the revaluation of the asset on 1 January X3.
Closing entries are not required.
3. Prepare the journal entry for the impairment of the asset on 31 December
X3. Closing entries are not required.
Check your answers
1. The recoverable amount is the present value of the future net inflow of economic
benefits from selling the land or from using the land − in other words, the higher
of the VIU or NSP, i.e. R900 000.
2. 1 January X3
3. 31 December X3
When the fair value of an asset decreases after the asset has been revalued, we first
reverse the amount in the Revaluation surplus account before we recognise an
impairment expense.
What if, on 31 December X3 the land had a recoverable amount of R1 200 000? The
carrying amount of R1 500 000 would need to be decreased by R300 000. The journal
entry would have been:
In this example there was no impairment expense because the full amount of the
reduction in the fair value was used to reverse the surplus on the previous revaluation
of the land.
Something to do 6
The carrying amount of an item of property, plant and equipment can be
determined by looking at three different general ledger accounts. Name them.
Check your answers
We record the purchase of an asset and subsequent expenditure in the asset

account.
•
We record the revaluation of an asset in the asset account.

We record the write down to recoverable amount, i.e. impairment of the asset, in the
•
Accumulated Impairment account (negative asset)

•
We record the consumption of the asset in the Accumulated depreciation account

(negative asset).
•
The carrying value of an item of property, plant and equipment is therefore equal to:
Original cost when purchased
+ subsequent capitalised expenditure
− accumulated depreciation
− accumulated impairment

Let’s look at examples that combine all the concepts for property,
plant and equipment that we have discussed so far.
11.6.1 Combining the concepts of revaluation,

impairment, subsequent expenditure and
depreciation
Event 1
Judy purchases a machine for R1 150 000 (VAT inclusive) on 1
January X1 to use in the production of leather bags. The machine has
a useful life of 5 years, at the end of which Judy will be able to sell
the machine for R57 500 (VAT inclusive). The asset is expected to be
used evenly over the 5-year period. The machine is ready for use on
1 February X1.
Event 2
On 1 April X2 Judy spends another R115 000 (VAT inclusive) on a
part for the machine, which will be used until the end of the
machine’s useful life.
Event 3
On 1 May X3 a marketing expert tells Judy that the market for
leather bags has changed dramatically. It is estimated the present
value of the future net economic benefits expected to flow into the
business from the sale of the bags and the machine at the end of its
useful life is R300 000. The machine has a net selling price of R25 000.
Something to do 7
Prepare all the necessary journal entries to record the transactions that
occurred between 1 January X1 and 31 December X3.
Check your answers
Event 1
1 January X1
31 December X1
The depreciable amount is R950 000, calculated as follows:

R1 000 000 (R1 150 000 × 100/115) − R50 000 (R57 500 × 100/115)
The depreciation expense for the year ended 31 December X1 is calculated as
follows: R950 000/5 × 11/12 = R174 167
We calculated depreciation for only 11 months because the machine was ready for
use on 1 February X1.
At the end of the 5-year period, the carrying amount will equal R50 000, which is
equal to the anticipated proceeds on sale (less the output VAT).
Event 2
1 April X2
Do you understand why it was appropriate to capitalise the additional

expenditure?
The expenditure meets the asset recognition criteria.
Increase of cost of machine on 1 April X2
During the year ended 31 December X2 Judy had a machine with a cost of R1 000 000
for 3 months (1 January X2 to 30 March X2) and a machine with a cost of R1 100 000
for 9 months (1 April X2 to 31 December X2).
We first depreciate the machine to the date of the increase in the cost of the
machine:
R950 000/5 × 3/12 = R47 500
On 1 April X2 we increase the cost of the machine. We have a new carrying amount of
the machine on 1 April X2. The new amount will be used over remaining estimated
useful life.
In our example, the carrying amount of the machine on 1 April X2 is R878 333. This
is the original cost of R1 000 000 less the accumulated depreciation to date of R221
667 (R174 167 + R47 500), plus the cost of the subsequent expenditure of R100 000.
Depreciable amount 1 April X2
This (R878 333) is carrying amount and we want to depreciate the depreciable
amount. We adjust the new carrying amount for the residual value. The depreciable
amount of the machine is R878 333 − R50 000 = R828 333.
Remaining useful life 1 April X2
The total useful life of the machine was 60 months (5 years × 12 months). We used 11
months in the first year (1 February X1 to 31 December X1) and 3 months in X2 (1
January X2 to 31 March X2). The remaining useful life for the new asset is 46 months
(60 months less 14 months).
The depreciation expense for the remainder of the X2 year is based on the new
depreciable amount of the asset over the new estimated useful life. The depreciable
amount of the machine is R828 333 and the remaining useful life is 46 months. The
depreciation expense for the current year from 1 April X2 to 31 December X2 is R162
063 (R828 333 × 9/46).
31 December X2
Event 3
On 1 May X3 the value in use is R300 000 and the net selling price is R25 000. The
recoverable amount is therefore R300 000. We need to compare the carrying amount
of the asset on 1 May X3 with the recoverable amount. The comparison of the carrying
amount to the recoverable amount is called an impairment test and any amount
written off is an impairment expense. (Go back to section 11.5.1 if you do not
understand the principles of asset impairment.)
We need to calculate the carrying amount of the machine on 1 May X3. The carrying
amount of the machine on 31 December X2 was R716 270 (1 100 000 - 174 167 -
209 563). We used the machine for 4 months in the current year (1 January X3 to 30
April X3) and must record depreciation for the period up to 1 May X3.
1 May X3
The carrying amount of the machine on 1 May X3 is R644 242 (R716 270 − R72 028).
The recoverable amount is lower than the carrying value, so we reduce the carrying
amount of the asset by R344 242 (R644 242 − R300 000). The carrying amount
recognised on the statement of financial position is R300 000 and we recognise an
impairment expense of R344 242.
1 May X3
The carrying amount on 1 May X3 of R300 000 is recorded in the general ledger in
three separate accounts: the Machine cost account of R1 100 000, the Accumulated
depreciation account of R455 758, and the Accumulated impairment account of R344
242 (R1 100 000 − R455 758 − R344 242).
The carrying amount of the machine is R300 000. R250 000 (R300 000 − R50
000) of this amount will be consumed over the remaining useful life. The R50 000 is
not consumed during that period as that is the amount that the asset is expected to be
sold for at the end of its useful life (residual value). The remaining useful life is 60
months less 27 months that the machine has already been used (11 + 12 + 4). On 1
May X3 the machine's remaining useful life is 33 months.
The depreciation expense for 1 May X3 to 31 December X3 is R60 606 (R250
000/33 months × 8 months).
31 December X3
The carrying amount of the machine on 31 December X3 is R239 394, recorded in the
general ledger in three different accounts: a Machinery cost of R1 100 000,
Accumulated depreciation of R516 364, and Accumulated impairment of R344 242.
A very important issue regarding the calculation of depreciation

When any of these three adjustments is made, the carrying amount
for the purposes of the depreciation calculation must be recalculated
and will be depreciated over the period of the asset’s useful life
remaining after the date of the expenditure, revaluation or
impairment.
This section (11.6.2) is included for additional information but is
no longer examinable by SAICA.
Something to do 8
Judy buys a factory building on 1 January X1 for R17.25 million.
Judy starts to use the building on 1 January X1. The factory building is going to be
used to make and sell leather goods. Judy expects to use the building for a period
of 20 years. It is estimated that the building will be used evenly over the period of
use (indicating that the depreciation method for the building is straight line), and
there is a zero residual value. On 1 January X2 the property's fair value increases
and an appraiser gives Judy the net replacement cost of the factory building on 1
January X2 as R23 million (including VAT). Judy uses the revaluation model when
dealing with increases in fair value of the items of property, plant and equipment.
Prepare all the necessary journal entries for the factory building for the years X1
and X2.
Check your answers
1 January X1
31 December X1
We know that Judy uses the revaluation model, which means that she will recognise
any increase in the fair value of an item of property, plant and equipment that happens
after the initial recognition of the asset.
We therefore have to compare the carrying amount of the factory building with the
net replacement cost of R23 million. Any increase in fair value will be recognised in
terms of the accounting policy selected.
The carrying amount of the building on 1 January X2 is R14 250 000, recorded as
cost of R15 000 000 and accumulated depreciation of R750 000.
Comparing the carrying amount of the building to the net replacement cost of the
building of R20 million (R23 000 000 × 100/115), we can see that the fair value of
the building has increased since its initial recognition by R5 750 000 (R20 000 000 −
R14 250 000). We have to increase the carrying amount of the building in the general
ledger so that it is recorded at the net replacement cost, because Judy has selected
the revaluation model. If Judy had selected the cost model for the factory building, we
would not adjust the value of the building for this increase but would continue to show
the asset in the general ledger at depreciated cost.
1 January X2
This journal entry is processed only when we do a revaluation. IAS 16 allows us two
different options from which to choose. However, at this level of accounting, when we
revalue an asset we transfer the balance of the Accumulated depreciation account to
the asset (cost) account. There will therefore be a zero balance in the Accumulated
depreciation account once the full balance has been transferred to the asset account.
The asset account will now reflect the cost less the accumulated depreciation. This
transfer to the asset account is not processed when we have subsequent expenditure
or asset impairment.
In our example the asset general ledger account will look as follows:
On 1 January X2 the asset account now shows a balance of R14 250 000. If we want
this account to show the fair value of R20 000 000, we need to increase the asset
account by R5 750 000.
1 January X2
31 December X2
Complications in calculating the depreciation charge

Do you remember that whenever we change the value of an asset with subsequent
expenditure, impairment or revaluation, the carrying amount for the purposes of the
depreciation calculation changes? The new carrying amount, adjusted for any residual
value, will be depreciated over the remaining useful life.
The new carrying amount for the purposes of calculating depreciation for the period
1 January X2 to 31 December X2 is R20 000 000. In this case, because there is no
residual value, the depreciable amount (the adjusted carrying value used for the
depreciation calculation) is the same as the carrying amount. The period of use of the
building remaining after the date of revaluation is 19 years (20 years − 1 year). The
depreciation amount for the current year (X2) is R1 052 631 (R20 000 000/19). The
carrying amount of the building on 31 December X2 is R18 947 369, recorded in two
different general ledger accounts: the asset account of R20 000 000 and the
Accumulated depreciation account of R1 052 631.
Do you see that the asset account will not necessarily show the cost of the asset? If
we revalue an asset, it will show the fair value or net replacement cost of the asset at
the date that it was revalued. However, as we will find in section 11.8, Disclosure, we
must also show what the carrying amount would have been under the cost model
(refer to section 11.8.2).
Think about this 5

Do you think that a zero depreciable amount means that the asset has a
zero carrying value?
Check your answer
For the purpose of this question, assume that we bought the machine on 1 January X1
and use it from 1 February X1 for 5 years. The machine cost R1 000 000 and has a
residual value of R50 000.
If the asset has a residual value, the asset would have a zero depreciable amount
when its carrying amount was equal to the residual amount.
The general ledger accounts for this example would look as follows:
The carrying amount on 31 January X6 is R50 000 (R1 000 000 − R950 000). The
depreciable amount on 31 January X6 is zero (R50 000 − R50 000). A zero
depreciable amount therefore does NOT necessarily mean that the asset has a zero
carrying amount.
11.7 Disposing of an item of property,

plant and equipment
Let’s think about what would happen if we sold the factory building
that Judy purchased in the example in section 11.6.2.
The carrying value of the building on 31 December X3 is R17 894
738 (R18 947 369 − R1 052 631).
This was recorded in the general ledger as a revalued asset of R20
000 000 (original carrying value of R14 250 000 plus revaluation of R5
750 000) and accumulated depreciation of R2 105 262 (2 × R1 052
631).
Let’s assume that Judy sells the building on 1 April X4 for R21 850
000 (VAT inclusive). When we dispose of an asset we update the
carrying amount of the asset to account for depreciation relating to
using the asset in the current period up until the date of disposal. In
this example, Judy used the building for 3 months in the current
year (1 January X4 to 31 March X4). We need to recognise
depreciation for 3 months to determine the carrying amount of the
building on the date of sale, being 1 April X4.
Let's process the journal entry for the depreciation in the current year
(X4).
1 April X4
On the date of the sale, the building had a carrying amount of R17
631 580.
Judy sold the building for R21 850 000 including output VAT. R19
000 000 (R21 850 000 × 100/115) accrues to the business. R2 850 000 is
the output VAT that has to be paid to SARS.
11.7.1 Profit or loss on sale

How do we record the disposal of an item of property, plant and
equipment?
If an asset with a carrying amount of R17 631 580 is sold for R19
000 000 (VAT exclusive amount), what is the profit on sale? The
profit or loss on sale is the difference between the proceeds and the
carrying amount of the asset on the date of the sale. If the proceeds
on sale are less than the carrying amount of the asset, then the
transaction will give rise to a loss on sale. If the proceeds on sale are
more than the carrying amount of the asset then the transaction will
give rise to a profit on sale.
Any profit or loss on the disposal of an item of property, plant
and equipment is recognised in the profit or loss calculation on the
statement of profit or loss and other comprehensive income as
income or an expense.
Let’s look at why the profit on sale (or disposal) of an item is
income. When we sell (or dispose of) an asset, such as the building,
assets decrease and assets increase by the amount we receive for the
building. These proceeds can be in cash, or we may receive another
asset as payment for the item sold. In our example, the business
assets decreased by R17 631 580 − the carrying amount of the

building sold. Assets also increased by the proceeds received in
exchange for the building, the cash receipt of R19 million. This
resulted in a net increase in assets of R1 368 420, resulting in an
increase in the net asset value of the business, not due to a
contribution by the owner. Income is therefore recognised.
If the amount we receive is less than the carrying amount of the
asset being sold, we will have a net decrease in assets, resulting in
the decrease in the net asset value of the business not due to a
distribution to the owner. An expense is therefore recognised.
Think about this 6

Do you think that the proceeds on the sale of an item of property, plant and
equipment should be shown as part of the revenue (sales) of the business?
Check your answer
Think back to the definition of property, plant and equipment − it is an asset that is
held to be used by the business. It was not bought with the intention of being sold in
the ordinary course of business. Revenue from sales includes only amounts earned in
the ordinary course of business. If the asset that was sold was included in inventory,
the proceeds on the sale will be revenue, and the carrying amount of the asset would
be shown as cost of sales.
As items of property, plant and equipment were not bought with the intention of
being sold, the proceeds and the carrying amount of the asset are set off against each
other, and the net amount is shown as profit or loss on sale.

equipment
Whenever we dispose of an item of property, plant and equipment
we use an account called the Asset disposal account. The Asset

disposal account is a temporary account (like Purchases in Chapter
6, Inventory).
Information relating to an item of property, plant and equipment
could appear in three general ledger accounts: the Asset account
(records the cost or the revalued amount), the Accumulated

depreciation account (records the portion of the cost/revalued
amount that has been used) and the Accumulated impairment

account (records the portion of cost/revalued amount that has been
written down). The balances in each of these accounts are
transferred to the Asset disposal account, leaving a zero balance in
respect of this item in all these general ledger accounts.
Any proceeds received by the business are also recorded in the
Asset disposal account. The balancing amount on the Asset disposal
account is the difference between the proceeds received and the
carrying amount of the item (cost − accumulated depreciation −
accumulated impairment). This is the profit or loss that the business
made on the disposal of the item of property, plant and equipment.
We close off this account by transferring the profit or loss to the
Profit on sale account or the Loss on sale account. After transferring
the profit or loss, the disposal account will have a zero balance and
will cease to exist. The only purpose of the Asset disposal account is
to be a temporary (holding) account in which we calculate the profit
or loss on disposal of the asset.
Let's prepare the journal entries needed for the sale of the building.
1 April X4
The carrying value of the building on the date of the sale is R17 631
580 and we received R19 000 000 (VAT exclusive amount) as
proceeds for the building. This means that Judy made a profit of R1
368 420 (R19 000 000 − R17 631 580) on disposal of the building.
The final journal entry in respect of the sale of the building is:
We have now removed the balances relating to the sold building
from all the relevant general ledger accounts, which is correct as this
building is no longer Judy’s asset and we have recorded the profit on
sale as income.
The Asset disposal account would look as follows in the general
ledger:
Do you see that there is a zero balance on this Asset disposal account
once we have recorded the profit or loss on sale, so this account will
not be listed in the trial balance?
Different types of asset disposal

We should also remember that an asset is not disposed of only when
we sell the asset. There is an asset disposal whenever we eliminate
the asset from the books of the business. This can happen if the asset
is scrapped, given away or stolen.
11.8 Disclosure requirements for property,

plant and equipment
To provide the users of financial statements with information that
will help them make their various economic decisions, certain
information needs to be disclosed in the financial statements or in
notes to the financial statements.
These requirements are called disclosure requirements and simply

refer to information that should be presented for the benefit of the
various stake-holders.
Let’s have a look at some of the more important disclosure
requirements relating to property, plant and equipment and
understand the value the disclosure is adding to the decision-
making of the users/stakeholders.

We need to show the user of the financial statements what
depreciation methods and rates we have used for each class of
assets.
The depreciation method and rate are subjective estimates and as
such will differ between businesses depending on the judgement of
the different managers and accountants. Stakeholders should be
shown all information that has been quantified, based on judgement
and not fact, so that they can assess the reasonableness of the
judgement and also be able to compare these financial statements
with those of other businesses whose managers and accountants
have arrived at different estimates for similar transactions.
11.8.2 How property, plant and equipment is

measured
The gross carrying amount of property, plant and equipment refers
to the amount recorded in the asset account. This means the original
cost or the revalued amount of the asset increased by any
subsequent expenditure.
The gross carrying amount of the item of property, plant and
equipment is either at cost or fair value. This choice (cost model or
revaluation model) is significant to the user. If the cost model has
been used, the carrying amount of the asset does not reflect the fair
value of the asset. Instead, it would reflect the portion of the original
cost of the asset that has not yet been consumed. If the revaluation
model is selected, the company is required to revalue the assets with
sufficient regularity so that the carrying amount of the asset
approximates the fair value of the asset.
It is therefore not possible to directly compare the results of
companies using different bases without making some adjustments
to make the results comparable. When a business revalues its
property, plant and equipment, it is required to disclose in the notes
to the financial statements what the amount in the statement of
financial position and the statement of profit or loss and other

comprehensive income would have been had the asset not been
revalued. This disclosure enables the user to make the adjustments
and compare the results with what they would have been had the
asset not been revalued.

We show the user the carrying amount at the beginning of the year
(the opening balance) and at the end of the year (the closing
balance).
This is relevant because, although it is useful to know that the
business owns a factory building with a cost of R20 000 000, it is
equally important to know what portion of this amount has already
been consumed (accumulated depreciation) and what portion is no
longer recoverable (accumulated impairment).
Compare the information you derive from the following two
situations:
Situation 1
Your business has property, plant and equipment with a cost of R10
million.
Situation 2
Your business has property, plant and equipment with a cost of R10
million (with accumulated depreciation of R9 million and
accumulated impairment of R1 million).
With this additional information, you can see that the property,
plant and equipment has a carrying amount of zero (R10 million −
R9 million − R1 million). This is important information to have when
you are trying to estimate the future cash flows and profitability of a
business. The estimation would be difficult if you were told only the
cost of an asset.
Think about this 7

If you were considering lending money to a business, would you prefer it to have
assets with a cost of R1 200 000 and accumulated depreciation of R200 000, or
assets with a cost of R10 000 000 and accumulated depreciation of R9 000
000?
In both cases the carrying amount of the asset is R1 million.
Check your answer
The assets with a cost of R10 000 000 are nearly fully depreciated and therefore near
the end of their anticipated useful life. This implies that these assets will soon need to
be replaced, which will cause a drain on the financial resources of the company. This
may make it difficult for the company to repay your loan.
This is in contrast to the company with assets costing R1.2 million and accumulated
depreciation of R200 000. Only 16% of the assets have been consumed, indicating
that these assets have a significant period of their useful life remaining and therefore
will not need to be replaced for a while.
11.8.4 Reconciliation of the carrying amount at the

beginning of the year to the carrying amount at
the end of the year
What would you think if you saw the following information in the
statement of financial position?
X2 X1
Property, plant and equipment R1 000 000 R20 000 000
The business’s property, plant and equipment decreased from R20
million at the beginning of the year to R1 million at the end of the
year. If you had invested in this business, you would probably want
to know what had happened to the property, plant and equipment!
It is for this reason that a reconciliation between the carrying
amount at the beginning of the year and the end of the year needs to
be prepared. The reconciliation discloses the different types of
transactions that occurred during the year with respect to property,
plant and equipment.
The carrying amount of property, plant and equipment will
change due to the following:
• Purchase of an additional item of property, plant and equipment
• Incur subsequent expenditure which is capitalised
• Dispose of or sell an item of property, plant and equipment
• Increase or decrease the carrying amount of property, plant and
equipment because of revaluations or impairments
• Depreciate the item of property, plant and equipment because of
use during the current period.
What does the property, plant and equipment reconciliation note look
like?
11.8.5 Additional information for the revaluation
model
If property, plant and equipment is measured on the revaluation
model, the users need information on what basis we revalued the
asset. This requires an explanation of how the revalued amount was
determined. Did we, for example, use the fair value of the asset as
calculated by a market survey or a net replacement cost to
approximate fair value?
We need to state when (at what date) the asset was revalued and
whether management or an independent valuer valued the asset.
This disclosure requirement provides the user with more
information about the reliability of the revalued carrying amount.
If a business has prepared the financial statements using the
revaluation model, the financial statements must still show what the
carrying amount of each class of property, plant and equipment
would have been had the business chosen to use the cost model. This
disclosure allows the user of the financial statements to compare this
business with other businesses that selected the cost model. It also
shows users the effect of the revaluation on the statement of
financial position. This is important, because this revaluation process
is an estimation of fair value dependent on the judgement of
different people.
11.8.5.1 Reconciliation of the revaluation surplus

Do you remember how we showed the users the movement between
the carrying amount at the beginning of the year and the carrying
amount at the end of the year for each class of property, plant and
equipment? We also showed the user how the balance on the
Revaluation surplus account changes from the opening balance to
the closing balance. This disclosure is automatically provided when
we prepare a statement of changes in shareholders’ equity for a
company, a financial report that has specific reference to a company
and which you will learn about in Chapter 12.

We also need to show the user of the financial statements the
impairment expense recognised in the profit or loss calculation in
respect of items of property, plant and equipment.

The assets shown on the statement of financial position of a business
must be split between current assets and non-current assets.
A current asset is an asset that is expected to be used or sold within

one year after the financial year-end. Non-current assets are
expected to have the potential to generate future cash flows over a
much longer period, usually more than one year after the period end .
Assets are categorised in this way to help the users of financial
statements to estimate what the future cash flows from the business
will be.
The separation of assets into current and non-current is not
strictly based on a period of one year after the period end date. The
underlying principle to classifying the assets as current is whether
the asset will be used or sold within the operating cycle of the
business − the time it takes between ordering goods and collecting
the money from the customer. If the asset will be used or sold in the
operating cycle of the business, it is classified as a current asset. As
most companies have an operating cycle of less than one year, most
companies use a period of one year to classify assets as current or
non-current.
Where an asset is going to be used or sold within the operating
cycle of the business, this asset will be classified as current. As
property, plant and equipment items are used over a period longer
than the operating cycle, these assets will be shown as non-current.

You should be aware that the disclosure requirements we have
discussed in this chapter do not represent all the disclosure
requirements stipulated in terms of IAS 16 and IAS 36. You can refer
to the actual GAAP standards to obtain a complete list of all the
information that should be disclosed in respect of property, plant
and equipment as well as impairment of assets.
Did you know?

The first note to the financial statements usually sets out all of the accounting
policies that have to be used to recognise, measure and present the various
elements of the financial statements. If you want to see on what basis a set of
financial statements has been prepared, you can look at the note on accounting
policies.
Let’s have a look at some of the disclosure requirements we have
been discussing in the context of an example. The extract from the
financial statements below should show you some of these
disclosure requirements. The complete set of these financial
statements is presented in section 12.12.
Handbags for Africa Limited

Notes to the Financial statements at 31 December X6
1.1 Basis of preparation

The financial statements are prepared on the historical cost
basis, except for property, plant and equipment, which is
revalued.
1.4 Impairment
The carrying amounts of the assets are reviewed if there is
any indication of impairment. When the recoverable
amount of the asset is less than the carrying amount of the
asset, the impairment loss is recognised in profit or loss
calculation, to the extent that it is not a reversal of a
revaluation.
The company has chosen to use the revaluation model for
property, plant and equipment in terms of IAS 16. Property,
plant and equipment are depreciated on the straight line
basis at rates that will reduce the cost to estimated residual
values over the anticipated useful lives of the assets as
follows:
Vehicles 4 years
7. Property, plant and equipment

2. Operating profit includes the following costs, among others:
We should note that in this example the property, plant and
equipment was not revalued or impaired, but for your information
we have shown how the note would look had this occurred.

During the course of our discussion regarding the accounting
treatment for property, plant and equipment we have learnt about
depreciation. We know that the depreciation expense for the year
depends on the estimate of how long the asset is expected to be
used. Depreciation is based on a number of estimations and
assumptions about:
• The residual value of the asset at the end of its useful life
• The useful life of the asset
• The depreciation method appropriate for the asset (how the asset
is consumed).

Assume that we purchase a machine for R115 000 (VAT inclusive) on
1 January X1 and the machine is ready for use on 1 February X1. This
machine is used to make leather bags that we will sell to customers.

On the date we start using the machine we estimate that the machine
will be used evenly for 5 years. It is estimated that at the end of the
five years we will sell the machine for R16 100. We are registered
VAT vendors.
Let’s look at the journal entries we will process for the equipment
for the year ended 31 December X1.
1 January X1
31 December X1
Depreciable amount = R100 000 − R14 000 (R16 100 × 100/115) = R86
000
Remember we start to depreciate the asset from the date that the
asset is ready for use (1 February X1).
11.9.1 Depreciation calculation for a change in

estimate
It is now 1 January X2 and we have a meeting with the production
manager. The manager tells us that, based on his experience during

the past year, he is reasonably sure that the machine’s useful life
should have been estimated at 3 years from the day we started using
the machine and not 5 years.
What has happened is that the estimate of the useful life has
changed. There is a statement of generally accepted accounting
practice, IAS 8, which deals with how we account for a change in
estimate. When we change an estimate, we do not go back and
change the financial statements that have already been issued. All
we do is recalculate the depreciation charge for the current year and
future years using the new estimates.
The depreciation expense for the year ended 31 December X2 will
be calculated on the basis that from 1 February X1 the machine had a
useful life of 3 years or 36 months (12 × 3). We depreciate the
carrying amount of the machine on 1 January X2 over the remaining
period of 25 months (the revised estimate of useful life of 36 months
from February X1 less the 11 months of use to date). The carrying
amount of the machine on 1 January X2 is R84 233 (R100 000 − R15
767). The depreciable amount on 1 January X2 is R70 233 (R84 233 −
R14 000), and the machine is estimated to be usable for a further 25
months. The journal entry to record depreciation for the year ended
31 December X2 is:
11.9.2 Disclosure requirements for a change in

estimate
The depreciation charge for the year ended 31 December X2 using
the new estimate is R33 712 and using the old estimate would have
been R17 200. Depreciation is an expense that reduces profit.
Management could abuse the fact that they are allowed to change
estimates, and if they made a few poor decisions during the year,
they could compensate for this by changing the useful life of the
assets to reduce the current year’s depreciation charge. It is therefore
important that management discloses to investors or other
stakeholders in the business the details of any changes in estimates
that have been made during the current year.
Statement IAS 8 requires us to show in the notes to the financial
statements the nature and the amount of any change in estimate that
has a material effect in the current period.
Let’s look at how the change in estimate affected the depreciation
charge in the current year.
We would have had a depreciation charge for the year of R17 200
on the basis of the old estimate of the machine’s useful life of 5 years.
The new estimate of useful life of 3 years (from the date of use)
changes the depreciation charge to R33 712.
The depreciation charge in the current year’s profit or loss
calculation has therefore increased by R16 512 (R33 712 − R17 200)
because of the change in estimate of the machine’s useful life.
Let’s look at the disclosure relating to this change in estimate in the
Statement of comprehensive income for the year ended 31 December

X2
Depreciation − Machinery Note 2 R33 712
Notes to the financial statements for the year ended 31 December X2
2. Change in estimate
On inspecting the machine on 1 January X2, it was decided that
the original estimate of the machine’s useful life of 5 years made
on 1 January X1 was incorrect. The useful life has subsequently
been reassessed and it is estimated that the machine should be
able to produce leather bags for a period of only 3 years from
the time the machine started production.
Increase in depreciation and decrease in pro t in the current R16

year 512
Decrease in depreciation and increase in pro t in future years R16
512
This disclosure will show the user of the financial statements
that the profit for the year was reduced by an additional R16 512
because of the increase in the depreciation charge resulting from
the change in the estimated useful life. It will also show the
effect on the future years’ depreciation and profit.
11.10 Control of property, plant and

equipment
Property, plant and equipment can represent a large percentage of
the total assets controlled by a business. These assets are of value to
the business, not only because their loss would mean that the
business would have to replace the asset and suffer financial loss,
but also because they are used in the operation of the business. If
equipment, for example, were to be stolen from Judy’s factory, the
business would be unable to produce the leather goods and meet the
orders of customers. This would result in the loss of not only current
sales but possibly also potential future sales, because the customers
would think that Judy’s business could not be relied on to deliver on
their orders as promised.
It is important for a business to have control over its property,
plant and equipment. One control measure over fixed assets is a
fixed asset register. This is a list of all the items of property, plant
and equipment owned or controlled by the business. Each item of
property, plant and equipment will have a specific number tagged
(attached) to it. This number will be cross-referenced to the item of
property, plant and equipment listed in the register. The register will
show the number of the asset, the description, the location, the date
of purchase, and the purchase amount. It is possible to use the
register to check that all assets that have been purchased have not
been misappropriated and are being used in the location and for the
purpose that management have authorised. A manager will check
the details in the register against the physical asset from time to
time. Every time an asset is purchased, sold or moved, the fixed
asset register is updated.
This control system identifies not only assets that have been stolen
but also assets that are being used for unauthorised purposes. An
example of this is where an office computer is taken home for
personal use.
The other important control to implement is to make sure that the
value of the property, plant and equipment is adequately covered by
insurance. In this way, not only will the business be compensated for
the financial loss of an asset being destroyed, damaged or stolen, but
also, more importantly, the business will be able to replace assets
quickly and continue with normal business operations.

As the name implies, investment property is a property that is held as
an investment instead of being used by the entity that owns it. If an
entity that owns a property is using it, it is referred to as “ owner-

occupied property”, and must be accounted for as PPE. Simply put,
that means that the property will be split into land and buildings,
with buildings being depreciated. Both components of the property
can be revalued if that is the accounting policy choice.
A property that is not being used but is held to earn rental income
and/or capital appreciation is an investment property. The nature of
that property is more an investment than property. A separate
treatment is permitted in terms of a specific standard, IAS 40,
“Investment Properties”. In terms of the standard, one option is to
measure the fair value of the property at each reporting date and
recognise the movement in fair value in profit or loss (one of the
ways investments in shares can be accounted for). Another option is
to depreciate the property as explained above for owner-occupied
properties.

• We know why only certain assets can be included in the asset
classification of property, plant and equipment.
• We know when and how to record, recognise, measure the cost of
property, plant and equipment, including subsequent
expenditure.
• We know what expenditure can be included in the cost of the item
of property, plant and equipment.
• We have learnt how to record, recognise, measure, and disclose
increases and decreases in the value of the property, plant and
equipment that occur after the initial recording of the asset.
• We know why we depreciate an asset and how to calculate and
record depreciation.
• We know how to record the disposal of property, plant and
equipment.
• We have learnt what information about property, plant and
equipment needs to be presented to the users of the financial
statements.
• We know about some control systems for property, plant and
equipment.
• We know that accounting for properties that are held as
investments may be different from the usual procedure.
What's next?
In the next chapter, Judy decides to form a company in order to
attract more capital so that she can expand her business even more.
We will help her to understand the accounting principles and
reporting requirements in a company.

QUESTIONS
QUESTION 11.1 (C)

Ignore VAT.
Eden Ltd produces and sells organic products. The company has a
growing base of socially-responsible clients spread across Africa,
and is planning to expand its Garden Route production facility. In
particular, the company requires cash to purchase and rehabilitate
land for growing its products. The following information is
provided relating to the year ended 31 December 20X9:
Statement of Financial Position of Eden Ltd as at 31 December

20X9 20X8
R R
Assets
Non-current assets
Property, plant and equipment ? ?
Investments 20 000 35 000
? ?
Current assets
Inventory 1 046 533 1 125 060
Trade receivables 371 821 351 648
Bank ? 2 188 443
SARS (Income tax) 0 15 963
? 3 681 114
Total assets ? ?
Equity
Share capital: Class A ? 10 550 000
Share capital: Class B ? 960 000
Retained earnings ? 4 943 095
? 16 453 095
Liabilities
Loan ? 1 500 000
Current liabilities
Trade payables 1 097 423 1 195 621
Shareholders for dividends ? 0
SARS (Income tax) 138 267 0
Accrued interest expense ? ?
? ?
Total equity and liabilities ? ?
1. The company has two classes of property, plant and equipment:
plant and machinery, and vehicles. Both classes are measured
using the cost model.
2. A portion of the plant and machinery that had originally been
purchased for R900 000 on 1 June 20X8 was sold on credit for
R670 000 on 31 August 20X9. This amount was settled on 1
October 20X9. The plant & machinery that was sold had a
residual value of R250 000. Plant and machinery is depreciated
using the diminishing balance method at a rate of 20% p.a. No
other plant and machinery had been purchased or sold during
the 2009 financial year.
3. The table below provides information about the carrying
amount of vehicles.
Carrying amount, 31 Dec Carrying amount, 31 Dec

20X9 20X8
Vehicles 590 000 600 000
The vehicles on hand as at 31 December 20X8 consisted of three
identical vehicles purchased on 1 July 20X6, each with a residual
value of R20 000 and an estimated useful life of five years, with the
benefits consumed evenly over time. On 31 December 20X9, one of
the vehicles was damaged in an accident but could still be used as a
back-up vehicle by the business. On 31 December 20X9 the value-in-
use of this vehicle amounted to R90 000 and the fair value less costs
to sell amounted to R60 000. The total depreciation expense for
vehicles for the year ended 31 December 20X9 amounted to R270
000. No vehicles were sold during the 20X9 financial year.
1. Prepare all the general journal entries required on 31 August
20X9 relating to the plant and machinery that was disposed of
on that date. Closing entries are not required. Ignore dates and
narrations.
Briefly explain the reason that generally accepted accounting
2.
practice requires businesses to perform an impairment test on
damaged assets at the end of each financial year.
3. Prepare the general journal entry to record the impairment
expense for the year ended 31 December 20X9.
QUESTION 11.2 (B)

Ignore VAT.
Kayak Creations is a company that manufactures and sells kayaks
(canoes). The business has a year end of 30 June. The financial
manager has decided to join a group of people that will kayak the
entire Lake Malawi and is not available to finalise the financial
statements for the year ended 30 June X5. You have been asked to
answer a few questions relating to the year ended 30 June X5.
Extract from the Statement of financial position as at 30 June X4

PPE (Carrying value) (Note 1) R475 000
Note 1
The business purchased THREE machines on 1 July X0. The
machines are used to manufacture the kayaks. The machines are
depreciated over their useful life, with the expectation that benefits
will be generated evenly over the respective period.

1. On 1 November X4 the business disposed of Machine A for R15
000 cash.
2. New material that allows the manufacturers to produce lighter
kayaks while retaining their stability has come onto the market.
In order to remain competitive, the business incurred the
following expenditure on Machine B:

2.1 On 1 July X4 the business paid for a complete maintenance
overhaul on the machine at a cost of R125 000. The machine
will still need its annual maintenance check on 1 July X5.
2.2 The business purchased a new part that will allow Machine
B to produce kayaks using the new, lighter material. The
part cost R114 000. There has been no change in the useful
life or residual value of the machine.
• The purchase invoice for the new part was received
and paid on 1 March X5.
• The new part was delivered on 1 April X5.
• The new part was installed on 1 May X5 and
installation costs amounting to R2 964 were paid.
• The machine started producing kayaks on 1 June X5.
3. Machine C is unable to be adapted to produce kayaks with the

new material. As at 30 June X5 Kayak Creations has estimated
that, owing to lost business (a decline in demand for the older
kayaks), the value in use of Machine C amounts to R190 000.
Machine C could be sold for R198 000 assuming repairs
amounting to R18 000 were done. The business intends to
continue using the machine, and there has been no change in
the estimated useful life or the residual value of the machine.
4. An inventory count of kayaks available for sale as at 30 June X5
amounted to R90 000.

Included in the inventory count are 10 kayaks, costing R2 100
each, that are extremely unstable. They can be sold to lifeguards
for R2 200 if a lifejacket, costing R200, is provided with each
kayak sold.
On 30 June X5 Kayak Creations started a kayaking school. 10
kayaks, currently in the warehouse, with a cost of R3 000 each,
have been made available to be used as training kayaks. The
kayaks will be used for three years, after which it is estimated
that they will be sold for R1 000 if R150 is spent on repairs. No
entry has been processed to record this information.
1. Prepare the Asset Disposal account in the General Ledger of
Kayak Creations to record the disposal in point 1 of the

additional information. (6 marks)
2. Prepare ALL the general journal entries required to record the
expenditure in points 2.1 and 2.2 of the additional information.

Dates must be provided. Omit narrations. (7 marks)
3. Briefly explain WHY you have chosen to Dr the particular
account(s) for the general journal entry(ies) required to record
point 2.1 of the additional information. (2 marks)
4. Prepare the general journal entry(ies) required to record the
information provided in point 3 of the additional information.

5. Prepare the general journal entry required to record the (5 marks)
depreciation expense for the year ended 30 June X5. Dates must
be provided. Omit narrations. (6 marks)
6. Briefly explain the following terms:
6.1 Depreciation
6.2 Fair value (3 marks)

7.1 Prepare the general journal entries required to record the
7.
information in points 4.1 and 4.2 of the additional information.
If no journal entry is required, briefly justify your decision.
7.2 Briefly explain WHY you have chosen to Dr the (5 marks)
particular account(s) for the general journal entry(ies)
required to record point 4.2 of the additional information.

(2 marks)
QUESTION 11.3 (A)

Part A
Ernst Young and Cash Gates were discussing basic accounting
concepts one Friday evening, after attending lectures in the
afternoon in March X3.
Ernst: “My father has a motor repair business and he has asked
me whether the following are assets of his business for purposes of
reporting in the statement of financial position at the end of the
financial year, which is 31 December X2:
• A spanner purchased in X9 for R250 (estimated useful life 4
years)
• Equipment hired on a weekly basis from ‘The Weekly Hire
Company’, and
• The good reputation (goodwill) of the business with its
customers.”
Explain whether you would recognise each of the above as an asset.
Justify your answer with specific reference to the conceptual
framework.
(Maximum number of words − 100)
Part B
A company uses specialised machinery in the process of
manufacture. The company sends an invoice which transfers the
ownership of one of these machines to a purchaser. The purchaser,
however, is building new premises and will be unable to use the
machine until the new premises are completed. The seller will
therefore continue to use the machine until the premises are
completed.
Explain briefly the treatment of the machine in the financial
statements of the seller company if the statements are prepared
BEFORE the purchaser’s premises are completed.
Part C
Ignore VAT.
Round up to the nearest rand.
Beta Foil Manufacturers is a firm specialising in the manufacturing
of foil chocolate wrappers and chip packets. The accounting

department personnel of Beta Foil Manufacturers provided the
following financial information on 31 December X10:
1.
2. On 1 January X11, without disrupting operations, Machine A
was improved. After the improvements had been made the firm
decided to re-estimate the depreciation rate for Machine A as
follows:
3. On 1 October X11, machine A broke down and was damaged
beyond repair. The insurance company was prepared to pay
only R550 000.
Prepare the asset disposal account, as it would appear in the general
ledger after the necessary general journal entries have been recorded
and posted. (The account must be properly closed off.) (9 marks)
Part D
Delux Traders reported the following information in its X2 annual
financial statements:
X2 X1
R R
Statement of financial position information
Inventory 187 600 173 500
Trade payable 67 450 73 900
Statement of comprehensive income

Cost of sales 763 500 691 890
Assume that Delux Traders uses the perpetual method of recording
inventory and 80% of all its inventory purchases are on credit.
1. Calculate the total purchases for the year X2. (4 marks)
2. Calculate the amount of cash paid to creditors during X2.
(4 marks)
12 Companies
Now that Judy is manufacturing and selling her products to the
market, she has a great deal more control over what she sells and
the costs of producing what she sells. She has used all the money
from the bank loan to invest in property, plant and equipment. Her
sales are still growing and her competitors are talking about her
more than ever before.
One day, while visiting Tracey, Judy commented, “This business
is really going places. I see so much potential for more product
innovation and a bigger range. The market is ready for me. I just
wish I had more money. I have exhausted all the capital I borrowed
from the bank to set up my manufacturing operation.”
Tracey replied, «Well, if this venture is going to make money,
why don't you find some people to invest capital in your business?
If they think it is going to earn them a good return, I am sure they
will want to invest in your concern.»
Judy thought a while and then said, “Do you think I should form
a company before I ask other people to invest in this business? I
don't know a lot about forming a company or exactly what a
company is about. I have also learnt only a few accounting
concepts which help me to record transactions in my small
business. Will I have to learn many new accounting concepts so
that I know how to account for the business activities of a
company?”
Learning objectives
• Know what we mean by the term “company”
• Understand new terminology that is specific to companies
• Know a bit about the 2008 Companies Act
• Know the different types of companies allowed by the 2008 Companies Act
• Understand the basic principles and procedures for forming a company
• Discuss how a company obtains capital
• Understand what is meant by the term “shareholders” and the rights of the
shareholders
• Record the transactions which are specific to companies
• Describe how a company issues share capital
• Know what happens when a company declares a dividend
• Recognise income tax and capital gains tax
• Discuss dividend tax
• Understand when retained income and other reserves arise
• Understand the importance of share buy-backs
• Know how to prepare a statement of changes in equity
• Present the annual financial statements of a simple company in terms of generally
accepted accounting practice.
Judy is considering expanding her business. She has the option of
bringing in partners, or she could start a separate entity in which
other individuals could participate. We will look at partnerships in
detail in Chapter 13.
What would Judy’s options be if she decided to start a separate
entity in which other individuals could participate?
Judy could decide to start a company. The Companies Act of 2008
provides for two types of companies, namely profit companies and
non-profit companies. A company is a profit company if it is started
(incorporated) for the purpose of financial gain, which means with
the aim of making a profit for its owners (shareholders). In terms of
the 2008 Act, a single document, the Memorandum of Incorporation

(MOI), will describe how the company must operate.
Did you know?

Prior to the 2008 Companies Act, you could have used a different form of legal
entity called a “close corporation”. These are generally known as “CCs”. In terms
of the 2008 Companies Act you may no longer form a CC, but may continue to
operate an existing one.

A company is a person just like Judy, except that Judy is a natural
person, which means that Judy is a person because of her physical
state as a living human being. A company, on the other hand, is a
legal (or “artificial”) person. It has no physical existence, because it is

created in terms of law, specifically the Companies Act. This means
that a company is not simply an association of persons, like a

partnership, but is in itself a separate person with legal standing.
The company is regarded as an entity with rights and duties
separate from its shareholders. The assets of a company belong to
the company itself and not to its shareholders. As a legal person a
company can enter into contracts with other persons (whether
natural or legal persons) and can also be sued. The powers of a
company and what acts a company can perform as a legal person are
indicated in the Companies Act 71 of 2008, which replaced the
Companies Act 61 of 1973 in 2010.

shareholders
12.2.1.1 Limited liability and lifting of the corporate
veil
If Judy forms a company, she will be a shareholder, and the
company will be a separate person from Judy. All the plant,
equipment and other assets purchased by the company will belong
to the company. Any liabilities the company incurs will be
obligations of the company. If the company performs very poorly
and as a result has to close down and is consequently wound up or
liquidated, any liabilities and creditors that have to be paid are the
obligation of the company. If the company does not have enough
money to settle these debts, Judy as the shareholder will not have to
use her personal resources to settle the company’s liabilities. This is
because the company is a separate legal person from Judy and
incurred these liabilities on its own. The fact that Judy is not
responsible for the liabilities of the company means that Judy has
limited liability in so far as creditors of the business are concerned.
The name of a company indicates that liability is limited because it
includes the word “Limited” (which is usually abbreviated to

“Ltd”). If Judy contributes R100 000 as capital when the company is
formed and the company is not able to pay its obligations, the
maximum amount of money that Judy can lose is her original
investment of R100 000. In other words, if the company is wound up
or liquidated, Judy has no obligation to settle any of the outstanding
debts of the company.
Lifting of the corporate veil

Limited liability means that the directors and shareholders of a
company are generally protected against being personally liable for
the debts of a company. However, the South African courts will not
allow a company to be used for fraudulent or dishonest purposes. A
court can, in certain exceptional circumstances, hold the directors
and shareholders personally liable for the debts of the company if
there is evidence of criminal wrongdoing or dishonesty − it can
pierce or lift or pull aside the corporate veil.
12.2.1.2 Perpetual succession

Another important consequence to a company being a separate legal
person is that a company allows for perpetual succession. This
means that individual shareholders of a company can change, but
the company will continue to exist. For example, a company can
enter into a lease agreement in terms of which it leases business
premises. If any shareholder should die, or sell his or her shares in
the company, the lease agreement will not be affected at all by the
change in shareholders. Perpetual succession means that a company
will continue indefinitely until such time as it is wound up or
liquidated. Being a juristic or legal person, a company, unlike Judy,
cannot die. Therefore its assets will still belong to the company itself,
and contracts that it has entered into will continue to be valid, even
if there are changes in the make-up of its shareholders.
Consider how Judy has been operating her business so far.

Judy operates her business as a sole proprietorship. This means that
her business is not a separate legal entity, and the assets and
liabilities of the business (the worth of the business) form part of
Judy’s personal assets and liabilities. If her sole proprietorship was
unable to pay its debts, Judy would be responsible for settling any
outstanding debts from her personal resources. This means that
there is unlimited liability in a sole proprietorship, because the owner

and the business are the same person for legal purposes. When the
business enters into a contract, in terms of the law it is actually Judy
entering into the contract. When the business purchases assets, these
assets legally belong to Judy. If Judy were to die, her business would
no longer exist, because with a sole proprietorship, the owner and
the business are the same legal person. This is why some businesses
prefer not do business with a sole proprietor. Consider the situation
where a businessman, Pete, has built up a business relationship with
Judy, who is now a major customer. Imagine that he has just sold
Judy R100 000 worth of leather bags and Judy dies before paying
him. Pete has lost a major client and source of income, and the R100
000 owed to him will become a liability in Judy’s estate. Depending
on how much money she had and what other debts she had
incurred, Pete might recover only a portion of this debt.
Entity concept
Do not confuse the concept of unlimited liability in a sole
proprietorship with the entity concept. When we record the financial
performance and position of a business, we keep the records of the
business and the owner separate. This practice is called the entity
concept. However, from a legal perspective, the transactions of a
sole proprietorship are regarded as transactions entered into by the
owner personally. You can revise the entity concept in Chapter 2.

There are certain laws that govern Judy’s behaviour in society. For
example, Judy, a natural person, is subject to the laws contained in
theConstitution of the Republic of South Africa, 1996 and the

common law. In the same way, the behaviour of a company, which is
a legal (or “artificial”) person, is governed by legislation. The
Companies Act is a set of rules specifically drawn up for companies.
The Companies Act provides for the incorporation, registration,

administration and winding up of companies. South Africa has had a
total of three Companies Acts. The first Companies Act for South
Africa was passed in 1926, the next in 1973, and the most recent in
2008. The 2008 Act was implemented from 1 April 2011.

Just as there is an Attorney-General and a police force to administer
the Constitution and the common law, there is also an organisation
that administers the Companies Act. In terms of the 2008 Companies
Act, the office that regulates and registers companies is the
Companies and Intellectual Property Commission, often referred to as

CIPC, and is located in Pretoria.

Incorporation of a company means the formation of a company.
Remember a company is a separate legal entity. The 2008 Companies

Act requires the company to lodge the following two forms in order
for a company to be incorporated (registered):
• The notice of incorporation, and
• The Memorandum of Incorporation (MOI).
Once the incorporation of the entity is registered, the company is a
legal entity and can enter into contracts and purchase assets.
12.4 Different types of profit companies

In the group of profit companies, there are four separate types of
entities. These are the following:
1. A private company ((Pty) Ltd)
2. A public company (Ltd)
3. A personal liability company (Inc), and
4. A state-owned company (SOC).
When Judy formed Handbags for Africa, she had to decide what
type of company the organisation would be. The two main types we
will discuss are known as a private company and a public company.

A private company has all the characteristics of a company that we
have discussed so far, but has some restrictions that are unique to
this type of company. These restrictions are the following:
• A restriction on how to attract new shareholders, and
• A restriction on the sale of shares.
These restrictions are discussed below.

Restriction on how to issue share capital
If a private company wants to raise money by issuing shares, it is not
allowed to offer shares to the general public. The offer of shares
would have to be made by specific invitation to potential investors
who have expressed an interest in investing in the company. Private
companies therefore approach certain intermediaries, such as banks,
when they want to raise capital or organise an investment in the
business. Alternatively, a direct approach can be made to wealthy
individuals or other companies.
Restrictions on transfer of ownership of a share

The restricted transferability of a company’s shares is an essential
attribute of a private company, and a shareholder’s right to
“transfer” shares must be restricted by the company’s
memorandum. The memorandum of a private company can restrict
transferability by giving existing shareholders the right to purchase
a seller’s shares. In other words, before a shareholder can sell his or
her shares to an outside third party, these shares must first be
offered for sale to the remaining shareholders. This right is known as
a right of pre-emption.
Assume that three investors subscribe for shares in the company.
They contribute money to the company in exchange for the rights of
a shareholder. The subscribers are Judy (40 000 shares), a company
called Taking Care of Business (Pty) Ltd (35 000 shares), and a friend
called Tracey (25 000 shares). A few years pass, during which the
company performs well and earns good profits each year. Tracey
decides to go back to university to study and urgently needs money
for the fees. She decides to sell her shares in Handbags for Africa
(Pty) Ltd to raise the cash she needs.
Although Tracey will sell her shares to whoever comes along with
an acceptable offer, the transfer of shares in a private company from

one owner to another has to be done in the manner provided for in
the memorandum of the company. For example, the memorandum
could require that any sale must be approved by either the directors
or the other shareholders. A shareholder in a private company is
therefore not free to transfer ownership of his or her share in the
company to whomever he or she chooses.
Name of the company

Judy will have to register the name of the company as Handbags for
Africa Proprietary Limited or (Pty) Ltd if she registers this company as

a private company. Including the word “proprietary” makes it clear
that this is a private company.
Think about this 1

Imagine that you have some spare cash! You are offered two different
companies to invest in:
• Shares in Company A: these shares are not freely transferable.
Shares in Company B: these shares can be sold to whomever you want
without any restrictions on the change in ownership.
•
Which share would you prefer to purchase if these companies were identical in
all other aspects such as, for example, the same profit expectations?
Check your answer
You may prefer to purchase shares in Company B, because it would be easier to sell
these shares if and when you wanted to. This is because there are no limitations on
the transfer of ownership of these shares. There is less risk in owning a share that is
freely transferable, because you can sell the share if the company's performance is
below expectation without having to get the approval of the directors or other
shareholders. When shares are freely transferable, we are usually prepared to pay
more for them because it is easy to liquidate (convert into cash) our investment by
selling the shares in the company.
A public company has all the general characteristics of a private
company, but also has certain qualities that are unique to a public
company.
To whom can a public company issue share capital?

A public company can raise capital from the general public, and the
shares of a public company are freely transferable.
How does a public company raise capital from the general public?
The company issues an invitation by way of an advertisement which
appears in a newspaper, a business journal, or the Internet, or
through any other means of communication. This invitation is called
a prospectus, and the public are invited to apply for (or subscribe to)
shares in the company. To protect the public, there are a number of
rules in the Companies Act that govern what information must be
included in the prospectus. The rules ensure that the prospectus is
not misleading and does not contain false information about the
company. A private company will never issue a prospectus because
it is not allowed to offer its shares for sale to the general public.
Where or how are the shares of a public company sold?

Imagine that you are a farmer and you have fresh vegetables to sell.
You will probably find out where the fresh produce market is held
every morning and take your produce there to sell. This market is
merely a place where buyers and sellers meet to buy or sell their
goods. The existence of a market is important for buyers, to find out

what products are available for sale, and for sellers, to access a large
number of buyers.
Just as fresh produce is a commodity that you can sell, so are
shares in a public company. In order to bring the buyers and sellers
of shares in the various public companies together, a marketplace for
shares was created. This marketplace in South Africa is called the
JSE Limited (JSE). There are many marketplaces like the JSE for the
purchase and sale of shares in public companies all over the world.
There are, for example, exchanges in London (LSE: London Stock
Exchange) and New York (USA) (NYSE: New York Stock Exchange).
The JSE connects buyers and sellers of shares, and controls share
trading via its Main Board, and for smaller, often start-up,
companies, on its Alternative Exchange board (AltX). A public
company, once it has met certain requirements (such as size, profit
history, and number of shareholders) can list its shares on the Main
Board or on the AltX, bringing the shares to the market. The buyers
of shares will review the exchange listing and buy those shares that
they want. Shares bought and sold through the JSE are referred to as
listed shares (because they are included with the shares that are
listed as trading on the JSE). Not all public companies are listed, as a
public company does not have to have its shares listed on an
exchange. Shares in this type of public company are known as
unlisted shares.
In 2010 the JSE had 331 companies listed on its Main Board and 75
companies listed on the AltX. The AltX was launched in 2003 in
order to allow for the listing of small to medium-sized growth
companies. The main indicator of the equity market’s performance is
the FTSE/JSE All Share Index. The Securities Services Act 36 of 2004
ensures that all trading in shares is properly regulated, and the JSE is
licensed in terms of this Act.

The JSE Main Board lists all shares of public companies that are
involved in the same business or industry together. This makes it
easier for the investor to find possible investments within the same
sector. Examples of some of the sectors on the JSE in South Africa
are resources (one subsector being mining), basic industries (one
subsector being chemicals), and financials (subsectors include
investment companies, banks, and life assurance). In 2004 the JSE
launched the Socially Responsible Investment Index (SRI Index)
which measures compliance by companies with “ triple bottom line”

criteria, focusing on a company’s economic performance,
environmental impact, and societal impact, based on the concept of
sustainability.
Did you know?

What does it mean when the company's name ends with the letters “plc”, such
as Old Mutual plc? It is the abbreviation for public liability company, and has
the same meaning as Ltd for companies registered in the United Kingdom.
Name of the company
Judy will have to register the name of the company as Handbags for
Africa Limited or Ltd if she wants to register this company as a
public company.

The shares in a public company are mostly owned by the general
public. For this reason a copy of the financial statements of a public
company is sent to CIPC and the financial statements are available
for any member of the public to read. The financial statements need
to be sent to CIPC only if the financial statements are required to be

audited. An audit is an independent check of whether published
financial statements are fairly presented. The 2008 Companies Act
has regulations which prescribe whether a company has to be
audited. The greater the number of shareholders, lenders and
employees has, the more likely it is that the company will have to be
audited.
The transferability of a private company’s shares is restricted by
its Memorandum of Incorporation.
In theory, a public company has the potential for much bigger
growth in profits. This is because this company has the potential to
obtain unlimited capital investment from the general public. This
capital would be used to expand continuously and increase the
efficiency and profitability of the company. This is particularly the
case when the public company is listed on a securities exchange.
This is very different from a private company, where capital
contributions are far more limited.
Think about this 2

What should Judy's decision be? Should she register Handbags for Africa as a
private or a public company?
Check your answer
Judy would like to keep control of the company, but realises that a large amount of
capital will be required to start the business as well as to expand the business over the
next few years. If Judy feels that the loss in control is worth the increased capital base
to which a public company has access, she should decide to register the company as a
public company.
In one specific situation, a company can be a legal person, but the
directors of these companies can be liable for the debts of the
company (unlimited liability). Under the 2008 Companies Acts, it is
possible to register a personal liability company, where the directors

are jointly and severally liable with the company for debts and
liabilities. Professional persons, such as attorneys and accountants,
often incorporate their practices in this manner. These companies
usually have the letters “Inc” after their name, indicating that it is an
incorporated entity.

As the name “state-owned company” implies, this is a separate legal
entity owned by the state (government). The activities of a state-

owned company are generally governed by the Public Finance
Management Act 1 of 1999. A state-owned company can be
identified by the letters “SOC”, which will form part of its name.
12.5 Legal requirements for the formation

of a company
How do we create a legal person called a company?

Before Judy can form a company (create a separate legal person), she
will have to carry out all the requirements as provided for in terms
of the Companies Act. Forming a company is called incorporating a

company.
12.5.1.1 Company name
The company will need to reserve a name for the company. Judy has
decided on Handbags for Africa Ltd as the name for the new
company, so she has to submit a form (CoR 9.1) to CIPC, requesting
this name. CIPC can prevent you from using a particular name if the
name is undesirable or too similar to the name of an existing
company, or if it belongs to a company which is already registered.
12.5.1.2 Company's objectives and goals

In terms of the 2008 Companies Act, the incorporators of a company
will submit a Memorandum of Incorporation as the founding
document of a company. The Memorandum of Incorporation (MOI) is

defined as the document that sets out rights, duties and
responsibilities of shareholders and directors.
The following steps must be taken in order to incorporate a
company:
1. One or more persons may incorporate a profit company,
whereas three or more persons may incorporate a non-profit
company.
2. Each person should complete and sign the MOI.
3. A Notice of Incorporation must be filed with the Commission.

The purpose of the Commission is to register companies, to
keep information in respect of companies, and to ensure that
there is compliance with the provisions of the Companies Act.
4. The MOI of the company must accompany the Notice, together
with the prescribed fee.
5. An MOI can be in a form that is unique to the company, or the
company can use the MOI provided in the Schedule of the Act.
On accepting the Notice, the Commission will assign a unique
registration number to the Company. The Commission must enter
the prescribed information relating to the company into the
Companies Register. When all formalities are in order, a Registration

Certificate will be issued and delivered to the company. The
registration certificate shows that all the requirements for the
incorporation of the company have been complied with and that the
company is incorporated from the date stated in the certificate. The
date of incorporation on the certificate is the date on which the
company comes into existence as a separate legal entity.

A company’s MOI will deal with a number of different issues,
including the following:
• The objects and powers of the company
• Any restrictions or limitations on the powers of the company
• What happens to the assets if the company is dissolved
• The composition of the Board of Directors
• Alternate directors
• The frequency of Board meetings
• The Committees of the Board
• The personal liability of directors
• The indemnification of directors
• Powers of directors and shareholders
• Rights of shareholders
• The disposal by shareholders of their shares
• The ability to create rules of the company
• Shareholders’ meetings and the procedures involved
• The process for amending the MOI.
Unless a company’s MOI provides otherwise, the board of directors
of a company may make or change any rules relating to the

governance of the company that are allowed in terms of the
Companies Act. The board must publish a copy of the rules and a
copy of the rules must also be filed with the Commission.
A company’s MOI and any rules of the company are binding as
follows:
• They are binding between a company and each shareholder
• They are binding between or among the shareholders of the
company
• They are binding between the company and each director
• They are binding between the company and each prescribed
officer of the company.
Does a company have the same legal powers as a natural person such
as Judy?
The 2008 Companies Act provides that a company has the legal
capacity and powers of an individual, except where an artificial
person (such as a company) is incapable of exercising any such
power, for example, to enter into a contract of marriage.
The Act specifically provides that if there are restrictions in a
company’s MOI, any contract with a third party which is not
allowed in terms of the MOI would still be valid. The restrictions or
limitations will be legally relevant only if the third party was
actually aware of them. The restrictions in terms of the MOI are
binding between the company, its shareholders and/or its directors.

Go and watch What is a share: This video explains some of the common
questions relating to shares.
Now that Judy has formed a company, her company needs funds to
acquire assets and to operate the business. Where the funds come
from is called a financing decision, because it focuses on the source
of funds that are required by a business. Judy either has to find
potential investors and persuade them that her company will
perform well, making a profit that they will receive as a return on
their investment; or she will have to borrow the required funds.
Investors who subscribe for shares are referred to as equity investors,

and believe (a) that they will receive returns from the business by
way of dividends, and (b) that their shares will increase in value and
thereby increase their wealth.
When equity investors contribute funding into a business, we say
they purchase shares in the company. Owning a share in the
business is documented by issuing the shareholder with a share

certificate that sets out the details of ownership. Ownership of this
share can be transferred to another person. The share certificates of
all companies listed on the JSE are electronic or computerised
documents (they are referred to as uncertificated securities). This

process is known as STRATE, which stands for Share Transfer
Records All Totally Electronic.

12.6.2.1 The right to share in the net assets of the
company on liquidation
When investors subscribe for shares in a company, they contribute to
the equity of the company. Equity is defined in accounting literature
as a residual, which means the total assets minus all liabilities.
Shareholders are therefore entitled to their share of the net asset

value of the company when the company stops operations and
liquidates (sells off) its net assets. The company first pays the
creditors and any remaining assets are distributed to the
shareholders.
Something to do 1
Handbags for Africa Ltd issues 10 000 R1 shares to shareholders. Judy buys 4
000 of these shares. Ten years later the company has stopped trading and is
about to liquidate (sell) its net assets of R15 million (total assets less total
liabilities), reflected on the statement of financial position.
Assume that the assets and liabilities making up the R15 million were valued
on the basis of what they could be sold for (the liquidation basis), rather than the
usual going concern basis. If this is the case, then the R15 million represents the
actual amount we can expect to realise, or earn, from the sale of the net assets.
Do you remember that financial statements are usually prepared on the going
concern assumption? This assumes that when valuing the assets and liabilities of
a company, it is expected that the company will continue to trade in the
foreseeable future. This is different from the liquidation basis which values the
assets and liabilities of a company at what the assets can be sold for, and what
the liabilities must be settled at, as the company is no longer trading.
Check your answer
Judy is entitled to 40% (because she owns 4 000 of the 10 000 shares issued) of R15
million on liquidation. The R6 million (40% × R15 million) will be paid across to Judy
when the company has sold off all its assets and settled all its liabilities. After Judy and
the other shareholders have been paid, there will be no assets or liabilities left in the
company, the company will be de-registered, and it will no longer exist as a legal
person.
12.6.2.2 The right to receive a share of the profits:

dividend policy
A shareholder does not have a legal right to receive a share of the
profits until the company declares a dividend.

The decision the company makes about how much of its profit to
distribute to the shareholders is called the company’s dividend

policy. A company will want to keep some of its profits in the
business so that the business can use these profits to expand (by
acquiring more assets) or become more efficient (by using the money
to fund operations). Tracey is a friend of Judy’s and bought 1 000
shares in Handbags for Africa Ltd, because she wanted to receive
income every year from a dividend payment from the company. The
company had stated that its dividend policy was to distribute 30% of
the profit for the year as a dividend. If the company does not pay out
any of its profits (pay dividends), Tracey could sell her shares, but
some shareholders interpret the non-payment as a sign that the
company is doing badly and cannot afford to pay out profits as a
dividend. These shareholders panic because they think that the
company is going to make losses, so they sell their shares.
Companies that are doing well could decide to keep the cash in
the company for expansion rather than pay it out to the
shareholders. Shareholders are often happy with that decision, as the
company may be able to earn more on the cash than the investor
would earn by putting the cash in the bank. A company needs to
communicate its dividend policy to potential shareholders so that
those who need the cash flow from dividends buy shares in a
company that plans to pay regular dividends.

12.6.2.3 The right to choose a board of directors
Shareholders are not generally involved in the day-to-day operating
decisions of the business, so they appoint directors to make these

decisions. The shareholders appoint directors at a general meeting of
shareholders. The directors then have certain rights, powers and
duties.
The main objective of the board of directors is to take over the
responsibility of managing the company. They will be responsible
for all decisions except those relating to matters that specifically
have to be decided by the shareholders. In terms of the Companies
Act, certain matters have to be decided by the shareholders
themselves and not by the directors. A resolution or decision by the
shareholders is needed for these specific matters. The shareholders
make this formal decision at a general meeting.
A resolution or decision of shareholders will be made if voted for
by a majority (more than 50%) of the shareholders at a general
meeting at which there is a quorum. There are some decisions that
are so important to a company that they require a special resolution

to be made. This simply requires more shareholders to support the
decision before it is voted in (75% of the shareholders at a quorate

meeting must support the decision). A quorum is the minimum
number of shareholders required at a meeting (in terms of the MOI)
before any resolutions can be voted on. The 2008 Companies Act
provides some flexibility in the percentages required if these are
specified in the MOI, but the general principle continues to be
applied. The percentage required to approve decisions is one of
what the 2008 Companies Act refers to as “alternative provisions”,
as the company has some discretion.

The directors decide that the company should issue more shares to increase its
share capital, because funds are needed by the company to expand its operations.
This is not a decision the directors are allowed to make. The Companies Act makes
the decision to issue share capital the responsibility of the shareholders. This
action has to be voted for by a majority (more than 50%) of shareholders who
attend a general meeting at which there is a quorum.
Personal liability of directors
The directors carry out a very important function and are placed in a
position of trust. They have a duty to carry out their work with care
and skill. Anyone who is appointed as a director of a company
should know all the duties that he or she has to perform. These
duties are laid down by the common law, the employment contract
with the company, and the Companies Act.
The 1973 Companies Act did not contain clear rules regarding the
duties of directors. These matters were largely left to common law
and to Codes of Corporate Practice, such as the King Report.

The 2008 Companies Act introduces new law, entitled “standards
of directors' conduct”, which includes a fiduciary duty, which means

that the director has to act in a way that benefits the shareholders,
not him- or herself, and a duty of reasonable care, which means that
the director has to be diligent in carrying out his or her duties. The
provisions governing directors’ duties are supplemented by other
new provisions addressing conflict of interest, directors' liability,

indemnities and insurance.
The 2008 Companies Act provides that the director must exercise
a high degree of care, skill and diligence. Directors satisfy their
obligations if they have taken reasonably diligent steps to become
informed about a particular matter. A director can rely on one or
more employees of the company whom the director reasonably
believes to be reliable and competent in terms of skills or expertise
related to the particular person’s professional or expert competence.

The director may also rely on information, opinions, reports or
statements provided by legal counsel, accountants, or other
professional persons retained by the company.
If a director’s personal interests conflict with those of the
company, the director should disclose the conflict of interest to the
shareholders or the board of directors of the company. The director
may disclose any personal financial interest in advance by
delivering a notice in writing to the board of directors or the
shareholders, setting out the nature and extent of the personal
interest.
12.6.2.4 The right to sell shares in the company

Let’s assume that Handbags for Africa Ltd issued 10 000 shares. If
Judy purchased 4 000 of these shares she would be a shareholder of

the company and would have all the rights designated to the class of
shares she purchased. Judy has the right to sell her shares. If Judy
needs money urgently or if she feels that the company is no longer
performing well, she can sell some or all of her shares in Handbags
for Africa Ltd. Judy will sell her shares at the current market price;
this is called the share price. The share price is the price investors are
prepared to pay for a share in the ownership of a company, based on
their current expectation about the company’s ability to make a good
profit in future. If investors believe that Handbags for Africa Ltd is
going to make future earnings, the share price will increase.
Think about this 3

What is the difference between a company issuing shares and a shareholder
selling shares?
Check your answer
When a company issues shares, these are new shares, and the cash raised goes to the
company (look at the journal entries in sections 12.6.4.5 and 12.6.4.6 that illustrate
the effects of the share issue by a company).
If Judy sells her shares, she will get cash from the sale. The only difference to
Handbags for Africa Ltd is that the shareholders have changed, and all the company
will have to do is change the name in the share register. The transaction (buying and
selling shares) is between two shareholders and does not involve the company. It is
also important to remember (see the discussion in section 12.2.1.2 on perpetual
succession) that even though shareholders can change, the company itself is
unaffected, because the company is a separate legal person, distinct and apart from
its shareholders.
Types of investments
An investor could buy a share because he or she wants to keep the
share as a long-term investment. This investor wants the company to

make profits from which he or she will benefit, either in the form of
dividends or by increasing the value of the shares. The profits that
are kept by the company over the years (where profits are retained
and not paid out of the company as dividends) will increase the
financial worth (equity) of the company, and the investor will
receive his or her share of this increased worth when the company
stops trading and liquidates (sells) its net assets, or when the
shareholder decides to sell the shares.
An investor can also buy shares in a company because he or she
thinks that the share price of the company is going to increase soon.
The investor buys the shares so that they can be sold at the increased
share price and he or she can make a profit. This is known as
speculating in shares (as opposed to investing).

12.6.3 Shares and share certificates
When a company issues shares, the assets of the company increase,
as the new shareholders subscribe for shares by investing money or
other assets in the company. The amount of funding that is
contributed to a company by shareholders is referred to as share

capital, and forms part of the equity of the company.
12.6.3.1 Share classification

The way in which shares are classified has changed. The table below
indicates how shares are classified in terms of the Companies Act,
2008, in comparison with the classification under the Companies
Act, 1973:
Companies Act, 2008 Companies

Act, 1973
Class A shares − shares with voting rights and entitlement to Ordinary
distributions; shareholders are entitled to the net assets on shares
liquidation of the company.
Class B shares − shares with no voting rights, with entitlement 10%
to a xed distribution of 10% of issue price prior to any preference
distributions to Class A shares. shares
Class C shares − shares with no voting rights, with entitlement 12%
to a xed distribution of 12% on issue price prior to any redeemable
distributions to Class A shares. Shares are redeemable at the preference
option of the company. shares
According to the 2008 Companies Act, a share is a collection or
bundle of rights, and all authorised and issued shares should have a
distinguishing designation, such as voting rights, rights to fixed
dividends, preferences or limitations, and so on. Each class of shares

has a different distinguishing designation (in other words, each
different bundle of rights and/or limitations must be indicated
separately).
For example, a company may have the following shares:
Class A shares
• Class A shares (previously referred to as ordinary shares) have
voting rights with no fixed distribution amount and share in the
net asset value on liquidation.
Class B shares
• Class B shares (previously referred to as preference shares) have
no voting rights, but have a fixed distribution rate of 10% of the
consideration received.
Class A shareholders would be entitled to dividends from a
company, if and when dividends are declared. Class B shareholders’
rights are more specific, and Class B shareholders are entitled to
fixed dividends. Class A shareholders also have the right to vote at
meetings on decisions about the running of the company. At least
one class of shares has to have voting rights, and at least one class of
shares has to have the rights to share in the net asset value of the
company on liquidation.
12.6.3.2 Authorised and issued share capital

The subscribers of a company are the people who originally formed
the company. Judy is one of the original subscribers of Handbags for
Africa Ltd. Before a company applies to be registered as a company,
the subscribers of the company must decide on a maximum number
of shares that may be issued to investors in the company. In terms of

the 2008 Companies Act, the details of the maximum share capital
must be included in the company’s MOI.
This authorised share capital is therefore the maximum number
of shares that a company can issue to investors. Issued share capital

is the actual number of shares or amount of share capital that the
company has issued to shareholders.
12.6.3.3 Par value shares

In terms of the 1973 Companies Act, a company could issue either
par value or no par value shares. In terms of the 2008 Companies Act,
all shares will be no par value shares. According to the transitional
arrangements of the 2008 Companies Act, existing companies with
par value shares (unless they have already been authorised) will not
be allowed to issue additional par value shares when raising capital.
These companies will also have to convert their par shares into no
par value shares. The timing of this conversion has, as yet, not been
set.
So what were par value shares?

Par value shares were referred to as such because each share had a
nominal value. For example, a company’s authorised share capital
could consist of 1 000 000 shares of R1 each. The par value of such
shares was R1. The nominal value was the price the subscribers
allocated to each share when the company was registered. The par
value was not necessarily the price at which the shares were issued
or what the shares were worth after they had been issued.
Share premium
The par or nominal value should not be confused with the rand
amount the company receives for the share when the shares are
issued. If the share price was more than the par value of the share,
this difference was known as the share premium. Both the Share
Capital account and the Share Premium account recorded the capital
of a company. The par value of the shares issued was recorded in the
Share Capital account, and any amount in excess of the par value
was recorded in the Share Premium account. Because the nominal
amount of par value shares bears little resemblance to the issue price
of the share, or its market value, the 2008 Companies Act no longer
allows companies to issue par value shares.
Did you know?

The percentage that you own of a company's shares is more relevant than how
many shares you own. If you own 50% of the company, you will get 50% of the
profits when dividends are declared. It does not matter whether you own 100
shares, 1 000 shares or 1 000 000 shares.
12.6.3.4 No par value shares

No par value shares refer to shares where a nominal (par) value is
not allocated to each share. If a company has no par value shares, the
MOI will contain only the number of shares that may be issued. This
is the company’s authorised share capital. When no par value shares

are issued, the full proceeds are taken to the Share Capital account.

We know that a public company raises capital by selling shares to
the general public. The first shares that a company issues will be to
the subscribers or founding members. After this, a company can
issue more shares to the existing shareholders (this issue is called a
rights issue), or the company can issue shares to the general public.
In terms of the 2008 Companies Act, the directors can issue shares at
any time but only to the extent authorised by a company’s MOI and
only in respect of the classes as determined by the MOI. Shareholder
approval for the issue of shares is required only if the shares are
issued to the directors themselves or to a prescribed officer of the
company.
12.6.4.1 The procedure for a share issue

If an offer of shares is made to the general public, the company will
first publish a prospectus. This is an invitation to the public to buy
shares and will indicate, among other aspects, the opening and
closing dates of the share issue. Members of the public apply for
shares in the company by completing and submitting an application
form and payment for the shares to the company.
12.6.4.2 Applications
The company receives all the applications and banks all the
payments received. No application for shares is accepted unless
payment has been made in full. All share capital has to be fully paid
up either in cash or by means of some other asset. Once share

applications have closed, the company identifies how many shares
have been applied for, and the shares are allotted (distributed) and
issued to the applicants.
12.6.4.3 Application and allotment account

When the company receives the applications for shares, the Bank
account is debited with the payment received, and an account called
Application and Allotment is credited. This account is a liability

account, where the amount of capital applied for is recorded until
the shares are allotted to the investors and issued. Once the shares
have been allotted and issued, we transfer the capital from the
Application and Allotment account to the Share Capital account (for
no par value shares), or to the Share Capital and Share Premium
accounts (for par value shares).
12.6.4.4 Issue of no par value shares
Something to do 2
Prepare the journal entries to record the issue of 490 000 no par value
shares at an issue price of R22 per share.
Check your answers
When we issue no par value shares, the total amount of R22 per share is recognised in
the share capital account.
General journal
12.6.4.5 Over-subscription of shares
Let’s assume that a company has offered 10 000 Class A shares to the
public. Class A shares have voting rights and no fixed distribution
amount (they used to be referred to as ordinary shares). Once all the
applications have been counted, the directors find that 15 000 shares
have been applied for by the public. This is called an over-

subscription of shares. If the company had received applications for
only 6 000 ordinary shares, this would be fewer than the company
wanted to issue, and it is called an under-subscription of shares.

If there is an over-subscription of shares, the directors have the
option of allotting the full amount applied for, or the company will
allocate the available offered shares (100 000) among all the
applicants. The allocation method will have been explained to
investors in the prospectus. The unsuccessful applications will be
returned to the investors together with their cash payment. The cash
received with the share applications is therefore deposited into a
bank account opened specifically for the purpose of cash from share
applications. This is because the company does not know whether
the cash received will be returned to the investors or will remain in
the company as equity.
Recording an over-subscription of shares in the general ledger

For the issue of the 490 000 Class A shares (issue price of R22),
Handbags for Africa Ltd received applications for 600 000 shares.
Let’s look at the general journal entries:

After the allocation procedure and refund there is a nil balance in the
Application and Allotment account. In the journal entry we
prepared above, the Bank was credited with the R2 420 000, being
the cash refunded to unsuccessful applicants, Share Capital was
credited with R10 780 000, and the Application and Allotment
account was debited with R13 200 000.
Did you know?

If you apply for shares in a public company, there is no guarantee that you will be
issued with shares. If the issue is over-subscribed (there are more applications
than there are shares available), you may have your application returned to you
and your money refunded, or you may be issued with a portion of what you
applied for.
12.6.4.6 Under-subscription of shares

Remember that if a company has offered 10 000 Class A shares to the
public and received applications for only 6 000 ordinary shares, this
would is referred to as an under-subscription of shares.

A share issue is under-subscribed if not all the shares offered for
issue are applied for by the public. This is a poor signal to the
market, because it shows that investors do not think the company
will generate good returns. An under-subscription of shares can
have a negative impact on the company’s share price.

The company offers shares in order to raise capital for a specific
purpose. This could be to expand operations or to repay a portion of
its debt. If the issue is under-subscribed, the company would not
obtain the capital it needed, and would be unable to expand or to
repay the debt.
For each share issue the company has to raise a minimum amount
of money. This is known as the minimum subscription and is stated
in the prospectus. If insufficient shares are sold (below the minimum
subscription), the directors are not allowed to issue any shares and
all the cash received is refunded to the applicants.
12.6.4.7 Underwriting a share issue

A number of companies protect themselves from the negative
consequences of an undersubscribed share issue by using the
services of an underwriter. This is a business that guarantees the
company that its share issue will be fully subscribed (that all the
shares on issue will be bought). In order to fulfil this guarantee, the
underwriter undertakes to purchase any unissued shares if the issue
is under-subscribed by the public. This means that all the shares on
issue are sold and the company receives all its required capital from
this share issue.
The underwriter is taking a risk, because there is a chance that a
significant purchase of the company’s shares will have to be made if
the issue is largely under-subscribed. On the other hand, the public
may apply for all the shares on issue, and the underwriter will not
have to purchase any shares. The company pays the underwriter an
underwriter's commission for this service, no matter whether the
underwriter has to buy shares or not. This payment is for assuming
the risk of having to purchase the shares. The commission is usually
a percentage of the total value of the shares on issue.

Recording an under-subscription of shares in the general ledger
Handbags for Africa Ltd used an underwriter called Investment
Banks Ltd to underwrite the share issue in X6. The agreement was a
commission of 5% of the value of the share issue. Of the 490 000
Class A shares issued at R22 each, only 400 000 were applied for by
the general public.
12.6.4.8 Share issue costs set off against equity

The issue of shares involves complying with a great deal of
legislation and results in administration and legal costs. These costs
are called share issue costs. Share issue costs and underwriter’s
commission are set off against equity and are not be recognised as an
expense in the statement of profit or loss and other comprehensive
income. Think about the definition of an expense in the Framework
− the definition excludes all amounts relating to transactions with
the owners (shareholders). This means that to close off Share issue
expenses, we debit an equity account, such as Share Capital or
Retained Profit (the Share Premium account was debited if the
shares were par value shares) with the share issue costs and credit
the Bank account (paid in cash) or a liability account (costs are still
owed).
Handbags for Africa Ltd incurred R300 000 share issue costs
related to the issue of shares during the current year. The share issue
costs are reflected in the statement of changes in equity.
Something to do 3
Prepare the journal entry that the company processed to record the R300
000 share issue costs.
Check your answers
*Note that Share issue costs is not an expense but a type of suspense (temporary
holding) account, where costs related to the share issue will be accumulated until the
shares are issued. These share issue costs are then closed off to the Share capital
account.

12.6.5.1 Rights issue
A rights issue means that the share offer is made to the existing
shareholders of the company, in proportion to their existing
holdings, as opposed to the company offering the shares to the
general public. If the 490 000 shares had been offered by Handbags
for Africa Ltd to the existing shareholders, this issue would be called
a rights issue. The accounting for a rights issue is as described above
− the only difference is who the shares are issued to.
12.6.5.2 Capitalisation issue or “bonus” shares

The directors of Handbags for Africa Ltd may want to issue the
current shareholders of the company with shares for free. This is
done by a capitalisation of the profits of a company. Profits that have

been retained in the company are transferred to the share capital
account. No cash is received by the company when these shares are
issued. When capitalisation shares are issued, they are issued to
shareholders in the same ratio as their existing shareholding. The
total equity (consisting of share capital plus retained income) does
not change, but the retained profits are reduced and share capital is
increased. This is illustrated in an example below. The directors
decide on the price of the shares. They can issue them at the par
value if they are par value shares, or at the market value, or at some
other value on which the directors decide. This is the amount that
will be transferred out of Retained Income.
Tracey, a shareholder in Handbags for Africa Ltd, owns 10% of
the company’s class A shares and will therefore receive 10% of the
capitalisation shares. There will be no change in a shareholder’s
percentage holding relative to the other shareholders after a
capitalisation issue. A capitalisation or bonus issue requires a special

resolution of the voting shareholders.
Something to do 4
Handbags for Africa Ltd has a capitalisation share issue on 31 December X6.
The terms of the issue are that every shareholder will get three ordinary
shares for every two shares held. The existing shareholding before the
capitalisation issue was 2 190 000 shares.
1. Calculate the total number of shares that will be issued with this
capitalisation issue.
2. At what amount will the capitalisation shares be issued? In other words,
what amount per share will be transferred from Retained Income to the
Share Capital account?
Check your answers
1. 2 190 000/2×3 = 3 285 000 bonus shares.

2. The 2008 Companies Act allows the company to decide on the rand amount of the
capitalisation issue. If we assume that the company decides to allocate R5 per
share, the company will transfer 3 285 000 × R5 = R16 425 000 from the
retained profit account.
When the company uses profit to fund this issue of shares, it takes profit that would
have been available for distribution to the shareholders and reallocates it to share
capital.
Recording a capitalisation issue in the general ledger

The journal entry to record this capitalisation issue, assuming that
the issue is funded by profits and the capitalisation shares are issued
at R5 per share, is as follows:

12.7 Dividends
A dividend is the term given to a share of the profits that is
distributed to the shareholders. The directors of a company
recommend the amount of a dividend, and the actual dividend is
declared by shareholders themselves, and is done in accordance
with a company’s MOI. From the date of declaration, the directors
have a legal obligation to pay the shareholders the dividend that
they announce. Dividends are declared out of a company’s profit

after tax.
A dividend is an appropriation of the profits

A dividend is an appropriation (distribution) of a company’s profit
after tax. It is very important to distinguish an appropriation of
profits from an expense. Remember, an expense is a decrease in
assets or an increase in liabilities not due to a transaction with the
owner. In determining a company’s profit for the year, all expenses
must be taken into account. A dividend, on the other hand, is a
distribution of profit. When we declare a dividend we will either
have an increase in liabilities (when the dividend is declared but not

paid) or a decrease in assets (when the dividend is paid), but this is
due to a transaction with the owner. The net asset value of the
company has decreased but it is not an expense, because this
decrease was caused by a distribution to equity participants in their
capacity as shareholders. A dividend is not an expense because it
does not meet the expense definition in the IAS Framework. A
dividend is not a charge (cost) against profits; it is a distribution of
profits.
12.7.1.1 Ordinary or Class A dividends
Ordinary or Class A dividends can be a variable amount and can
differ at each dividend declaration date. The dividend is quoted as a
certain number of cents per share, for example, 10c or 134c per share.
Each share in issue on the declaration date is entitled to this
dividend.
12.7.1.2 Preference dividend or fixed dividend

Shares with a fixed distribution receive a fixed amount when a
dividend is declared. These shares are issued for a specified amount
(the consideration received or the face value of the share), and the
fixed distribution is a fixed amount (percentage) of the face value of
the share. Each share in issue on the declaration date is entitles to
this dividend. However, the dividend declared on shares with a
fixed distribution is time based. This would mean that if the share
was issued on 1 July X1 and the dividend was declared on 31
December X1, the shareholder would be entitled to a dividend for
only six months. This topic is covered in more detail in section
12.8.3.8.
In some circumstances, the nature of preference/fixed dividend
shares is more closely related to a liability than equity, for example,
shares that have to be repaid on a specified date after paying fixed
dividends. In this case, the shares will be treated as a liability and
the dividend treated as an interest expense.
12.7.1.3 Interim and final dividend

An interim dividend is a dividend declared quarterly or half-yearly
and a final dividend is declared at the end of a financial year. The
final dividend will be paid during the following year.

The directors decide how much of a company’s profits should be
declared as a dividend. Directors recommend the amount of the
dividend, and the shareholders in a general meeting declare that
dividend. In other words, shareholders declare a company’s
dividend, but that amount cannot exceed the amount recommended
by the board of directors.
In terms of the 2008 Companies Act, directors can recommend a
dividend only if they are satisfied that the company will be both
liquid and solvent after such declaration; in other words, the
company will be able to pay its liabilities for the foreseeable future,
and its assets exceed its liabilities. This requirement seeks to ensure
that a company continues as a going concern, and that shareholders
will receive a dividend only if it does not threaten the existence of
the company itself. A shareholder has no inherent right to receive a
share of the profits and must accept the directors’ decision.

The dividend policy of a company will have an effect on the capital
structure of a company. Distributing profits to the shareholders as
dividends means that the company will have reduced the amount of
profits that can be reinvested in the business. The directors will have
to decide whether to replace these funds, if needed, by issuing
shares (capital) or by taking out loans (debt).

Why would a company pay dividends and then borrow money to fund its
operations?
This may be necessary to keep its shareholders happy. If a company has a
long history of paying dividends, shareholders may expect those to continue. The
recession in 2008−2009 caused many listed companies to skip dividend
payments.
Think about this 4

In what financial report do you think you will show the dividend
appropriation?
Check your answer
The dividend is not an expense and so will not be reflected in the statement of profit or
loss and other comprehensive income. The dividend is an adjustment to equity and is
therefore disclosed in the statement of changes in equity. Go to the statement of
changes in equity (section 12.12) and see what dividend the directors of Handbags for
Africa Ltd declared for the year.
The statement of changes in equity is a report that shows the users of financial
statements how the equity of the company has changed during the year. It shows how
the equity has changed due to transactions with the owners, in their capacity as
owners, that is, shares issued and dividends, as well as all gains and losses made
during the year. Refer to section 12.12 for a more detailed discussion about the
statement of changes in equity.
12.7.4 Recording a Class A dividend in the general

ledger
When do we record a dividend in the general ledger?

The directors of Handbags for Africa Ltd have recommended a final
dividend each year. At the end of December X6 the shareholders had
not yet declared the dividend. The declaration of a total dividend of

R10 000 for X6 was made on 31 March X7. This dividend of R10 000
related to the X6 year, but the dividend was paid on 30 April X7.
The question that we have to ask is, on what date did the
company have a liability, an obligation, to pay the shareholders a
dividend of R10 000?
Before we can recognise a liability, the transaction has to meet the
definition and recognition criteria for a liability. The company did
not have a liability to pay the dividends on 31 December X6 because
there was no obligation arising from something that had happened
in the past. The declaration of the dividend is the event that gives
rise to an obligation to pay the dividend. The dividend therefore
meets the definition of a liability only on 31 March X7, so it is only
on this date that we can record the transaction. The dividend of R10
000 will therefore not be reported in the financial statements for the
year ended 31 December X6.
The general journal entry to record a dividend is as follows:
31 December X6
In the general ledger for the year ended 31 December X6 there will
be no journal entry, because the transaction has not as yet met the
definition of a liability.
31 March X7
The dividend has been declared but has not yet been paid. As this is
a distribution of profits, equity will decrease and a dividends
account is debited. We credit a liability account called Shareholders

for dividend. If we had to draw up a statement of financial position
on 31 March X7, we would show Shareholders for dividend as a
current liability, as this obligation was payable within 12 months
from the date of the statement of financial position. At year-end the
Dividends account will be closed off to the Retained Profit account.
30 April X7
31 December X7

dividend
A capitalisation share issue can be used to issue shareholders with
bonus shares. There is another reason for making a capitalisation
issue: to issue shares as payment of a dividend that has been
declared. The shares are given to the shareholders instead of cash as
payment of the dividend.
When a company declares a dividend, the dividend is usually
paid in cash to the shareholders. If the company has insufficient cash
resources, it will have to borrow money to pay the dividends. The
memorandum of incorporation can allow directors to pay the
dividends otherwise than in cash. One example of this is where the
company pays the dividend by giving shareholders an asset equal in
value to the amount of the dividend. This is called a dividend in

specie (a dividend in kind). This concept will be dealt with in more
detail in future accounting courses.
The company can also pay the dividend by giving the
shareholders company shares to the value of the dividend amount
owing. This is known as a scrip dividend. A scrip dividend occurs
when capitalisation shares are issued to pay a dividend declared.
12.7.5.1 Recording an issue of shares as payment of

a dividend
Let’s assume that the dividend of R10 000 declared by Handbags for
Africa Ltd was paid by issuing capitalisation shares. The dividend
was paid to 2 190 000 shareholders. The journal entry to record this
dividend is as follows:
What reserve is being used to fund this capitalisation issue (scrip

dividends)?
We have debited the Dividends general ledger account with the total
value of the share issue. The Dividends account in the general ledger
is closed off to the Retained Income (Accumulated Profit) ledger
account at the end of the year. We are reallocating R10 000 from the
accumulated profit to capital (recorded in the Share capital account).
We can also understand this transaction by identifying two separate
parts of the transaction. Firstly, we declare a dividend and, secondly,
the shareholders reinvest this dividend in the business by
purchasing shares. This is why a dividend paid for with a
capitalisation issue is also called a dividend reinvestment plan.

In many instances shareholders are given the choice between
receiving their dividend in cash or in shares. Many shareholders
choose the share option, as they believe in the company and wish to
reinvest their dividends in the company.
12.8 Shares with a fixed dividend

(preference shares)
David and Judy had not seen each other for a few months, so they
decided to go to dinner and catch up with each other's news. Judy
was telling David how well the share price of Handbags for Africa Ltd
was doing and that if she had to sell her shares now, she would get
double her original investment back.
David replied, “I wish I could find some way to invest in your
company, but is it possible to invest and still meet all of my other
needs?” Judy asked, “What features do you want this investment to
have?”
David answered, «Well, I need to have my capital repaid to me in
five years' time because I plan to buy a house. I will need to be pretty
sure that as a minimum I am paid my original investment. This is
why I cannot invest in class A shares, it's simply too risky. If I want to
sell the share, the share price might have fallen and I will be repaid
less than my original capital amount. Oh yes, I also need to make
sure that I receive a regular, fixed income each year to help me cover
all my living expenses. At the moment I receive interest income every
year. As I understand it, the Class A share has no right to a fixed
dividend, and that you are not guaranteed to get an annual
dividend.»
Judy thought for a moment and then replied, «You know, David,
you could invest in shares with these characteristics. I am sure that
there is a class of share that will meet all your needs.»
12.8.1 Recording the issue of shares with a fixed
distribution
The journal entries for the issue of fixed distribution shares are the
same as the entries for the issue of shares with no fixed distribution.
Something to do 5
Handbags for Africa Ltd issued fixed distribution shares at the issue price of
R20. The shares were described as class B. Assume the issue was fully
subscribed − neither over-subscribed nor under-subscribed.
Prepare the journal entry for the issue of the shares.
Check you answer
12.8.2 Recording a fixed dividend in the general

ledger
On 1 January X7, a company issues 10 000 12% shares with a face
value of R1. The face value of the share is the rand value at which the
company issues the share. This means that 10 000 shares having a
face value of R1 each have been issued. On 31 December X7 the

company declares a dividend. The dividend per share would be 12
cents (R1 × 12%), resulting in a total dividend of R1 200 (10 000 × R1
= R10 000 × 12%). The dividend was paid on 20 January X8.
The general journal entry to record a dividend is as follows:
X6
In the general ledger for the year ended 31 December X6 there will
be no journal entry because the transaction has not as yet met the
definition of a liability.
31 December X7
The dividend has been declared but has not yet been paid. As this is
a distribution of profits, equity will decrease and a dividends
account is debited. We credit a liability account called Shareholders

for dividend. If we had to draw up a statement of financial position
on 31 December X7, we would show Shareholders for dividend as a
current liability, as this obligation was payable within 12 months
from the date of the statement of financial position. At year-end the
Dividends account will be closed off to the Retained Profit account.
31 December X7
20 January X8
Think about this 5
What would the dividend declared amount to if the shares in section 12.8.2
had been issued on 1 July X8?
The dividend declared would amount to R600 [10 000 × R1 = R10 000 ×
12% × 6/12]
12.8.3 What type of rights could shares with a fixed

Let’s look at some options for “a distinguishing designation”
attached to shares with a fixed distribution rate. This list is not
exclusive, as companies can decide what rights, preferences or
limitations to attach to each class of shares.
1. No voting rights and a fixed distribution rate
2. No voting rights and a preferential fixed distribution rate
3. No voting rights and a cumulative fixed distribution rate
4. No voting rights, a cumulative fixed distribution rate, and the
right to participate in the distribution to shares with no fixed
distribution
5. As 3 above, and redeemable at the option of the company
6. As 3 above, and redeemable at the option of the shareholder.
12.8.3.1 Right to receive a fixed distribution

A shareholder has a right to a dividend only if the directors decide
to declare a dividend. Shares with a fixed distribution rate receive a
fixed amount when a dividend is declared. These shares are issued

for a specified amount (the consideration received or the face value
of the share), and the fixed distribution is a fixed amount
(percentage) of the face value of the share. The directors would have
no discretion in setting the amount of the dividend declared; the
amount of the fixed dividend is agreed on at the time the shares are
offered.
Think about this 6

Would you invest in preference fixed dividend shares in an economy with high
inflation?
Inflation means that the purchasing power of the currency of a country
decreases over time. At today's prices, R40 will buy you two cheeseburgers in
South Africa. If the inflation rate is 10%, you will need R44 to buy the same two
cheeseburgers next year.
Check your answer
With preference fixed dividend shares, the amount of income you will receive as a
dividend, if one is declared, remains the same for the whole period in which you invest
in the shares. If there is high inflation, this fixed amount will have less and less
purchasing power as the years pass. You will be able to buy less with the income. It is
for this reason that preference shares are not a popular investment on the securities
exchange if inflation is a factor. Investors want to earn a return that increases at least
by the inflation rate over the years so that their purchasing ability at least remains the
same.
12.8.3.2 Preferential right to receive a fixed

distribution
Shares could have the right to receive a dividend before other share
classes. This means that the owners of the other classes of shares will
not receive a dividend unless the company has declared a dividend
to the shareholders with a preferential right to a distribution.
12.8.3.3 Right to share in the net assets of the

company
Shareholders could have a right to share in the net asset value of the
company when the company stops trading and liquidates (sells) the
net assets. If the company has performed well over the years, the net
asset value will have increased, and shareholders will have their
original capital investment repaid, as well as receiving a share in the
growth or surplus net asset value in proportion to the nominal value
of their shareholding (the value of their original capital
contribution). If the business has performed poorly and losses over
the years have reduced the net asset value of the company,
shareholders may be repaid an amount significantly less than their
original capital investment.
12.8.3.4 Preferential right to be paid out their capital

before other shareholders
The distinguishing designation at the time of issuing the shares can
give shareholders a preferential right to be paid their original capital

on liquidation. In this case, the shareholders will generally receive
only their initial capital investment back and will not share in any
increase or decrease in the net asset value of the company. These
shareholders could lose out on receiving a share of the increase in
the net assets, or they may benefit by not having their capital
investment reduced by the losses of the company. When
shareholders have a preferential right to repayment of their
investment, there is less risk of losing their original capital

investment. But there is a cost attached to having less risk, as these
shareholders are not given any growth on their original capital
amount.
12.8.3.5 Right to vote

Shares that do not have any voting rights attached to them are not
involved in the decision-making of the company. Certain non-voting
shares can acquire voting rights in certain circumstances. We discuss
this circumstance later in the chapter.
12.8.3.6 Right to a cumulative fixed distribution rate

Shareholders have no right to a distribution unless a dividend is
declared. If a company does not declare a dividend in a year, the
shareholders with no fixed distribution will have to forgo any
possible dividend earned on their shares in that year.
Shareholders with the right to a fixed dividend could also have
the right to a cumulative dividend. If the company does not declare
a dividend in one year, the company will owe these shareholders
this fixed amount. The shareholder will therefore not necessarily lose
the fixed payment if no dividend is declared this year; it becomes an
amount the company owes the shareholders and has to pay in the
future.
We do not raise a liability for the dividend at this stage, because
no dividend declaration has been made. As soon as the company
misses the annual declaration of the fixed dividend, these shares
could be given rights to vote at the general and the voting rights
generally remain until the company declares the arrear fixed

dividend. If these shares also have a preferential right to a dividend,
no other share class can receive a dividend until the arrear dividend
is declared.
If a contract of issue does not mention whether the share is
cumulative or not, we may legally assume that the share is
cumulative. For a share to be non-cumulative, the contract must
specifically state this.
Think about this 7

Let's make sure we have understood the rights of a cumulative fixed distribution
share by looking at an example. A company issues 10 000 12% R1 cumulative
fixed distribution shares. The directors do not declare a dividend in X5. What
dividend must the directors declare in X6 before a dividend can be declared to the
other classes of shares?
Check your answer
At the end of X5 the company owes the cumulative shareholders a fixed dividend of R1
200. They did not declare a dividend at the end of X5, so these dividends are now in
arrears. The directors should declare a cumulative dividend of R2 400 in X6 before
other dividend can be declared in X6. This would consist of the R1 200 arrears
dividend and the R1 200 for the current year. The dividend will be recorded only when
it is declared.
12.8.3.7 Right to a participating fixed distribution

Shareholders with the right to a fixed distribution receive a fixed
amount when a dividend is declared. Shares with no fixed
distribution rate can receive whatever dividend the directors choose
to declare. The amount of the dividend depends on the performance
of the company and the dividend policy. If the company has made
good profits, it is likely that the dividend will be larger. If the
company has performed poorly, the dividend is usually smaller.
A participating share receives the fixed dividend as set at the date

of issue, as well as being allowed to share in the distribution to
shareholders with no fixed distribution. The directors will decide on
the proportion in which the participating shareholders share in this
distribution in relation to the other shareholders. Sometimes
participating shareholders are allowed to participate in the profit
distribution only once the other shareholders have received a
minimum dividend.

A company issues 10 000 12% R1 participating fixed distribution
shares. The directors decide to distribute 20% of the remaining profit
after the fixed dividends have been declared. The participating
shareholders are entitled to share in this distribution in the ratio of 1
: 3.
Pro t for the year 100 000

Fixed dividend (R10 000 × 12%) (1 200)
Pro t available for distribution 98 800
Distribution (98 800 × 20%) 19 760
Participating dividend (19 760 × 1/4) 4 940
No xed distribution − dividend (19 760 × 3/4) 14 820
The participating shareholders therefore receive a total of R6 140 (R1
200 + R4 940).
12.8.3.8 Shares with the right to be redeemed

Certain shares offer the shareholder the right to invest in the
company for a limited period of time. This means that the company
has to repay the shareholder’s capital within the specified period.
The period of the investment and whether the shares are redeemable
at the option of the company or at the option of the shareholder is
decided when the shares are issued. If the share is redeemable at the
option of the shareholder, the share has similar characteristics to a
loan, because the shareholder will be repaid his or her capital after a
specified period of time and will receive a fixed distribution. The
amount repaid to the shareholder is his or her original capital
contribution and possibly an additional amount, called a premium on

redemption. This premium is agreed when the redeemable
preference shares are issued and represents the amount of capital
return that the shareholder will receive.
Think about this 8

Do you remember that you are supposed to account for the substance and not the
legal form of a transaction? What is the difference in economic reality (substance)
between a loan of R1 million with an interest rate of 12%, repayable in five years'
time, and redeemable cumulative shares with a dividend rate of 12% redeemable
in five years' time?
Check your answer
Apart from the different tax consequences, in substance the two transactions are the
same in that redeemable and cumulative shares are repayable at a specified date and
earn a fixed income − in substance the same as in the case of a loan. These shares
can be disclosed as a liability and the fixed dividends shown as part of the interest
charge.
Think about this 9
When can a company repay shareholders their initial capital investment before
liquidation if the shares are not redeemable shares?
Check your answer
The shareholders will be repaid their capital investment before liquidation if the
company decides to offer the shareholders a share buy-back or the shareholder sells
his or her shares.
Think about this 10

Let's see whether Handbags for Africa Ltd has issued any shares with the right to a
fixed distribution. Do these shares have any other rights or preferences? You will
find the statement of changes in shareholders' equity and note 12 to the financial
statements helpful in answering these questions.
Check your answer
The company has authorised share capital of 500 000 15% R20 redeemable
cumulative fixed distribution shares. To date the company has issued 150 000 of
these shares. The shares have the right to a cumulative fixed distribution and are
redeemable.
Think about this 11

How would redeemable cumulative fixed distribution shares be disclosed on the
statement of financial position and statement of profit or loss and other
comprehensive income of Handbags for Africa Ltd?
Check your answer
Handbags for Africa Ltd would show the R3 million capital invested by on the statement
of financial position as a non-current liability. This is consistent with treating the share
as a debt and not equity, because the rights of the shareholders are in substance
similar to the rights of a debt holder.
This dividend of R450 000 is not shown in the statement of changes in equity. The
directors have disclosed this dividend as part of the interest expense. The fixed
dividend of R450 000 will be shown as part of the total interest expense. This
treatment is correct in the context of treating this share as debt and not equity.
12.9 Company taxes

12.9.1 Normal tax
12.9.1.1 Accounting profit and taxable income
The company is a legal person separate from its owners and
managers and is registered with the South African Revenue Service

(SARS) as a separate taxpayer.
The company has to pay tax on the taxable income that it earns in
a year, or alternatively, in the case of small and medium-sized
companies (if the company chooses to register as one with SARS), on
its turnover. Companies with a turnover of R1 000 000 or less can
choose to be taxed on their level of turnover rather than on their
taxable income.
Taxable income is calculated in the manner prescribed by the
Income Tax Act 58 of 1962, and therefore the rules that are applied
in determining a company’s taxable income are different from the
accounting rules on how to determine profit for the year.

Although there are many transactions that are treated in the same
way by SARS and by accountants, a company’s taxable income is
often different from the accounting profit for the year.
Let's make sure we understand this concept by looking at a quick

example.
Statement of profit or loss and other comprehensive income

Sales 1 00 000
Cost of sales (60 000)
Gross pro t 40 000
Dividends received from RSA 1 000 000
The accounting profit is R1 040 000. However, in terms of the Income
Tax Act, dividends received from South African companies are tax-
free. The taxable income is therefore only R40 000. This means that
the company will pay income tax on taxable income of only R40 000.
If normal tax is based on a company’s taxable income, the rate of tax
that applies in 2011 is a flat rate of 28%. If normal tax is based on a
company’s turnover, the tax payable will be calculated on a sliding
scale up to a maximum of 6% of turnover.
Taxes include taxes payable on ordinary operating income, capital

gains tax and when an asset is sold. A company also collects a
number of taxes on behalf of SARs. This includes VAT, employees
tax (PAYE), and from 2012, a tax on dividends. VAT was covered in
Chapter 7. Employees tax and dividend tax are withholding taxes,
where the company reduces the amount paid to employees and
shareholders by the amount of the tax (the company withholds the
tax). The company is obliged to pay the tax over to SARS. As with
VAT, the company is acting as an agent for SARS in collecting the
tax. When the tax is withheld, a liability to SARS is raised, but the
company will not recognise a tax expense. See section 12.9.2 for how
dividend tax is recorded.
12.9.1.2 Current income tax expense

When we prepare the financial statements at the end of the financial
year, we do an estimation of what we think the company’s income
tax will be for the year, using the rules of the Income Tax Act. For
the year X6, the estimate of the current year’s income tax expense
was R4 680 969 (go to note 4 of the financial statements and check
this). We would record this with the following journal entry:
X6
We have recognised a liability for the income tax expense that relates
to the profit earned during the year. This is an application of the
accrual basis of accounting. We recognised the income tax expense
when it was incurred and not when we paid SARS. The income tax
was incurred when we earned the profit from which this tax liability
arises.
12.9.1.3 Income tax return

A company has to show SARS how much profit it has earned during
the current year. For this reason the company has to complete and
submit a form (IT14) together with a copy of its financial statements

to SARS. SARS then calculates the taxable income according to the
rules of the Income Tax Act and sends the company a bill for the tax
owing (this bill, or account, is called an IT34). This can be done
online using the SARS e-filing system.

If the company has correctly estimated the tax charge, there
should be no difference between the income tax expense recorded in

X6 and the amount on the IT34 form. However, sometimes the
company makes a mistake or SARS has a different opinion, and the
tax charge according to SARS is different from the amount processed
at year-end.
Let’s assume for this example that when we receive the IT34 a few
months after yearend (in June X7), the income tax expense for the X6
year as assessed by SARS is shown as R5 000 000. This means that
we under-provided for the income tax expense in X6. We do not go
back and change the tax expense; all we do is process the additional
amount as an expense in the current year (X7).
X7
12.9.1.4 Provisional payments to SARS

When the company pays SARS the income tax owing according to
this example, the journal entry will be as follows:
When does a company pay the current tax amount to SARS?

If the income tax for the current year (X6) is paid only when the
company receives the assessment form (IT34) from SARS, the
company would have to have to pay R5 000 000 in that month. This
would obviously be quite a drain on cash flow. For this reason,
SARS introduced a system whereby companies pay income tax in
instalments during the year. These payments are called provisional

tax payments. A payment or instalment has to be made every six
months in the company’s financial year.
The journal entry to record these payments would be as follows:
If our estimate for the current year‘s income tax is correct, the tax
expense shown by SARS will amount to R4 680 949. However,
because the company paid provisional payments of R3 359 130
during the year (on 31 August X6 and 31 December X6), only R1 321
839 will still be owing for the year X6 when we receive the
assessment form requesting payment in September X7.
Normal tax and the sole proprietor

If a business is a sole proprietorship, the business and the owner are
regarded as the same legal person. The owner and the business are
the same taxpayer. This is in contrast to a company, where the
company is a registered taxpayer and the owners or shareholders are
registered taxpayers in their own right. With regard to a sole
proprietorship, SARS adds any other taxable income of the owner to
the taxable income of the business. This is regarded as the owner’s
taxable income and is subject to income tax. A natural person, does
not pay a flat rate of income tax, as a company does (28%). A natural
person has a different scale of tax rates ranging from 18% to 40%.
The tax rate applicable increases as the total taxable income range
increases (these are known as marginal rates).
Let's look at a simple example.
Something to do 6
Judy did some work for another company during the year and earned R200 000
as a salary. Her business (sole proprietor) made a profit of R50 000. Can you
calculate what Judy's taxable income for the year would be?
Check your answer
Judy's taxable income for the year is R250 000. You would need to use the tax tables
provided by SARS to work out how much tax is payable.
12.9.2 Dividend tax

Dividend tax is a withholding tax, payable by the company on
behalf of a shareholder. The rate at which dividend tax will be levied
is 20%. Companies will withhold the tax on dividends paid unless
the dividend is paid to an entity that is exempt from dividend tax,
for example, South African resident companies. For example, if a
dividend of R100 000 is declared, the R100 000 will attract a dividend
tax of 15%, which is R15 000, and the shareholder receives the net
dividend of R85 000. The tax is an expense to the shareholders and
not to the company declaring the dividend.
Let's look at an example where all the shareholders are individuals

On 31 December X7, Handbags for Africa Ltd declares a dividend of
R15 000. All of the company’s shareholders are individuals. Prepare
the general journal entries to record the dividend declaration and the
dividend tax.
31 December X7
What do we notice?
1. Dividend tax amounting to R15 000 × 20% = R3 000 is withheld
as all of the shareholders are individuals.
2. The dividend tax liability would be recognised on the same day
as the dividend is declared.
Let's look at an example where all the shareholders are South African
companies.
On 31 December X7 Handbags for Africa Ltd declares a dividend of
R15 000. All of the company’s shareholders are SA-resident
companies.
Prepare the general journal entries to record the dividend
declaration and the dividend tax.
31 December X7
What do we notice?
1. No dividend tax is withheld, as all of the shareholders are South
African resident companies.
2. The dividend tax liability would be recognised on the same day
as the divided is declared.
Let's look at an example where the shareholders are both South

African companies and individuals.
On 31 December X7 Handbags for Africa Ltd declares a dividend of
R15 000. Sixty percent of the company’s shareholders are SA-
resident companies.
Prepare the general journal entries to record the dividend
declaration and the dividend tax.
31 December X7
What do we notice?
1. The dividend tax liability is recognised on the same day as the
divided is declared.
2. Dividend tax is withheld only from shareholders that are not
South African resident companies.
3. There is no tax expense recognised by the company as the tax is
levied n the shareholders. The company acts as the withholding
agent (similar to VAT) and pays the tax over to SARS.
12.9.3 VAT
If you need to revise VAT, you should refer to Chapter 7. There is no
difference between how a company and a sole proprietor calculate
and record VAT. The company will be a registered VAT vendor if
the total of the company’s taxable supplies (sales) for the year
exceeds R1 million (prior to 1 March 2009 the limit was R300 000). A
company that is taxed on a turnover basis (that is to say, not on
taxable income, but on turnover) cannot register as a VAT vendor
and will therefore not charge VAT nor be able to claim VAT inputs
on its purchases.
The only significant difference between a company and a sole
proprietor with regard to VAT is that a company has to operate on
the invoice basis for VAT. This means that the company has to pay
SARS the VAT output when it invoices its customers, and it can
claim its VAT input when it receives a tax invoice from its suppliers.
A company might not yet have received the cash from its debtors,
but would have to fund the payment of the output VAT to SARS.
A sole proprietor has a choice in some circumstances between the
invoice basis and the cash basis. Using the cash basis, the sole
proprietorship pays the output VAT to SARS only when it receives
the cash payment from its customers, and it claims the input VAT
only when it makes the cash payment for the purchase or expense.
This helps a great deal with the cash flow of a business.
A sole proprietor on the cash basis can wait until the debtor pays
and then pay the output VAT portion of the cash receipt to SARS,
thereby avoiding any effect on the business cash flow.

Where we use an asset in the business for a significant period of time
to generate income, this asset is called a capital asset. We can
describe it as the tree from which the fruit (the income) grows. An
example of a capital asset is the property, plant and equipment
controlled by Handbags for Africa Ltd. This would include a
warehouse, for example, that is used to store the leather goods
which are then sold to customers for cash. The warehouse is a capital
asset because it is used to generate income and is a non-current
asset. If Handbags for Africa Ltd were to sell the warehouse, any
profit earned on the sale would be a capital profit and would be
taxed at an effective rate of 14% as described above (once again, be
aware that a company that pays tax based on its turnover is not
subject to capital gains tax).
Compare this to a company that buys and sells warehouses as its
main business (a property dealer). In this company, the warehouse is
inventory, because it is bought with the intention of selling it as part
of the ordinary business. This is a revenue asset because it is not part

of the income-producing infrastructure, but rather an end product
that is sold. The profit this company makes when it sells the
warehouse (sells its inventory) is subject to income tax at the full
rate, currently 28%.
As far as capital gains tax is concerned, a company (other than
those companies that pay tax based on their turnover) must include
50% of all capital profits in their taxable income, which is then
subject to the 28% income tax rate. This means that if a company
makes a capital profit of R100 000 in 2009, R50 000 of this will be
included in the company’s taxable income, so the company will pay
income tax of R14 000 (R50 000 × 28%) on this profit. Capital gains
are therefore taxed at an effective rate of 14% (50% × 28%). In the
case of an individual, only 25% of any capital gain must be included
in that person’s taxable income, whereas with a company, 50% of
any taxable capital gain must be included in the company’s taxable
income. The maximum effective tax rate on capital gains is therefore
10%, which is 25% of 40%.

12.10 Reserves
A company uses the capital invested by the shareholders to invest in
assets to use in carrying out its operations. If the company makes a
profit, this profit can either be kept in the company or distributed to
the shareholders as a return on their investment (dividend). The
profit that is not distributed becomes part of the reserves (or
retained income) of the company.

A reserve is therefore the name given to profits/gains that have
previously been earned by the company and have not yet been
distributed by the company as dividends. Reserves therefore form
part of the equity of the company, as is clearly shown in the
accounting equation below:
Assets = Equity (Share capital plus Reserves) + Liabilities (debt)
Some reserves (such as the revaluation surplus) do not arise from
operating profit earned by the business. In the case of the
revaluation surplus, for example, the reserve arises because
property, plant and equipment has been revalued to its fair value (go
back to Chapter 11 to read about revaluation of assets). The gain
recognised in other comprehensive income is transferred to the
revaluation surplus.
Let's have a look at the reserves of Handbags for Africa Ltd.

You can find this information on the statement of financial position:
Revaluation surplus 800 000
Retained profit 17 860 857
The total reserves of the company are R18 660 857. All these reserves
consist of gains that have been earned by the company and not
distributed as dividends. R800 000 of the total reserves relates to a
Revaluation Surplus, discussed in more detail below. The balance of
R17 860 857 relates to Retained Profit − profits previously earned
and retained by the company.

Can we ever reduce the issued share capital of a company? The
answer to this question is “yes”, provided that certain requirements
of the Companies Act are met.
12.11.1 Reduction of share capital − share buy-backs

If, before 1999, a company wanted to reduce its share capital, it had
to have the transaction authorised by a special resolution of the
shareholders. The company also had to obtain written consent to this
reduction in capital by all its creditors. If this consent was not
obtained, the company had to obtain a court order allowing it to
reduce its share capital.
The Companies Act was changed in 1999, when a section allowing
share buy-backs was introduced into the Act. The 2008 Companies
Act continues to allow a company to buy back shares, provided that
after such transaction, the company satisfies the liquidity and

solvency test. This test is specifically defined in terms of the 2008
Companies Act. The test also has to be applied every time a
company decides to distribute a dividend. In other words, a
company can buy back its own shares only if, after such buy-back,
the company is both liquid and solvent. This requirement seeks to
ensure that creditors of a company are not prejudiced by any share
buyback.
In a recession, where the price of a company’s shares is depressed, a
company may decide to buy back shares if it has the cash resources
to do so. These shares will need to be cancelled from issued shares
(and are restored to authorised share capital). A share buy-back
could strengthen the value of the shares of those shareholders who
did not sell their shares back to the company. When dividends are
declared in the future, there will be fewer shareholders, and the
profits being distributed will be shared among fewer shareholders.
If a company has excess cash resources and does not have any
viable investments, the directors may think it is better for the
company to use these cash deposits to buy back some of its shares
and reduce its capital.
Did you know?

Treasury shares in South Africa refer to shares in a holding company that have
been bought by one of its subsidiary company. These shares will appear as
treasury shares on the consolidated financial statements. Treasury shares are
also used in share-incentive schemes. A subsidiary purchases shares in the
holding company that are held as treasury shares and can be used in a share
incentive scheme.

At this point you should be very familiar with the statement of profit
or loss and other comprehensive income and statement of financial
position, and we will deal with statements of cash flows in detail in
Chapter 14.
Let's look at the statement of changes in shareholders' equity.

Shareholders want to know why the equity of the company changes
from year to year, because this means that the net assets (the claim)
of the company have changed. To show why this has happened, the
company prepares a statement of changes in equity. This shows the
user how each type of equity account on the statement of financial
position has changed over the year.
The statement starts with the balances of each equity account at the
beginning of the year. All the movements that have happened in
each equity account (share capital, retained profit, revaluation
reserve) during the year are shown. The statement reconciles the
balance of the equity account at the beginning of the year and the
balance of the equity accounts at the end of the year (together with
comparatives for the prior year.

The statement of changes in equity will show the users of the
financial statements why the total equity changed from R37 557 051
to R54 040 857 by showing all gains and losses and transactions with
the owners, in their capacity as an owner.
What do we notice?
1. The statement of changes in equity requires you to show:
a) All the gains and losses, and each type of OCI either on the
statement or in the notes.
b) All transactions with owners in their capacity as owners,
that is, shares issues and dividends.
2. Share capital can increase if new shares are issued and can
decrease if shares are bought back by the company or if the
company incurs share issue expenses.
3. The profit for the period of R8 921 247 and the revaluation gain
of R400 000 are shown as changes in total comprehensive
income.
4. Retained profit will increase if the company generated a profit
during the year and will decrease if the company distributed
part of the profit to the shareholders.
5. The revaluation surplus will increase if the company revalued
assets during the year (increase in the fair value). The
revaluation surplus can decrease if the fair value of the asset
decreases or if a revalued asset is sold and the revaluation gain
is transferred to the retained profit account.
12.13 Financial statements for a public

company
The financial statements of a company consist of the following:
• Statement of profit or loss and other comprehensive income (with
the option of a separate income statement)
• Statement of financial position
• Statement of cash flows
• Statement of changes in shareholders’ equity, and
• Notes to the financial statements.
Let’s have a look at a basic set of financial statements of a public
company and see what elements in these financial statements we
have not come across in our study of the accounting process of a sole
proprietor.
HANDBAGS FOR AFRICA LTD
ANNUAL FINANCIAL STATEMENTS for the year ended 31
December X6
NATURE OF BUSINESS Manufacture and sale of leather goods
REGISTERED OFFICE
347 Main Road
Kenilworth
7708
REGISTRATION NUMBER 2000/002900/06
CONTENTS
Directors’ report
Auditors’ report
Statement of profit or loss and other comprehensive income
Statement of financial position
Statement of changes in shareholders’ equity
Statement of cash flows
Notes to the financial statements

APPROVAL OF ANNUAL FINANCIAL STATEMENTS
The Annual Financial Statements were approved by the Board of
Directors on 6 March X7 and signed on its behalf:
Chairman and Chief Executive Officer
Judy Abrahams
Director: Vusi Tshabalala
ANNUAL FINANCIAL STATEMENTS
for the year ended 31 DECEMBER X6
EXTRACT FROM THE REPORT OF THE INDEPENDENT
AUDITORS To
the members of Handbags for Africa Ltd
We have audited the annual financial statements of Handbags for
Africa Ltd for the year ended 31 December X6, set out on pages 2 to
16. The annual financial statements are the responsibility of the
company’s directors. Our responsibility is to express an opinion on
these annual financial statements based on our audit.
AUDIT OPINION
In our opinion, the annual financial statements fairly present, in all
material respects, the financial position of the company at 31
December X6 and the results of its operations and cash flow
information for the year then ended in accordance with International
Financial Reporting Standards, and in the manner required by the
Companies Act in South Africa.
Independent Auditors
6 March X7
1.1 Basis of preparation

The financial statements are prepared on the historic cost
basis.
1.2 Revenue (Sales)

Revenue, which excludes value added tax, represents the
value of goods invoiced after discounts.
1.3 Inventories
Inventory is valued at the lower of cost calculated on the
FIFO basis and net realisable value.
1.4 Impairment
The carrying values of the assets are reviewed if there is
any indication of impairment. When the recoverable
amount of the asset is less than the carrying value of the
asset, the impairment loss is recognised in the statement of
profit or loss and other comprehensive income.

The company has chosen to use the revaluation model for
property, plant and equipment in terms of IAS 16. Property,
plant and equipment are depreciated on the straight-line
basis at rates that will reduce the cost to estimated residual
values over the anticipated useful lives of the assets as
follows:
Vehicles 4 years
1.6 Investment properties
Investment properties are measured according to the fair
value model, and the resulting adjustment recognised in
the statement of profit or loss and other comprehensive
income.
2. Operating profit is calculated after taking the following costs

into account:
X6 X5
R R
Depreciation on property, plant, equipment 10 000 9 570 000
000
Auditors' remuneration 750 000 610 000
Employee remuneration costs 7 627 045 7 528 000
Directors' emoluments
− for services as directors 500 000 450 000
− for managerial services 1 750 000 1 450 000
Loss on disposal of property, plant and (97 500) 0
equipment
Rent received 1 136 760 0
Pro t on sale of investment 120 000 0
16 137 15 594
839 958
3. Interest paid
X6 X5
R R
Interest paid on loan 3 730 000 4 770 000
Interest paid on bank overdraft 143 379 0
3 873 379 4 770 000
4. Taxation
X6 X5
R R
South African normal taxation
Current income tax expense 4 680 969 4 140 842
5. Earnings per share

The calculation of the profit or earnings is based on the profit of
R8 921 247 (X5: profit of R7 830 116) and a weighted average
number of ordinary shares in issue during the year of 1 945 000
(X5: 1 700 000).
6. Distribution to shareholders
7. Property, plant and equipment

8. Investments
X6 X5
R R
Other investments
Unlisted shares 280 270 000
000
At cost less amounts written off and at
directors' valuation
Details of unlisted investments
% Cost less
impairments
X6
Raw leather (Pty) Ltd 2.73 280 000
X5
Best Designers (Pty) Ltd 0.05 270 000
9. Inventories
X6 X5
R R
Finished goods 1 744 000 2 472 000
Work-in-progress 1 715 000 1 236 000
Raw materials 201 000 288 400
Consumables 90 000 123 600
3 750 000 4 120 000
10. Trade receivable
X6 X5
R R
Trade receivable 26 778 570 24 528 570
Allowance for doubtful debts (850 000) 0
25 928 570 24 528 570
Trade receivable comprises amounts receivable for the sale of
goods for which the credit period ranges from 60 days to 80
days. The allowance for doubtful debts is an estimate of
amounts considered to be irrecoverable.
11. Interest-bearing borrowings
X6 X5
R R
Long-term borrowings 17 000 000 22 000 000
Short-term borrowings 5 000 000 5 000 000
Total borrowings 22 000 000 27 000 000
This loan is repayable in instalments over the period X6 to X11.
The annual instalment is R5 000 000, with the balance owing
being paid in X11. The interest rate of 16% is applied.
12. Share capital

The share capital of the company at 31 December was as
follows:
X6 X5
R R
Authorised
5 000 000 Class A shares
500 000 15% R20 Class B shares
Issued
2 190 000 class A shares 31 980 000
1 700 000 class A shares 21 500 000
150 000 class B shares 3 000 000 3 000 000
Total issued capital 34 980 000 24 500 000
Class A shares: voting rights, no fixed distribution.
Class B shares: no voting rights, with the right to a cumulative
fixed distribution.
The directors are authorised to allot all or any of the remaining
unissued shares on such terms and conditions as they may
determine. This authority will remain in place until the next
annual general meeting.
13. Trade payable, provisions and accrued charges

Trade payable and accrued charges are made up of amounts
outstanding for trade purchases and ongoing costs. The credit
period for trade purchases is between 15 and 30 days.
14. Statement of cash flows

14.1 Reconciliation of profit before taxation to cash generated by
operations
X6 X5
R R
Operating pro t 16 137 839 15 594 958
Adjust for non-cash items

Depreciation 10 000 000 9 570 000
Loss-sale of plant/machinery 97 500 0
Pro t on sale investments (120 000) 0
Working capital changes
Decrease in inventory 370 000 780 000
Increase Trade receivables (1 451 200) (7 438 085)
Decrease Trade payables (144 260) (120 000)
(Decrease)/Increase VAT (4 000) 6 000
Cash generated by operations 24 885 879 18 392 873
14.2 Taxation
Amounts unpaid 1 January (2 599 (601

837) 608)
Debited to statement of pro t or loss and other (4 680 (4 140
comprehensive income 969) 842)
Unpaid at the end of the year 1 321 2 599
839 837
Paid during the year (5 958 (2 142
967) 613)
Consists of:
Payment of outstanding tax 2 599 601
837 608
Provisional tax payments 3 359 1 541
130 005
14.3 Proceeds on disposal of property, plant and equipment
Carrying value of property, plant and equipment sold 297 500 0

Loss on disposal (97 500) 0
200 000 0
14.4 Proceeds on sale of investments
Carrying value of investment 270 000 0

Pro t on sale 120 000 0
390 000 0
14.5 Non-cash investing and financing activities

The company did not enter into any non-cash investing and
financing activities during the current and prior financial
years.
14.6 Cash and cash equivalents

Cash and cash equivalents consist of cash on hand and
balances with banks and investments in money market
instruments. Cash and cash equivalents included in the
statement of cash flows comprise the following statement of
financial position amounts:
X6 X5
R R
Cash/balances with banks 3 847 607 (1 792 244)
32-day call investment 10 000 000 0
13 847 607 (1 792 244)
The company has undrawn borrowing facilities of R3 000 000, of
which R1 000 000 may be used only for future expansion. The
credit risk on liquid funds is limited because the company banks
with institutions that have high credit ratings assigned by
international credit-rating agencies.

15. Commitments
X6 X5
R R
Capital expenditure approved
Contracted but not provided 5 500 000 1 800 000
Authorised but not contracted for 1 010 000 0
6 510 000 1 800 000
16. Contingent liabilities

There were no contingent liabilities as at 31 December X6.

When a company needs cash to finance a project or its operations
there are three main sources of finance to choose from:

1. Share capital, with various classes of shares available to issue
2. Retained Profits (it can be said that a company’s dividend policy
is part of its financing decision, as explained earlier in this
chapter)
3. Debt finance.
If a company has a high level of borrowing (debt) in relation to its
funding by way of equity, then it can be said that a company is
highly “geared”. Gearing relates to the extent of a company’s funds
obtained by way of borrowing.
There are various types of debt arrangements:

1. The company can take out a loan with a bank, which can be in
the form of a shortterm arrangement (such as a bank overdraft)

or a long-term loan.
2. The company can arrange terms with its trade payables where it
pays for goods purchased only after an agreed period of time
(usually not longer than 90 days). When a company buys goods
on credit, this is similar to a short-term loan, as the company has
received its goods and still owes the supplier for the purchase
price.
3. If the company needs the cash for a significant period of time, it
may consider the debt arrangement called a mortgage bond. A
mortgage bond is a long-term loan where the borrower agrees to

certain property acting as security for the loan. This would
mean that if the company defaults on interest or capital
repayments, the lender is entitled to use the property that has
been held as security to realise sufficient cash to cover the
amount owed by the company.
4. Other types of debt arrangements would include lease

agreements and hire purchase agreements.
5. Debentures, which are discussed below, are not as widely used
by companies in practice. They more often use normal loans,
bank overdrafts, trade payable or share issues.
12.14.1 Debentures
A debenture is a loan which is a contract between the company and
outside third parties, to lend it money for a specified period of time
and at a specified interest rate. The difference between the company
obtaining a loan from a bank or an individual and issuing a
debenture is that debentures are offered to the public, and members
of the public can finance part of the loan. The total loan is divided
into parts called debentures, which are issued and traded separately.
The debenture contract is transferable and can be bought and sold in
the market like a share.
Let's use an example to illustrate.

The company issues 10 000 10% R1 debentures, repayable in five
years’ time. This means that the company will receive R10 000 and
have to pay interest each year of R1 000 for five years. At the end of
five years the company will repay the debenture holders R10 000.
Let’s assume that Tracey buys 100 of the debentures on offer. She
pays R100 and receives the right to interest each year of R10. After
holding the debenture for two years, Tracey needs the R100 that she
loaned to the company. The company will not repay Tracey the
R100, because in terms of the debenture contract the amount is
repayable only at the end of a five-year period. However, because
this is a debenture, Tracey can sell the debenture, as she could sell a
share in the company, in the market. This transaction will have no
effect on the company.
The fact that debentures can be transferred to different owners
makes a debenture far more desirable for a lender than a normal
personal loan. This is because there is the opportunity to trade out of
the contract by selling the debenture and having the capital repaid.

The journal entry to record the issue of the debentures in the above
example is as follows:
Disclosure of debentures in the financial statements

A debenture is shown on the statement of financial position as a
liability and is recorded as interest-bearing borrowings (debt). The
company has to show in a note to the financial statements the full
details of the contract of all debentures issued.
12.15 Requirements for annual financial

statements (AFS)
12.15.1 Objective of financial reporting
According to the Conceptual Framework for Financial Reporting, the
objective of financial reporting is to provide financial information
about the business that is useful to existing and potential investors,
lenders, and other creditors when they make decisions about
providing resources to a business. The aim of all financial reporting
is to communicate information to the various stakeholders that is
relevant to their decision-making processes. All the information
presented by a company is disclosed as a means of achieving this
objective.
Over the years stakeholders have become more demanding about
what information a company should provide in its annual report. In
the past, this report consisted only of financial information, with the
company’s financial activities being reported statement of

in the
profit or loss and other comprehensive income, the statement of

financial position, and the statement of cash flows. However,
stakeholders have progressively found other information material to
their decision-making. This includes non-financial information such
as details of the total potential market in which the company could
sell its products, and the company’s current market share. This type
of information assists the user of the annual report to estimate the
future cash flows of the company with more insight and precision.
Stakeholders also require information about how the company’s
operations and product or service affect the environment and a
company’s attitude towards its social responsibilities. This includes
information describing social upliftment projects that it funds as part
of its commitment to the public and its employees.
The increase in the information included in a company’s annual
report is referred to as triple bottom line reporting: reporting on
economic (financial and non-financial) factors, environmental
factors, and social factors. All these factors influence the ability of
the company to create value in the future for the stakeholders and
are material to their decision making.
Did you know?

The discussion above refers to the “triple bottom line”. Do you know what the
bottom line is? It is the profit earned by a company during the year. The question,
“What is the effect on the bottom line?” asks how decisions by management
could affect profit. This is particularly important for listed companies, because
movements in their share price are often linked to movements in the bottom line
(profit).
The latest trend in reporting is integrated reporting. Integrated
reporting requires a company, when it makes a decision, to consider
the impact on the environment and society as well as the economic
effect of its decision, and report on how it has done this. Integrated
reporting will be looked at in greater detail in section 12.16.3.
12.15.2 Benefits of good financial reporting

We know that shareholders in a company use the annual report to
estimate the company’s future financial performance and position. If
shareholders feel that there is uncertainty about the future earnings
of a company, they will not be prepared to pay a high price for a
share in the company and may not even invest in the company at all.
A financial report that provides shareholders with as much
information as possible that is material to their projections will result
in the projections being more precise. This will reduce the risk for
shareholders, and there will be some certainty about future earnings.
When financial statements are prepared, it is important to know
what principles have been used in preparing those financial
statements. When a set of financial statements has been prepared,
there will be an introductory statement that indicates what basis has
been used. For example, the introduction to the accounting policies
in the Pick n Pay 2011 financial statements states: “These financial
statements have been prepared in accordance with IFRS and its
interpretations adopted by the International Accounting Standards
Board (IFRS).” The set of principles that has been used is referred to
as the reporting framework. The reporting framework may be IFRS
or IFRS for SMEs.

As your accounting studies progress, you will realise that the
requirements of accounting standards (principles) can be very
complex and difficult to comply with. Increasingly, companies are
required either to recognise or to give disclosure of the fair value of
various types of assets and liabilities, and to supply a great deal of
additional information in the notes to the financial statements,
relating to the potential risks the entity faces and the financial effects
of those risks. For a listed company with lots of shareholders, that is

appropriate information, but it may not always be necessary for a
simple business run by the owner. Until very recently, all South
African companies have been required to comply with full IFRS
(International Financial Reporting Standards), which means all the
requirements of all the accounting standards issued by the IASB.
There has been an increasing realisation that the requirements of
these standards are excessive for some companies; in other words,
the cost of complying with the standards may exceed the benefits
derived from compliance. Changes to the Companies Act have
resulted in differential reporting requirements for different entities,
depending on the size of the company and the number of people
that are likely to be interested in the published financial results. For
example, companies listed on the JSE have to use IFRS; certain
unlisted entities will be allowed to use IFRS for SMEs; while certain
companies and entities in a different legal form may have no
reporting requirements or a more simplified requirement. This is
known as differential reporting, where different reporting
requirements apply to different types of entities depending on the
information needs of the users of their financial statements.

General purpose financial statements are financial statements that
are prepared for the general information needs of different types of
users, such as investors, creditors and the tax authorities (SARS).
General purpose financial statements are required to present the
results of the entity fairly. Currently there are two reporting
frameworks (IFRS and IFRS for SMEs) that a company may use to
prepare its financial statements (a third is under consideration for
very small companies). Where an organisation does not have to use
one of the two reporting frameworks (IFRS and IFRS for SMEs), it
could choose to prepare its financial statements in terms of any basis
it chooses. These are special purpose financial statements, as the
basis selected will depend on the specialised needs of the person(s)
for whom the financial statements were prepared. Special purpose
financial statements are often prepared in terms of the Income Tax
Act.
12.15.4.1 International Financial Reporting Standards

(IFRS)
International Financial Reporting Standards (IFRS) are standards
issued by the International Accounting Standards Board (IASB).

These documents have a title commencing with IFRS or IAS (for
example, IFRS 3, “Business combinations”, or IAS 16, “Property,
plant and equipment”). Companies listed on the JSE are required to
use IFRS − any other entity may choose whether to do so. An entity
cannot say that they use IFRS unless they comply with all the
requirements of all the IFRSs that apply. There are two numbering
systems, as the body that issues the standards has changed recently.
IFRSs are issued by the new body, and IASs were issued by the old
body. The new body has fully adopted the standards issued by the
old body, but they are in the process of improving them.
12.15.4.2 IFRS for Small and Medium Enterprises

(IFRS for SMEs)
The IASB issued (in mid-2009) an accounting standard that is
intended to simplify the financial reporting requirements of small
and medium enterprises. The 2008 Companies Act allows unlisted
public companies and private companies with a “public interest
score” of more than 350, but are not considered to be accountable to

the general public to use IFRS for SMEs. Small and medium
enterprises whose “public interest score” is below 350 (see the
discussion in section 12.15.5, below) and are not accountable to the
general public would also be able to use IFRS for SMEs when
reporting. A bank or insurance company invests your assets and
therefore is publicly accountable. As a result they would be required
to produce detailed financial statements using full IFRS and would
not be permitted to use IFRS for SMEs.
Did you know?

South Africa decided to use the draft version of the IASB's GAAP for SMEs as a
standard in South Africa because the Corporate Laws Amendment Act 24 of 2006
permitted differential reporting in 2007, and there was no better version of
simplified accounting standards available at that stage. When the IASB issued the
final version of the standard in 2009, South Africa issued that as a revised
standard for SMEs.
12.15.5 Legal requirements for preparation and audit

of financial statements
The 2008 Companies Act requires companies to calculate their
“public interest score” each financial year. The company’s public
interest (PI) score will determine which financial reporting standards
are applied and whether or not the company’s financial statements
will need to be audited or will be subject to an independent review.
Entity Reporting Audit/independent

Standard review
Listed public company IFRS Audit
Unlisted public company/Private IFRS/IFRS Audit
company with a public interest score of for SMEs
350 or higher
Private company with a public interest IFRS/IFRS Independent review
score of between 100 and 349, or, if for SMEs An audit is required if
the public interest score is less than the nancial reports
100, their nancial reports were have been internally
independently compiled compiled (have been
prepared by the
company's own staff)
Private company with a public interest Not Independent review
score of less than 100 and their speci ed
nancial reports were internally
compiled
How to calculate the PI score:

According to CIPC (The Companies and Intellectual Property
Commission the PIS (Public Interest Score) for a company (and for
existing close corporations) is calculated as follows
(http://www.cipc.co.za/index.php/manage-your-
business/compliance-and-recourse):
• a number of points equal to the average number of employees of
the company during the financial year
• one point for every R1 million (or portion thereof) in third party
liability of the company, at the financial year end
• one point for every R1 million (or portion thereof) in turnover
during the financial year
• one point for every individual who, at the end of the financial
year, is known by the company
• in the case of a profit company, to directly or indirectly have a
beneficial interest in any of the company’s issued securities, or
• in the case of a non-profit company, to be a member of the
company, or a member of an association that is a member of the
company.
So what are an audit and an independent review?
An audit implies that an independent check is done to ensure that
the financial statements reflect what has actually happened in the
business. The purpose of the audit is to give users the confidence to
rely on the financial statements in order to make their decisions.
When an audit has been performed, an audit report is prepared
which will contain an opinion. The Pick n Pay audit report contains
the following audit opinion: “In our opinion, these financial
statements present fairly, in all material respects, the consolidated
and separate financial position of Pick n Pay Stores Limited at 28
February 2011, and its consolidated and separate financial
performance and consolidated and separate cash flows for the year
then ended in accordance with International Financial Reporting
Standards, and in the manner required by the Companies Act of
South Africa.”
Note that as Pick n Pay is a listed company, it has to comply with
IFRS. It also has to comply with the Companies Act, as it is a South
African company. The reference to consolidated and separate
financial statements is an issue that you will understand better as
your studies progress. Essentially, the consolidated results show the
combined results of all the companies controlled by the Pick n Pay
group, whereas the separate financial statements show the results of
Pick n Pay, the company, as a separate legal entity.
An independent review implies that an independent party (with
sufficient financial knowledge, but not necessarily an auditor)
reviews the basis used to prepare the financial statements, as
opposed to the more detailed checking done for an audit.

Corporate governance is concerned with how a company should be
controlled and managed in the interests of shareholders and all other
stakeholders. Corporate governance is also concerned with how a
company achieves its objectives and is successful in a socially
desirable manner. Corporate governance looks at how risk impacts
on the company, and how these risks should be identified, assessed
and managed. The emphasis of good corporate governance is on a
company’s sustainability and focuses on a company’s commitment

to the triple bottom line (economic, social, and environmental issues),
and not simply on profitability. Increasingly companies are

recognising that if they do not look after the resources their business
needs (natural and people), their business will soon cease to exist.
Over the past few years there has been concern in South Africa
about declining ethical business standards, the roles and

responsibilities of management and directors, and the duties and
responsibilities of the auditor. These are all key elements in
protecting the interests of the various stakeholders of a company.
The Institute of Directors in South Africa was instrumental in
forming the King Committee to investigate these concerns.
The concept of corporate governance was first introduced into
South Africa in 1994 with the publication of the King Report on
Corporate Governance (Institute of Directors Southern Africa (IODSA),
1994).
The First King Report (“King I”) of 1994 recommended standards

of conduct for directors of companies and emphasised the need for
responsible corporate activities, which meant that companies had to
start considering the society in which they operate. The First King
Report was somewhat groundbreaking at the time of its publication.
As a result of some highly-publicised international company
collapses (such as Enron and WorldCom), the evolving global

economic environment, and the large number of social and
legislative changes in South Africa, a second King Report (King II
Report on Corporate Governance (IODSA, 2002)) was made public. This
report introduced a Code of Corporate Practices and Conduct (“the
King Code”). In 2009, the King III Report was published (IODSA,
2009). All the King Reports sought to set out the principles as to
what constitutes good corporate governance in South Africa. The
King III Report builds upon the work of the previous reports, with a
greater emphasis on risk management in companies, and on the
need for good strategic planning.
There are seven primary characteristics of good governance:
1. Discipline (a commitment to governance)
2. Transparency
3. Independence (specifically regarding directors)
4. Accountability
5. Responsible management
6. Fairness (specifically in dealing with stakeholders)
7. Social issues.
Good corporate governance therefore has the intention of making
sure that a company is a law-abiding, responsibly-managed and
successful corporate citizen, taking into account the interests of all
stakeholders which are or may be affected by the operations of that
company. It also intends to ensure that directors do not abuse their
positions and that the auditor of a company is independent and
gives an honest opinion on a company’s financial statements.
The King Code sets out the principles as to what constitutes good
corporate governance in South Africa, but does not set out detailed
guidance to a company on corporate governance. In other words, a
company cannot simply view the Code as a set of principles to be

followed (a company cannot simply adopt a “tick-the-box”
approach), but must comply with the spirit and general principles of
the Code. A company must practically implement the principles in a
manner most suitable to the industry and environment in which the
company operates. Furthermore, the Code must be seen not in
isolation, but in the context of the principles and rules of company
law and other relevant legislation as a whole.
If a company adopts generally desirable standards of corporate
governance, the affairs of the company will be conducted in
accordance with company law as well as within the framework of
the King Code of Corporate Practices and Conduct. In addition, there
will be compliance with all other statutes that affect the operations of
a company.

King IV (IODSA, 2016) intends to ensure that there is a coherence
with international governance codes and best practice. This includes
areas such as aligning the King report towards integrated thinking
across the six capitals. The six capitals include financial capital;
manufacturing capital; human capital; social and relationship
capital; intellectual capital and, natural capital. King IV also focuses
on new reporting and disclosure requirements for example
Integrated Reporting. King IV was released on 1 November 2016 and
will be effective for financial year-ends starting on 1 April 2017.

Investors are increasingly complaining that they are not getting all
the information that they need to make their decisions. While there
is a lot of information provided on financial performance (some

would say so much that it is difficult to decide what is important),
there is insufficient information on the broader risks of the business
and its impact on society and the environment. This has resulted in a
new form of reporting that is rapidly developing, namely integrated
reporting.
Integrated reporting is the process of bringing together all the
significant information about an organisation’s strategy, governance,
performance and prospects. This implies much more than simply
combining the information on those aspects in one report − it implies
reporting on how the different aspects are interconnected and how
they reflect the commercial, political, social and environmental
context within which the company operates. The integrated report is

the document that will be distributed to shareholders and other
stakeholders.
The integrated report is intended to be the primary report sent to
shareholders, with additional detailed information referred to in the
report and provided electronically on the entity’s website. From the
financial information perspective, the integrated report should
provide sufficient information to comply with the JSE requirements
in respect of summarised financial statements in order to be
compliant with the JSE listing requirements.
The King 3 Report requires listed South African companies to
produce an annual integrated report. As King 3 was effective for
financial years ending on or after 31 March 2011, all listed companies
are now required to produce an integrated report or in terms of the
“apply or explain” approach of King 3, explain why they have not.
The King Report on Governance for South Africa, 2009 (King 3)
defines integrated reporting as a holistic and integrated
representation of the company’s performance in terms of both its
finance and its sustainability. The aim of integrated reporting is to
provide stakeholders with information relating to how the company

impacts on the environment and community in which it operates,
and how the environment and community impacts on the
company’s business.
The King III Code on Governance indicated that:
• Integrated reporting should be incorporated in an annual report.
• Statutory financial information and sustainability information
should be integrated.
• The integrated report should have sufficient information to record
how the organisation has affected, both positively and negatively,
the economic life of the community in which it operates.

Many people are familiar with the term ‘integrated reports’ or
‘integrated reporting’. Of much more relevance though is the
concept of ‘integrated thinking’. Integrated thinking is a basis of
making decisions that takes all relevant information into account – if
integrated thinking is happening in an organisation, preparing an
integrated report is easy, as it is simply a transparent picture of how
integrated thinking is being applied in that organisation. Integrated
thinking is a basis for making decisions that are based on a broad set
of information that is inter-connected and more forward-looking
than traditional financial analysis. It takes into consideration input
from many different parts of the organisation as well as what is
happening outside the organisation.
To apply integrated thinking you need to understand what drives
value creation in the organisation – that implies understanding the
business model, the inputs into the business and the outcomes of the
business activities and the external environment that the business
operates in.
Integrated thinking implies taking into account everything that
has the potential to impact value creation in the short, medium or
long term. It implies that you need to know what your inputs into
your business model are, and that means a careful consideration of
how your business depends on each of the six capitals. When
thinking of the different capital inputs, it is important to remember
that all inputs need to be considered irrespective of whether they are
recognised or owned by the entity e.g. reputational issues in your
supply chain can impact value creation.
It requires a good understanding of what outcomes or impacts
arise from that business model – again considering all six of the
capitals in order to correctly determine what value has been created
or destroyed and again considering the impact on the organisation
as well as more broadly. It is necessary to know what those impacts
are in order to make decisions that increase the value that is created.
It requires the identification of risks that may prevent or diminish
value creation as well as the opportunities available to create more
value i.e. anything that can influence the overall impact on the six
capitals. It requires a circular process for developing a strategy to
create value in the context of the risks, while identifying the risks
that arise from that strategy.
Integrated thinking is not likely to give you a precise answer, but
it should lead you to a decision that is consistent with the
Companies Act requirement of directors to act in the best interest of
the company and the corporate citizenship approach of King IV.
The sources of good corporate governance in South Africa are the
following:
1. The provisions of the Companies Act and promulgated
regulations
2. The common law (South African decided case law, and in some
circumstances relevant English law decisions)
3. All other relevant statutes (for example, the Basic Conditions of
Employment Act 75 of 1997, the Employment Equity Act 55 of
1998, and the Promotion of Access to Information Act 2 of 2000)
4. The King Code of Corporate Practices and Conduct (the King Code),
and
5. The JSE Securities Exchange Rules for listed companies.
Did you know?

South Africa was the first country to require all listed companies to publish an
integrated report (from March 2011). The International Committee that is
developing guidance on Integrated Reporting is chaired by Mervyn King. You
should recognise his name − he is the King of the King Reports.

• The basic accounting principles we have learnt for a sole
proprietor are equally applicable to accounting for financial
transactions in a company.
• A few new accounting principles specific to companies arise
because of the characteristics of a company.
• We have learnt what a company is and what the unique
characteristics of a company are.
• We know about the legal formalities required to form and operate
a company.
• We have learnt about the business and accounting principles that
relate to transactions, such as capital structure and the dividend
policy.
• We know how to record the transactions that are unique to
companies: − Transactions in respect of share capital

− Transactions in respect of dividends
− Transactions in respect of company taxes
− Transactions in respect of reserves.
• We know how to prepare the financial statements of a company,
including the statement of changes in shareholders’ equity and
the notes to the financial statements.
• A little bit about Corporate Governance.
What's next?
In the next chapter, we look at partnerships as an option for
operating a small to medium-sized business.

QUESTIONS
QUESTION 12.1 (A)

Ignore VAT. (13 marks: 16 minutes)
Perfume Smells Limited is a company that manages the advertising
strategy for a number of companies in the perfume industry.
Perfume Smells Limited is currently completing its financial
statements for the year ended 31 December X5, and you have been
provided with the following information:
1. The company has authorised share capital of 200 000 class A
shares. Class A shares have voting rights, with no fixed
distribution.
2. At the beginning of the current year the company had 100 000
class A shares in issue. These shares were issued on 1 January
1998 at a price of R8.75.
3. On 1 April X5, the company advertised a new share issue. 80
000 class A shares were offered to the public at a price of R15.
The closing date for applications was 1 July X5. The public
subscribed for 75 000 shares. The subscription was not
underwritten, but the minimum capital amount was exceeded.
The company issued the shares on 10 July X5.
4. The share issue costs from the share issue amounted to R114
000. All share issue costs were paid on 30 June X5.
5. The company made a loss (after tax) of R700 000 for the year
ended 31 December X5.

The directors declared a dividend of 50 cents per share on 30
6. November X5. The shareholders were paid the dividend on 31
December X5.
7. The equity section of the statement of financial position as at 31
December X4 was as follows:
X4
Share capital − Class A See notes 1 and 2
Share capital − Class A See notes 1 and 2
Retained earnings (pro t) 20 000 000
1. Prepare the general journal entry(ies) to record the receipt of the
cash from the share issue as well as the allotment (issue) of
shares during the current financial year. Show all dates.
Narrations are not required. (5 marks)
2. Prepare the following general ledger accounts in the books of
Perfume Smells Limited for the year ended 31 December X5:

a) Share Capital – ClassAaccount (4 marks)
b) Retained Earnings account. (4 marks)
QUESTION 12.2 (C)

Assume a company income tax rate of 28%.
Assume a dividends tax of 20% .

Ignore VAT .
With rugby world cup fever sweeping the nation, Player 23 Ltd, a
Johannesburg company that manufactures and sells South African
rugby jerseys and T-shirts, is gearing up to expand its operations in
order to capitalise on the potential for new supporters, and an
increase in demand for their products.
products.
Statement of Financial Position of Player 23 Ltd as at 30 June

20X1 20X0
R R
Non-current assets
Property, plant and equipment 3 400 000 2 000 000
Investments ? 200 000
Current assets
Inventory 62 000 ?
Bank 1 096 132 0
SARS (Income Tax) 0 26 800
Total assets ? ?
Equity
Share capital: Class A ? 1837 500
Share capital: Class B ? 235 000
Revaluation surplus ? 200 000
Retained earnings ? 1 380 000
Current liabilities
Trade payables 180 000 196 000
Shareholders for dividends ? 270 000
SARS (Income Tax) ? 0
SARS (Dividend tax) ? ?
Bank overdraft 0 400 000
Total equity and liabilities ? ?
Extract from the notes to the Statement of Financial Position at 30
June 20X0:
Authorised share capital:

1 500 000 Class A shares
100 000 Class B shares
Class A Voting rights; no right to a fixed distribution.
shares:
Class B No voting rights; right to a fixed, cumulative distribution of
shares: 7.5% of the R5 face value; preferred to Class A dividends.
1. By 30 June 20X0, Player 23 Ltd had issued 250 000 Class A
shares and 50 000 Class B shares.
2. On 15 October 20X0, Player 23 Ltd offered 100 000 Class A

shares to the general public at an issue price of R12 per share.
The closing date for the application of shares was 15 November
20X0. The share issue was fully subscribed. On 1 December
20X0, the shares were issued to the public. The share issue was
underwritten by Scrumpower Underwriters at an agreed
commission of 5%. Other share issue costs, excluding
underwriter’s commission, amounted to R34 000. All relevant
share issue costs were paid on 15 December 20X0.

On 1 July 20X0, Player 23 Ltd offered 40 000 Class B shares to
3.
the general public. By 1 August 20X0, the closing date for
applications, Player 23 Ltd had received a total of R350 000 for

share applications. The share issue had been oversubscribed by
25% and the directors decided not to issue the oversubscribed
shares. The shares were issued on 15 August 20X0. Share issue
costs amounting to R32 000 were paid on 31 August 20X0.
4. The investments held by Player 23 Ltd consist of 30 000 Class A

shares in SAIL Ltd, a listed South African company and 15 000
ordinary shares in Amazon.com, a foreign (non-South African)
company. SAIL Ltd declared a dividend amounting to 150 cents
per share on 30 December 20X0 and Amazing.com declared a
dividend of 200 South African cents per share on 30 December
20X0. No other dividend income was earned in the financial
year ending 30 June 20X1.
5. The directors of Player 23 Ltd declared an interim dividend of

250 cents per Class A share on 31 December 20X0. This was the
only date that dividends were declared during the current
financial year. The directors had declared a final Class A
dividend on 30 June 20X0.
6. Player 23 Ltd measures land on the revaluation model, with

revaluations performed annually. Independent valuations
indicated that the land had a fair value of R1 000 000 on 30 June
20X0 and a fair value of R1 400 000 on 30 June 20X1. No land
had been purchased or sold during the year ended 30 June 20X1.
7. By 31 July 20X1, the tax refund due for the 20X0 year had not
yet been assessed by SARS, and so was still owed to Player 23

Ltd. Player 23 Ltd made two provisional tax payments during
the year, R180 000 on 31 December 20X0 and R200 000 on 30
June 20X1. Taxable income amounted to 110% of profit before
tax. Profit before tax amounted to R1 662 500.

1. a) Calculate the issue price of the Class B shares issued on
15August 20X0. (2 marks)
b) Briefly explain whether share issue costs are recognised as
an expense during the year in which they are incurred. You
should refer to any relevant Framework definitions. (2 marks)
c) Prepare any closing entry/ies that would be processed with
reference to the Class B share issue referred to in (a) above.
Ignore dates and narrations. (2 marks)
2. Prepare the SARS (Income Tax) account as it would appear in

the general ledger of Player 23 Ltd for the year ended 30 June
20X1. (4 marks)
3. Prepare the statement of changes in equity for Player 23 Ltd for

the year ended 30 June 20X1. Marks will be allocated for
workings. Workings must be clearly labelled. Atotal column is
NOT required. (19 marks)
QUESTION 12.3 (A)

Real Africa (Pty) Limited was incorporated on 1 July X0 with
authorised share capital com prising 100 000 Class A shares.
The three founders of the company (the subscribers) each took up
20 000 shares in the new company at R0.50 each and paid cash for
their shares. In addition, an investor, John Gumede, was offered 15
000 shares at a price of R1.50 per share.

The accountant, Iam Irrelevant, is not sure how the above
transactions should be reflected in the Statement of financial
position. The financial year-end is 30 September X1.
Answer the following questions, based on the information above:
1. What is the rand value of the authorised share capital of Real

Africa (Pty) Limited? (1 mark)
2. How much did the three founders pay in total for their shares?
3. How much did John Gumede pay for the 15 000 shares in (1 mark)
the company? (1 mark)
4. What is the total number of Class A shares in issue at the year-
end 30 September X1? (2 marks)
5. What is the balance on the general ledger account “Share
Capital − Class A” at the year-end 30 September X1? (2 marks)

Partnerships, and a
13 brief note on close
corporations (CCs)
Shahieda Cassiem started a laundromat business a few years ago.
Her business in Lenasia has been extremely successful and she
has seen it expand to six outlets. Shahieda has been considering
expanding the business even further but realises that she would
need people to help her manage and run the new laundromats.
She believes that people who have a personal interest in the
business will be prepared to work far more to make it a success.
Her cousin is interested in joining her and has R400 000 of his
own money to invest in the business. Shahieda realises that once
she introduces someone else into her business operation in the
capacity of an owner, she will no longer be able to operate as a
sole proprietor. She feels that it will be more complicated, but is
not sure what all the possible complications are. She contacted
her friend Judy, who has been running a successful business in
Cape Town, for advice on a number of issues relating to bringing
her cousin into the business. She is aware that there are a number
of ways that this could be done but is unsure of what would best
suit her needs. Some of the issues she has raised with Judy are:
• What factors should she take into consideration in deciding
between setting up a partnership or a separate legal entity?
• How should the profits be shared between her and her cousin?
• How would the recording of transactions of a partnership or a
separate legal entity differ from those of a sole proprietor?
• How would the Statement of comprehensive income and
Statement of financial position of a partnership or a separate
legal entity differ from those of a sole proprietor?
Learning objectives
By the end of this chapter you will be able to:
• Understand the relationship between the owners and the partnership
• Understand the reasoning behind the owners' equity format of a partnership
• Understand that the underlying concepts of accounting do not change if the type of
business entity changes
• Record the transactions and complete the Statement of comprehensive income
and statement of financial position of a partnership
• Understand what are the major differences between introducing a partner to an
existing business as opposed to opening a new business
• Understand the process that is followed when a partnership is liquidated
• Record equity in a close corporation
• Understand the members' interest in a close corporation.
Understanding Shahieda’s problems

In this chapter we will highlight the accounting implications of
selecting a partnership as the business entity of choice. We’ll also
discuss briefly the accounting and disclosure requirements for and
implications of forming a close corporation (CC).
13.1 Partnerships
A partnership is defined as an organisation consisting of between
two and twenty persons who strive to achieve a common goal .
Partnerships are not covered by legislation in South Africa in terms
of the Companies Act 71 of 2008. Corporate law in South Africa does
not include partnerships, which means that partnerships are not
required by law to comply with either of the two reporting
frameworks (IFRS and IFRS for SMEs) when preparing financial
statements. However, if partnerships want to approach banks or
other lenders for funding, these organisations will be interested in
the financial position and performance of the business. The lenders
will also want to feel confident in the reliability and comparability of
the financial statements provided by the partnership. In this case,
partnerships would find it useful to prepare financial statements
according to an accepted reporting framework. The partnership may
choose to use IFRS for SMEs. To remind yourself about the
difference between IFRS and IFRS for SMEs, go back to Chapter 12.
13.1.1 Some important terms in respect of

partnerships
As with a sole proprietor, the partnership and the owners are the
same entity in terms of law, and therefore a partnership is not
regarded as a separate legal entity. A partnership is a business entity
that can have between two and 20 owners, who are referred to as
partners. In some circumstances, it is permissible to have more than
20 partners, for example, large firms of accountants or lawyers. One
of the key disadvantages of forming a partnership is that the
partners have unlimited liability.
Unlimited liability means that if the partnership is unable to pay its

debts, the creditors can claim the personal assets of the owners of
the business.
This means that the partners are personally liable for all the debts of
the partnership. This is in contrast to a company, which has limited
liability, which means that only the assets of the company (not the
shareholders (owners)) are used to pay the debts of the business. A
further disadvantage is that partners are also jointly and severally

liable.
Jointly and severally liable means that all the partners can be held
liable, either together or individually, for the debts of the partnership.
This means that each individual partner is potentially liable for all
the debts of the partnership and not just for his or her share. If the
partnership is unable to pay its debts, the creditors will often sue the
partner they feel is most likely to be able to pay the debt in his or her
personal capacity. The partner who has been sued by the creditor
will have the right to sue the other partners, but it may become a
problem to collect the money.
If Shahieda decides to start a partnership with her cousin, she has
to place a great deal of trust in him.
A partnership has the advantage of having access to more capital
(the contributions made by each of the partners) than a sole
proprietor, as well as access to the expertise that each partner brings
to the partnership.
Advantages Disadvantages
1. As a partnership is not a separate legal 1. As a partnership is not
entity, there are limited legal a separate legal entity,
requirements, so setting up a partnership it can be dif cult to
is easy. keep track of the results
2. Competition can be eliminated if two or of the business
more persons form a single entity instead separately from
of two or more entities selling the same personal activities.
product or delivering the same service. 2. Partners are jointly and
3. A larger capital amount can jointly be severally liable for the
contributed by the partners. debts of the entity. This
4. Technical competencies, business talent means that the
and personal characteristics of the personal possessions of
different partners can be utilised to the each partner can be
advantage of all the partners involved. used to cover any
5. Although the existing partnership is amounts owing to
terminated when there is a change in the creditors.
composition of the partners, it is 3. Each partner has the
generally easy for the new or remaining authority to bind the
partners to set up a new partnership partnership in any
agreement that allows them to continue contracts or
with the business activities of the old transactions that fall
partnership. within the purpose for
which the partnership
was established.
4. The sudden retirement
or death of a partner
can have a negative
in uence on the cash
ow of the entity and
may cause the
partnership to dissolve
(stop trading).
Did you know?
A partnership, as a form of business ownership, does not have a
continuous lifespan.
When a new partner joins or an existing partner leaves, a new
partnership will need to be formed. This means that a partnership
does not have perpetual succession. Even if one of the partners dies
or retires, a new partnership will have to be formed. If a new
partnership is formed, it is seen as a separate entity from the old
partnership. This means that a new partner cannot be held liable for
any debts of the old partnership, and the partner who has left the
partnership cannot be held liable for any future debts of the new
partnership.

If Shahieda decides to start a partnership with her cousin, she should
draw up a partnership agreement, which is a contract between the
partners.
A partnership agreement is a document that explains the
relationship that the partners have with each other and with the
partnership itself. It is important for Shahieda to go to a lawyer and
make sure that the partnership agreement is a proper legal
document.
If there are any disputes between the partners, the agreement will
be used to determine the outcome. A partnership can be started
without any written agreement, but this is an extremely risky option.
The partnership agreement should contain at least the following
information:
• The amount of capital that each partner will contribute
• The profit(or loss-) sharing ratio
• The rate of interest paid on capital contributions
• The rate of interest charged on partners’ drawings (the partners
agree to maintaining a strong cash position in the business, and in
order to limit the amount of cash withdrawn by partners, interest
can be charged on the cash drawings that partners make)
• The salaries to be paid to partners (either as an owner or an
employee)
• The procedure to be followed if there are disputes between the
partners
• The procedure to be followed if partners want to leave the
partnership.

Partners are often the only users of the financial statements of a
partnership. However, as indicated above, lenders or potential
future partners may also be interested in the financial statements.
Regardless of who uses the financial statements, it is important that
the information provided in the financial statements is an accurate
reflection of the operations of the business. We will see that the
accounting record-keeping and concepts, as discussed in Chapters 2,
3 and 4, are as applicable to partnerships as they are to any other
form of business entity. The financial records of a partnership will
also keep records regarding the capital contribution of each partner
as well as a record of all other transactions that each partner has
with the partnership.
Once the partnership has been agreed on, trading will begin. The
asset, liability, income and expense accounts will be similar
whatever the entity form we choose. The only difference between

recording information for a sole trader, partnership, close
corporation or company will be in how we account for transactions
between the owners and the business. The additional transactions
that are relevant for a partnership will be partners’ salaries,
drawings, interest on capital accounts and the partners’ current and
capital accounts.
In Chapter 3 we learnt about processing financial information. To
revise:
• Information from a source document is recorded in the relevant
journal.
• At the end of each month the journals are closed off to the
relevant accounts in the general ledger.
• A monthly trial balance is extracted from the general ledger to
check whether the debit and credit entries have been accurately
recorded.
• At year-end the necessary adjustments are processed.
• The closing entries are processed and the Profit or loss account is
drawn up.
• In the case of a sole proprietor, any profit that has not been
distributed to the owner can be transferred to the Capital account.
As there is only one owner and there is no distinction between the
owner and the business, the entire profit can be transferred to the
Capital account. Remember that the business could choose to
record the profit in an accumulated profit account, as this would
provide a separate record of the profit left in the business.
• A statement of comprehensive income, statement of financial
position and statement of cash flows can then be drawn up.
Let's look at the various roles that a partner can play within the
partnership.
13.1.4.1 The role of the partner in a partnership
Shahieda needs to realise that when she enters into a partnership,
she as a partner can fulfil various roles, which will include the
following:
The role of an owner

The partners’ capital contribution is recognised as equity. Partners,
as owners of the partnership, share in the profits or losses generated
by the partnership. Partners can also earn the following income from
the partnership:
• Interest (on the capital that each partner has contributed)
• A salary (dependent on the partnership generating a profit and
not for working in the day-to-day running of the business), and
• A share in the profits (or losses) of the partnership.
All these earnings have to be agreed upon by the partners in a
partnership agreement.
The role of a creditor

Shahieda will be a creditor to the partnership if the partnership owes
her money. For example, Shahieda will be a creditor of the
partnership if she has lent money, in her personal capacity, to the
partnership. A loan from partner account will be opened in the
books of the partnership and will be recognised as a liability. The
interest expense incurred on this loan will be recognised as an
expense (interest expense) of the partnership and form part of the
profit calculation.
Shahieda may have earned a share of the profit in the partnership.
If this has not been withdrawn out of the partnership, the
partnership will have an obligation to pay her the funds. The

amount owed to her by the partnership is recorded in an account
called the current account. This account would be recognised as a
current liability by the partnership.
Remember that although the business may recognise the loan and
current account as a liability, the partnership is not a separate legal
entity. The record-keeping is treating the business as separate entity.
The role of a debtor

Shahieda may fulfil the role of a debtor to the partnership. Shahieda
could borrow money, in her personal capacity, from the partnership.
In this case a loan to partner account will be opened in the books of
the partnership. This will be recognised as an asset. The interest on
the loan to partner will be recognised as income (interest income) in
the partnership’s profit calculation.
Shahieda can also be recognised as a debtor if she withdraws
from the partnership more money than is available to her, in her
current account. The current account will have a debit balance and
would be recognised as a current asset.
The role of an employee

Shahieda as a partner can also be an employee. Sometimes partners
work full-time for the partnership or offer additional services over
and above the normal duties of the partners as specified in the
partnership agreement. In this case, the partners receive a monthly
salary and this salary will be recorded as a general salary expense
for the partnership and will form part of the profit calculation of the
business.
13.1.5 Differences that occur when recording

information for a partnership
13.1.5.1 Recording capital contributions
Let’s assume that Shahieda decides to start a partnership with her
cousin, Joseph. They have decided to call it Cassiem’s Laundromat.
Both partners can contribute cash or other assets into the partnership
as their capital contribution. If assets other than cash are introduced
as part of the capital contribution, the partners will have to agree on
the value placed on these assets.
If Shahieda and Joseph decide to start the partnership, they will
contribute the following into the business as their capital
contribution:
• Shahieda will contribute R20 000 in cash, an existing shop valued
at R50 000, and three industrial machines with a combined value
of R20 000
• Joseph will contribute R1 000 and a delivery vehicle valued at R14
000.
Let’s look at what the journal entries would look like to record these
transactions.
Let’s see what the statement of financial position would look like on
1 July X2, the first day Shahieda and Joseph trade as a partnership.
Cassiem's Laundromat Statement of financial position as at 1 July

X2
Assets
Property, plant and equipment 70 000
Vehicles 14 000
Cash and cash equivalents 21 000
Total assets 105 000

Equity 105 000
Capital − Shahieda 90 000
Capital − Joseph 15 000
Liabilities 0
Non-current liabilities 0
Current liabilities 0
The only difference in recording these transactions is the information
relating to the capital contributions. In the case of a sole trader, a
single person contributes the capital, whereas in a partnership it can
be contributed by up to twenty people. We have indicated what each
partner contributes to the partnership. The assets (and if there are
any, liabilities) are recorded and reported in exactly the same way as
they would have been in the case of a sole trader or a company.
13.1.5.2 Appropriation of profit

For a sole proprietor, the profit earned by the business belongs to the
owner. The entire profit is transferred to the Capital account (or a

separate Accumulated profit account) at the end of the financial
year.
There can be between two and 20 people in a partnership, all of
whom have contributed capital and may be involved in running the
business. Partners earn interest on their capital contributions, as the
amount contributed by each partner may differ, and a share of the
profits. The profit-sharing ratio is not necessarily based on the
amount of capital contributed.
The profit-sharing ratio can be defined as the agreed-upon ratio

according to which the profits that the partnership has made will be
shared among the partners .
Any interest earned on the capital contributions, additional salaries
or bonuses earned by the partners will not be treated as a business
expense but will be treated as an appropriation (share) of the profits.
Any salary or interest accruing to partners (in the capacity of an
employee, creditor or debtor) will still be treated as a normal
operating expense or income.
What about taxation?

Because a partnership is not a legal entity, the income that the
partners earn will be taxed in their individual capacity. The
partnership itself will not pay tax. The partners, as owners, will
personally pay income tax on the rewards that they earn from the
partnership. We have seen that these rewards can be in the form of
salaries, interest, bonuses or a share of the remaining profits.
Let's look at an example of how the profit or loss calculation is drawn

up.
Profit or loss for the year ending 30 June X3

Services rendered 350 000
Less expenses 125 000
Depreciation (vehicles R3 000; PPE R9 000) 12 000
Salaries: Staff 35 000
Consumables 25 000
Delivery expenses 7 000
Repairs and maintenance 5 000
Telephone 6 000
Profit for the period 225 000
How would we have prepared the closing entries at the end of the
financial year?
Appropriation account
The profit that the partnership has made has been transferred to an
account known as the Appropriation account. Remember that the
partnership is not a legal entity so it does not earn and cannot retain
profit in its own right. The profit belongs to the partners and needs
to be shared between the partners.
Did you know?

The partnership could calculate the profit for the period, including the salaries of
the partners, as a general business expense [(R8 000 + R4 000) × 12]. The profit
transferred to the appropriation account would then amount to R81 000 (225 000
− 144 000). If the partners are providing necessary expertise and are being paid a
market-related salary, it provides more information to a potential investor if the
salaries are treated as a general business expense.
Let's look at how the profit is appropriated between the partners in
Cassiem's Laundromat.
Shahieda has contributed capital amounting to R90 000, whereas
Joseph has contributed only R15 000.
The partnership agreement includes the following stipulations:
• The partners will be paid a market-related interest of 12% on their
capital contributions
• Shahieda will be paid a monthly salary of R8 000 (Shahieda is
involved full time in running the business)
• Joseph will be paid a monthly salary of R4 000 (Joseph is involved
in finding decent premises and setting up new laundromats
where suitable)
• The remainder of the profit will be split between Shahieda and
Joseph in the ratio 4 : 1.
1. Prepare the journal entries that are necessary to record the
transactions for the year ended 30 June X3.
2. Prepare the closing entries to close off the interest on capital and
partners’ salaries accounts.

3. Prepare the statement of comprehensive income for Cassiem’s
Laundromat for the year ended 30 June X3.
1.
Current account
A current account is an account for each partner that reflects all
the monies that a partner has earned in the partnership.
The account is credited with the amount of interest or salary
that each partner is entitled to. The transfer of the interest or
salary into this account can occur every month or once a year. It
is important to note that this does not represent cash that has
been paid to the partners. The monies are now owed by the
partnership to the partners and therefore the current account is
classified as a current liability (as with shareholders for
dividends in companies). In this case, the partners are fulfilling
the role of a creditor.
If the partnership agreement indicates that the amount
reflected in the current account per partner can only be
distributed on agreement by all the partners, the current
account would be shown as part of equity.
If and when partners withdraw cash from the business, it is
shown as drawings. The drawings account of each partner will
be closed off, at financial year end, to each partners’ current

account. If the amount withdrawn exceeds the amount available
in the current account, it will result in a debit balance on the
current account. In such a case a partner has withdrawn more
money than was available to him/her. This amount is owed to
the partnership by the partner. The debit balance on the current
account is now reflecting that the partner is playing the role of a
debtor and the current account of that partner is now regarded
as a current asset. It is important to prevent partners from
making large cash withdrawals because this could lead to a cash
flow problem where the partnership is unable to make all of its
payments on time. To discourage partners from withdrawing
too much cash the partnership agreement could agree to, not
only charge interest on cash drawings made, but also to limit
the amount of cash withdrawn by each partner. We’ll look at
how to record the drawings a little later.
2. At the end of the financial period, the interest on capital and
partners’ salaries are closed off to the Appropriation account.
The interest on capital and salaries of the partners that have
been agreed upon by the partners in the partnership agreement
are paid to the partners in their capacity as owners. This is a
distribution of profit. The salaries and interest that partners earn
are taken directly to the Appropriation account as they are
distributions of profit and are not business expenses.
The remainder of the profit (calculated earlier in the chapter)
amounting to R68 400 (225 000 − 156 600) will be shared among
the partners in the predetermined ratio of 4 : 1.

The profits are being distributed in the ratio of 4 : 1. This means
that Shahieda receives 4/5 and Joseph 1/5 of the remaining
profit.
The appropriation account in the general ledger
We can see that the appropriation account does not have a
balance that carries over to the following financial period.
Remember that the profit generated by the partnership does not
belong to the partnership but belongs to the individual partners.
The current accounts in the general ledger

3. Here is the statement of comprehensive income for the
partnership at the end of the financial year:
Statement of net investment of partners

It is important that the partnership indicates how the profit has
been shared amongst the partners. This information can be
presented in an appropriation statement (this can also be

referred to as a statement of net investment of partners). This
statement will provide information regarding how the profit or
loss generated by the partnership has been allocated to each of
the partners.
Something to do 1
Use the additional information below as well as the information already recorded
with respect to Cassiem's Laundromat to draw up the statement of financial
position as at 30 June 2003, the end of the financial year.
During the year, Cassiem's Laundromat purchased new machinery amounting
to R42 000, and on 1 June they purchased a second delivery vehicle for R45 000.
Cash was paid for both assets. The trade receivables balance at the end of the
year amounted to R45 200 and the business had R125 800 in the bank. Land
and buildings are not depreciated. No drawings have as yet been made by the
partners.
Check your answer
Cassiem's Laundromat
Statement of financial position as at 30 June X3
Assets
Non-current assets 159
000
Property, plant and equipment (70 000 + 42 000 − 9 000 103
(depreciation)) 000
Vehicles (14 000 + 45 000 − 3 000 (depreciation)) 56 000
Current assets 171
000
Total assets 330
000

Equity (Note 1) 105
000
Current liabilities
Current accounts (Note 2) 225 000
Total equity and liabilities 330
000
Did you notice that the partners' current accounts increased by R225 000, which is the
profit for the period before partners' interest and salaries?
Remember that the information presented in note 2 above can also be presented in
a Statement of net investment of partners or appropriation statement format.
Drawings account
When partners withdraw money or other assets from the partnership, the following
journal entry is prepared:
Partners can withdraw the salary, interest earned and their share of the profits out of
the business. They may also withdraw more than they have in their Current accounts.
Interest can be charged on the debit balances of Current accounts. Remember that
interest is charged on a time basis. This means that the interest on the debit balance
of the current account will be charged for the duration of time that the debit balance
exceeds the credit balance. The Drawings account of each partner is closed off to his
or her Current account at year-end.
Something to do 2
Assume that Joseph withdrew a total of R70 000 out of the partnership at the
beginning of the year. He was sure that the price of gold shares would continue to
increase and decided to invest some money on the stock exchange. Interest at
12% p.a. is charged on drawings.
1. Prepare the journal entry to record the drawings.
2. Prepare the journal entry to record the interest on drawings.
3. Close these accounts off as necessary (assuming it is the end of the year).
Check your answers
1 and 2.
The drawings occurred at the start of the first year. This means that Joseph has taken
an advance on future profits. We have assumed that the salary and interest accruing to
him accrues at the end of the first year.
3. The Interest on drawings account will be closed off to the Appropriation account.
The Interest on Drawings account increases the amount of profits that

are available for appropriation to the partners.
13.1.5.3 Change in the number of partners
Admission of new partner

The laundromat business is doing extremely well and Shahieda and
Joseph are thinking of expanding their business by opening new
laundromats in Johannesburg. They have decided to admit Richard
as another partner. Richard will be contributing R150 000 in cash as
his capital contribution. The new partnership will be called Cassiem
and Bank’s Laundromat.
How will the admission of a new partner impact on the business?

Remember that the existing partnership between Shahieda and
Joseph will cease to exist and a new partnership including Richard
will be formed. The following points will need to be considered
when a new partner is admitted:
• The assets of the existing partnership will need to be revalued
• Goodwill will need to be accounted for
• The profit-sharing ratio could change
• The new partner’s capital contribution will need to be recorded.
It is important to understand that from a legal perspective the old
partnership (with Shahieda and Joseph as partners) will cease to
exist and a new partnership (with Shahieda, Joseph and Richard)
will come into being. Richard will not be held accountable for any
legal issues arising from the old partnership. The business will
continue operating as it did before, but the accounting records will
need to be adjusted to take into account the change in ownership.
Let’s look at these points in more detail.
Revaluing the assets of the partnership

When an existing business is sold, it can be sold for more or for less
than the carrying value of the assets. If the business is sold for more
than the carrying value of the assets, the profit will belong to the
owner(s). If the business is sold for less than the carrying value of
the assets, the owners will carry the loss. This highlights the fact that
most assets and liabilities are not carried at fair value in the
accounting records and therefore a profit or loss will arise on
disposal.
Remember that Shahieda and Joseph will be selling Richard a part
of an existing business. It is important to know what the assets in the
business are actually worth so that Richard does not benefit from
any increase in the value of these assets without having to pay
anything for this benefit, or have to pay more than the business is
worth.
Something to do 3
The assets of the partnership were revalued at 30 June 20XX:
Land and buildings are valued at R60 000 (remember that land and
buildings on the initial statement of financial position had a carrying amount
•
of R50 000).
• Motor vehicles are valued at R61 000.
• All other assets and liabilities are fairly valued.
How would this information be recorded in the books?
Check your answer
Let's look at the journal entries that will need to be processed. Refer to the initial
statement of financial position earlier on in the chapter to help you calculate the
revalued amounts.
The carrying value of the vehicles was R56 000 (R59 000 − R3 000), and they have
been valued at R61 000. The entries above will have the net effect of recording the
vehicles in the books of the partnership at the revalued amount of R61 000.
The total increase in value of the assets of R15 000 (R10 000 + R5 000) belongs to
the existing partners and will be shared between them according to their original profit-
sharing ratio (4 : 1). The total increase in the value of the assets is made up of an
increase of R10 000 in the value of land and buildings and an increase of R5 000 in
the value of the vehicles, the difference between the initial carrying amount of R56
000 and the revalued amount of R61 000.
The following journal entry will be processed to record this:
In the journal entry above it is important to note that the revalued amount has been
posted to the partners' Capital accounts. The capital amount represents the initial and
any subsequent contributions that the partners have made into the business. The
Current account represents the amount that the partner can withdraw from the
partnership. It is a record of the interest on capital, salaries and the share of profits
that have accrued to the partners. The revaluation of assets is an unrealised surplus
and partners will not be able to withdraw this amount from the business. The
revaluation surplus is therefore transferred to the capital accounts of the partners.
What would the statement of financial position look like after the assets were
revalued?
The Property, plant and equipment and Vehicles accounts are shown at the revalued
amounts. The Capital accounts for both Shahieda and Joseph have been increased by
the total revalued amount (shared according to the profit-sharing ratio).
The business will continue trading and any profits earned in the new partnership will
be appropriated using a new profit-sharing ratio. The profit will now be shared among
the three partners, Shahieda, Joseph and Richard.
13.1.5.4 Accounting for goodwill
What is goodwill?
Goodwill can be defined as the extra amount that a purchaser of an
existing business will pay over and above the fair value of the net
assets of that business. The goodwill is paid for the perceived future
value of the business .
Goodwill is a premium that a purchaser may pay when buying an
existing business as a going concern. The premium is the amount
paid over and above the net asset value of the business. The
premium (goodwill) could be paid because the business is in a good
location or has a good reputation or client base.
If Shahieda decided to sell the laundromat business, she would
need to decide on a price for the business. She could revalue all the
assets and see what she could get if she sold them separately, and
she would then have to settle the liabilities after she had sold off the
assets. If she did that, she would not be taking into consideration
that she was selling an existing business.
Shahieda has already built up quite a large group of people who
are regular customers at her laundromat (her client base), she has
extremely efficient staff, and because she has always offered really
good service, she has built up a good reputation. Some of her
satellite laundromats are also situated in locations where they are
convenient for customers who use the train. She offers them a one-
day service where they drop off their laundry in the morning and
collect it on their way home. These advantages will make her
business more attractive to a buyer than starting a new business.
Remember that Shahieda’s location, client base and reputation are
not on the statement of financial position as they do not have a cost
that can be reliably measured (which means that they cannot be
recognised as assets). Therefore they are not included in the net asset
value. However, a purchaser would be willing to pay extra for these
factors in the form of goodwill. If Shahieda decided to sell her
business as a going concern, she would take the reputation, client
base and good location into consideration when setting a fair selling
price for the business. If Shahieda sold her business, she would
charge the new owner for these advantages, known as goodwill.

Did you know?
Internal goodwill (such as the business location, the reputation or the client base)
cannot be disclosed in financial statements. This is because internal goodwill
does not have a cost or value that can be reliably measured and therefore does
not meet the recognition criteria of an asset.
Shahieda is not able to put this goodwill on her statement of
financial position because it is goodwill that she has generated

(known as internally generated or inherent goodwill). The goodwill
will not have a cost that can be reliably measured. However, once
the new owner has paid for the goodwill − the asset now has a cost
that can be reliably measured (known as purchased goodwill) − the
goodwill will appear on the statement of financial position of the
new owner.
So what does this mean for the new partnership?

Once Richard has joined the partnership, he will benefit from the
advantages of being part of an existing business (assuming that the
business has been run well).
The assets in Shahieda and Joseph’s business are worth R345 000.
The business has been run well and they have built up a regular
client base and a good reputation. They have agreed that the
business is worth R375 000. The goodwill amount is therefore R30
000 (the selling price of the business less the net asset value, when
the assets and liabilities are measured at fair value).
The value of the liabilities would be subtracted from the value of
the assets to give the net asset value of the business. The goodwill
amount is the difference between the selling price of the business
and the net asset value of the business.
The new profit-sharing ratio has been negotiated among
Shahieda, Joseph and Richard and they have agreed to a ratio of 2 : 1

: 2. This means that Shahieda and Richard will each get 2/5 of the
profit, and Joseph will receive 1/5.
The existing partners have built up the goodwill. Shahieda is
entitled to R24 000 of the goodwill (R30 000 × 4/5) and Joseph is
entitled to R6 000 (R30 000 × 1/5). The goodwill is written up in the
old profit-sharing ratio as that was the ratio when the goodwill was
generated.
When Richard joins he will be entitled to his share of the existing
goodwill. Using the new profit-sharing ratio of 2 : 1 : 2, Shahieda
would be entitled to R12 000 (R30 000 × 2/5), Joseph would be
entitled to R6 000 (R30 000 × 1/5), and Richard would be entitled to
R12 000 (R30 000 × 2/5). The goodwill is reallocated in terms of the
new profit-sharing ratio.
We can see in the above example that Shahieda has lost R12 000
(R24 000 − R12 000) worth of goodwill and Richard has gained R12
000 worth of goodwill. Joseph’s goodwill remains at R6 000.
What are the accounting entries required to reflect goodwill
arising from a change in the composition of the partnership?
Recording changes in goodwill

The partners have three choices in deciding how to record the
goodwill:
Choice 1: Goodwill is reflected as an asset in the business

Where goodwill is reflected as an asset in the business, it will appear
on the statement of financial position of the new partnership. This is
because someone has offered to pay for this goodwill, and it now has
a cost that can be reliably measured.
Choice 2: Goodwill is not reflected as an asset in the business

Where goodwill is not reflected as an asset in the business, we work
out the amount of the goodwill that will be allocated to the new
partner and record the payment for his share of the profit. The new
partner will pay the cash amount for the goodwill into the business.
Choice 3: Private cash settlement

The new partner can pay the existing partners cash for the goodwill
he or she is acquiring. This cash is paid to the partners in their
personal capacity and does not come through the books of the
partnership. This means that there will be no record of the
transaction in the books of the partnership.
Let's look at the journal entries that would be required to record each
of the options above.

The goodwill of R30 000 must be written into the books as an asset.
The existing partners’ Capital accounts must be credited with their
portion of the goodwill. The existing profitsharing ratio of 4 : 1 must
be used.
Richard will pay R150 000 for his share of the partnership. After we
have looked at all three choices, we’ll look at the journal entry for
admitting Richard as a partner and the statement of financial
position for choices 1 and 2.

The existing partners will need to be compensated for the goodwill
that has been acquired by the new partner. In this case Shahieda will
need to be compensated for the goodwill that Richard is acquiring.
Although goodwill does not appear in the books, it is useful to
use journal entries to explain what is happening to the goodwill in
the business when Richard enters the business.
This is the goodwill accruing to both the partners prior to Richard’s
joining the partnership.
This is the goodwill amount accruing to or being written off from
each of the partners after Richard has joined.
The movement in goodwill can be recorded either by processing
both of the above entries or by putting through an entry which
shows only the amounts where the entries don’t balance each other
out.
The entry above increases Shahieda’s Capital account by the amount
of goodwill that she will have lost and decreases Richard’s Capital
account by the amount of goodwill that he has acquired. We have
not adjusted goodwill. Before Richard was admitted as a partner, the

goodwill balance was zero, and it should continue to be zero after
Richard is admitted into the partnership.
Choice 3: Private cash settlement

There will be no entry in the books of the partnership to record this
transaction. It is a private transaction between the partners. In this
case Shahieda will be paid R12 000 by Richard. This amount will be
paid into her personal bank account. Joseph will not be affected, as
his goodwill is unchanged at R6 000.
Recording admission of new partner

We’ll look at the statement of financial position if goodwill is
reflected as an asset in the partnership (choice 1) and then we will
look at the statement of financial position if goodwill has not been
reflected as an asset in the partnership (choice 2).
The following journal entry will be processed to record the capital
contribution from Richard.

If we look at the statement of financial position, we can see that the
cash has increased by R150 000. This is the amount that Richard paid
into the business. Richard’s Capital account has a balance of R150
000. The goodwill of R30 000 is recognised as an asset. Shahieda’s
Capital account has increased by R14 000, Joseph’s capital account
has increased by R4 000 and Richard’s by R12 000. In total the
Capital accounts have increased by R30 000, as have non-current
assets, as they now include goodwill of R30 000. Note that the total
assets have increased by R180 000 in relation to the total assets in
section 13.2.4, after the assets were revalued but before a new
partner was introduced. The R180 000 is the R30 000 goodwill plus
the R150 000 cash introduced.

If we look at the statement of financial position, we can see that the
cash has increased by R150 000. This is the amount that Richard paid
into the business. Richard’s Capital account has a balance of R138
000. This is because when the goodwill entry was processed, his
account was debited with the amount of goodwill he had acquired
from Shahieda (R12 000). His Capital account was credited with the
full R150 000 he had paid for his share of the business.
13.1.5.5 Existing partner retires

The partnership could be dissolved if a new partner joins, if one of
the existing partners retires or dies, or because the partnership itself
stops operating.
Each partner is entitled to his or her share of the equity (value of
the net assets at the date of dissolution). This could include the
following:
• The balance on their Capital and Current accounts
• Any gains or losses on the revaluation of assets or goodwill that
occur on the date that the partner leaves or the partnership ends.

After three years of working together in the partnership, Joseph
decides to work in London for a few years and earn in pounds.
Shahieda and Richard wish to continue with the partnership and
decide to share the profits equally.
Both Richard and Shahieda currently have a 2/5 share of the
profit. In the new partnership they will each have a 1/2 (5/10) share
in the profits.
The new partnership continues to be called Cassiem and Bank’s
Laundromats.
The statement of financial position of the partnership prior to
Joseph’s retiring is presented below.

The partners have agreed on revaluations for all the assets. The
following asset values differed from their current carrying amounts:
Land and R115 000 (carrying amount R100 000)
building:
Vehicles: R78 000 (cost R100 000; accumulated depreciation R25
000) (carrying amount R75 000)
Goodwill: R48 000
Goodwill does not appear in the books of the existing partnership.
All other assets and liabilities were considered to be fairly valued.

13.1.5.6 Revaluation of assets
Something to do 4
Prepare the journal entries that are required to record the revaluation of the
assets on the date of Joseph's retirement from the partnership.
Check your answer
The total revaluation amount must be shared between the partners of the old
partnership according to the existing profit-sharing ratio.
Something to do 5
Prepare the journal entry to record the effect of the revalued assets on the
capital accounts of the partners. The total revaluation amount is R18 000 (15 +
3 [78 000 − (100 000 − 25 000)]).
Check your answer
13.1.5.7 Goodwill
Something to do 6
Prepare the journal entries to record the goodwill being considered on the date
that Joseph retires from the partnership. Remember that goodwill does not
appear on the books of the partnership.
Check your answer
The goodwill of R48 000 currently accrues to the owners in the ratio 2 : 1 : 2. This
means that Joseph is entitled to R9 600 of the goodwill (R48 000 × 1/5). The
remaining partners are acquiring this goodwill, and he will need to be compensated for
it. Both Shahieda and Richard will be acquiring an equal portion of Joseph's goodwill,
because they have decided to share profits equally in the new partnership.
Current account
Joseph’s Current account balance is transferred to his Capital
account. This is because the partnership has to pay out both his
Capital and Current account balance to him.
The following journal entry will be prepared:
The partnership can pay Joseph cash for his share of equity. Joseph
could choose to take an asset out of the business (for example, a
vehicle) as part payment of what he is owed or, if the partnership is
short of cash, the amount owed to Joseph could be treated as a
liability and he could be paid out over a period of time.
Something to do 7
Prepare the journal entry to record each of the following different assumptions:
1. The partnership paid Joseph cash for his share of the equity.
2. Joseph has taken a vehicle with a carrying amount of R40 000 as part
payment; the remainder of the amount owing has been paid in cash
(remember that as the assets have been revalued to fair value, the R40 000
will be both the carrying amount and the fair value).
3. The partnership needs the cash on hand to purchase a new piece of land. It
has been decided that the amount owing to Joseph will be treated as a loan
and he will be paid out over the next 12 months.
Check your answers
1.
2.
3.
Think about this 1

Do you think that the interest on the loan to Joseph should be treated as a
business expense or an appropriation of profit?
Check your answer
Once Joseph has left the partnership, the loan should be treated like any other loan
from an outsider, which is that interest on the loan is a business expense. Only interest
on the capital contributions is treated as an appropriation of profits, and, as Joseph is
no longer a partner, he has no capital invested in the business.
Something to do 8
Prepare the statement of financial position of Cassiem and Bank's Laundromat
after Joseph has retired. Assume that the business paid him cash for his share
of the partnership.
Check your answer
Capital account: Richard = 138 000 + 7 200 (revaluation) − 4 800 (goodwill)

Capital account: Shahieda = 114 000 + 7 200 (revaluation) − 4 800 (goodwill)
Did you notice?
The fair value of the property, plant and equipment at the date that Joseph left
the partnership is now shown as the cost. This is conceptually correct as the
partnership between Richard and Shahieda is now a new business that has
acquired second-hand assets at a cost equal to their fair value.
13.1.5.8 Partnership dissolution (liquidation of the

partnership)
The partners of a business can decide to stop operating. The entire
partnership will then end. The partners will have to pay all
outstanding liabilities and will sell all the assets in the business.
Once the liabilities have been paid, the partners will be paid out the
balance on their Capital and Current accounts, which will be equal
to the net asset value of the partnership. As all the assets are sold
(converted into cash or other liquid assets), this process is known as
liquidation.
Liquidation involves selling all the assets, settling all the liabilities,
and distributing what is left to the partners, in this case, or, in the
case of a company, to the shareholders.

Richard and Shahieda have been trading together for some time.
Shahieda has decided to change her career. She is going to study
graphic design at the University of Technology. Richard does not
wish to run the business on his own and they have decided to stop
trading and liquidate the partnership.

The statement of financial position below represents the business
at the end of June X8. They have decided to sell all the assets, pay the
liabilities and share out the remaining cash according to what is
owed to them.
The following transactions occurred during July in dissolving the
partnership:
• A vehicle with a carrying amount of R50 000 was sold for R39 000
• A vehicle with a carrying amount of R30 000 was sold for R12 000
• The trade and other payables were settled in full
• The land and buildings were sold for R140 000
• The equipment was sold for R100 000

• Trade receivables paid R40 100 in full settlement of all
outstanding debts
• The outstanding loan from SBS bank was repaid in full.
A Liquidation account is a temporary account that keeps track of
what is happening during the liquidation process. It is rather like the
Asset disposal account, where the cost, accumulated depreciation
and proceeds on sale are transferred and the profit or loss on sale of
the asset is calculated. A Liquidation account follows the same
general principle except that it combines the sale of all assets,
settlement of all liabilities, and the distribution of the remaining cash
to the partners or shareholders. The balances on the asset account
(cost) and the Accumulated depreciation account are transferred to
the liquidation account. The effect is that the asset accounts are
reduced to zero and the Liquidation account has a net debit balance
equal to the net carrying amount of the asset.
When proceeds on the sale of the asset are received, the amount
received is also taken to the Liquidation account. The difference
between the net carrying amount and the proceeds is not reported as
a profit or loss on sale of the asset but is part of the liquidation
process. By the time that the liquidation is finished, the partnership
ceases to exist and all the ledger accounts should have zero balances.
Let's look at the journal entries that will need to be processed to

record these transactions and the dissolution of the partnership.
The Current accounts are closed off to the relevant Capital accounts.
This represents the amount that the partnership owes each partner.
The partnership currently has R318 700 cash available to distribute
to the partners:
(R84 600 + 51 000 + 100 000 + 140 000 + 40 100 − 97 000)
Because the partners share profit and losses equally, the profits and
losses must be allocated to them.
The partners’ Capital accounts currently amount to:
Richard Shahieda
Capital account 152 400 130 400
Current account 43 500 54 500
Vehicles − loss on sale (14 500) (14 500)
Equipment − loss on sale (20 000) (20 000)
Land and buildings − pro t on sale 7 500 7 500
Trade receivables − loss on settlement (4 050) (4 050)
164 850 153 850
Note:
Partners do not always share profits and losses in the same ratio. For example,
Shahieda and Richard could share profits in the ratio 1 : 1, but losses in the ratio 4 :
1.
Think about this 2

In the example above, the partners all had credit balances on their Capital
accounts and the business had sufficient cash to pay out the capital amounts
owing to each partner.
1. What do you think would happen if one of the partners had a debit balance
on the Capital account?
2. What would happen if the partner with the debit balance on the Capital
account was insolvent (in a personal capacity)?
Check your answers
1. If one of the partners had a debit balance on the Capital account, he or she would
need to pay that amount into the business. The amount would be used either to
pay off outstanding liabilities or to repay the other partners their credit balances
on the Capital accounts.
2. If the partner with a debit capital balance was personally insolvent (which means
he is unable to pay his share of the liabilities − in other words the partner is
bankrupt), the remaining partners would have to pay their own money into the
business in order to pay off any outstanding liabilities. These partners could sue
the insolvent partner for the additional money that they had to put into the
partnership. This is because the partners are jointly and severally liable for all the
debts of a partnership.

A close corporation is a business entity where the owners and the
close corporation are seen as separate legal entities.
The owners of a close corporation are known as members. A close

corporation can have from one to ten members. The interest of each
member refers to the percentage ownership that each member has in
the close corporation. The contributions by members need not be in
the same proportion as the members’ percentage interest. It is the
members' interests, and not their contributions, which determine the

proportion in which profits and losses are to be shared. The liability
of the members of a close corporation is limited to their investment
(capital contribution) in the close corporation. This means that if the
close corporation is unable to pay its debts, the maximum that the
owners can lose is the amount they have invested in the close
corporation as equity (capital).
Did you know?

The new Companies Act 71 of 2008, which replaced the previous Companies Act
61 of 1973 (as amended), provides that close corporations registered prior to the
date on which the 2008 Act came into operation (1 May 2011) may continue to
operate as close corporations, and that they will still be governed by the Close
Corporations Act 69 of 1984. The 2008 Companies Act has, however, amended
the Close Corporations Act so that close corporations will, in some areas, be
governed in the same way as a company.
13.2.1 Accounting for transactions in a close

corporation
The daily transactions are recorded in precisely the same manner as
for a company, sole proprietor and partnership. The asset, liability,
income and expense accounts will be similar whatever the entity
form we choose. What will differ is the way we record and disclose
equity.
Accounting and disclosure requirements

Existing CCs have been brought into the scope of the 2008
Companies Act with respect to financial reporting standards and the
audit requirements. The 2008 Companies Act requires a close
corporation to prepare its financial statements within six months of
the end of the financial period. The reporting standard (IFRS or IFRS
for SMEs) required when preparing financial statements as well as
review or audit requirements for the financial statements of a close
corporation are the same as the requirements governing a company.
The requirement will depend on the PI score of the close
corporation. (See Chapter 12 for a review of the PI score.)
Close corporations could disclose the following additional
information in the notes to the financial statements:
• Contributions by members
• Retained earnings
• Revaluations of non-current assets
• Loans to and from members
• Transactions with members.
This information can be presented on a Statement of members' net

investment in the close corporation.
Let's assume that Shahieda decides to start a close corporation with

her cousin, Joseph.
The business is called Cassiem’s Laundromat CC, and started
trading on 1 July X2.
The founding statement contained the following information:

• Shahieda and Joseph’s interests were 80% and 20% respectively
• The members’ contributions were to be R75 000 from Shahieda
(R5 000 in cash and assets valued at R70 000) and R15 000 from
Joseph (R1 000 in cash and assets valued at R14 000).
Joseph paid only R100 of his contribution up front. He promised to
pay the rest within the next three months. Joseph also contributed a
delivery vehicle (valued at R14 000). Shahieda contributed R20 000 in

cash, an existing building valued at R50 000, and an industrial
machine valued at R20 000. The cash she contributed to the business
was in the form of her R5 000 contribution and a loan of R15 000.
Something to do 9
1. Prepare the general journal entry to record the initial transactions.
2. Prepare the statement of financial position as at 1 July X2.
Check your answers
1. General journal
2. Statement of financial position

Summary of partnerships
• The owners are not separate from the partnership and have
unlimited liability.
• The format of the Capital account shown on the statement of
financial position is different from that of a sole proprietor:
partners’ Capital accounts represent the capital contribution made
into the partnership, and the Current accounts represent the
amount that the partners can withdraw from the partnership.
• The profit does not remain in the partnership but is shared out
among the partners according to the agreed profit-sharing ratio.
• The salaries, interest on capital, interest on drawings, and profit
share are all recorded in the Current account.

• There is a separate Capital account, Current account and
Drawings account for each partner.
Summary of close corporations

• The owners are separate from the close corporation and have
limited liability.
• The format of the Capital account is different from those of a sole
proprietor and a partnership; members’ accounts are grouped
together and collectively known as “members’ contributions”.
• The profits of the close corporation do not automatically accrue to
the members.
• The salary, interest on capital contribution and profit distribution
accruing to the members is recorded in the Short-term loan to
members’ account.
• The undistributed profit remains in the close corporation as
“retained earnings”.
• There are liquidity requirements that have to be met before profits
can be distributed.
• Members can lend money to or borrow from the close
corporation. This information needs to be separately disclosed.
What's next?
In the next chapter Judy decides to expand her operations by setting
up a branch of her business in Knysna. She is concerned about
whether she has enough cash to pay for the venture. To help her
understand her cash position, we will extend the picture of the
financial statements produced by her company to include the
statement of cash flow.

QUESTIONS
QUESTION 13.1 (C)


Assume that all business are VAT vendors, unless otherwise stated.
Marshall and Royce own Skyfull Partnership, a business which
makes parts for gas stoves and ovens. They have approached you for
some help with finalising the partnership’s financial statements for
the year ended 31 October 20X11. They have correctly calculated that
profit for the year amounts to R2 million, before taking into account
any of the following information:
1. Salaries
Marshall and Royce both work for the partnership, although
Marshall does less work than Royce, who receives a regular
monthly salary of R20 000. Marshall is paid a salary of R100 000
at year-end, provided that profits are sufficient. Accordingly,
R100 000 was paid to him on 31 October 20X11. The business
also employs a parttime salesman, Bruno, whose salary is not
paid regularly, because it is based on the sales volumes that
Bruno earns for the business. Bruno was paid a total of R70 000
by the partnership during the year ended 31 October 20X11.
2. Machine
On 30 April 20X8, a machine had been purchased for R3 000 000
(excl VAT). Transport costs of R20 000 (excl VAT), and

installation costs of R30 000 had been paid on the same day. The
installation was performed by a non-VAT vendor. The machine
had been brought into use the following day. The partnership
measures machinery on the cost model, and depreciates it on
the straight line basis. The partners originally estimated that the
useful life was five years, and the residual value was R650 000.
However , they were informed by a consultant on 31 October
20X11 that the machine would in fact last for a total of 7.5 years,
and its residual value was R400 000.
3. Brands
The business has built up an excellent brand, which it has never
recognised on the statement of financial position. Skyfull's

products are protected by international copyright laws and their
quality is recognised and respected the world over. Many oven
and stove manufacturers have informed Skyfull that they

happily pay more for Skyfull's products because they know that
Skyfull's products are built to last. On 11 October 20X11, a
competitor offered to buy the Skyfull brand from Skyfull
Partnership for R4 million. Skyfull has approached a brand

valuation company, which has valued the brand at R6.5 million.
4. Additional information
On 1 March 20X11, Marshall made a capital contribution of R1
200 000 to the partnership. The partnership agreement states
that interest on capital is allowed at a rate of 15% per annum.
No other capital contributions were made in the 20X11 year.
Royce made a drawing of R350 000 from the partnership on 1
September 20X11. There is no interest on drawings. The
partnership agreement stipulates that, once other profitsharing
requirements have been met, profits will be shared equally
between the partners. The following extract of the statement of
financial position as at 31 October 20X10 is available to you:

Skyfull Partnership: Statement of financial position (extract) as at
31 October 20X10
R
Equity
Capital − Marshall 3 000 000
Capital − Royce 100 000
Liabilities
Current − Marshall 2 500 000
Current − Royce 200 000
1. Refer to point 1 above. Describe clearly whether each of the
three salaries should be expensed. Explain your answer, with
reference to the relevant Framework definition. (5 marks)
2. Refer to point 2 above.
a) Prepare the journal entry/ies required on 30 April 20X8 to
record the transport costs and installation costs relating to
the machine. Ignore dates and narrations. (4 marks)
b) For each amount that you chose to include or exclude in the
cost of the machine in your answer to part (a), explain the
treatment you chose. (3 marks)
c) Prepare the journal entry/ies required on 31 October 20X11
to record the depreciation of the machine. Ignore dates and
narrations. As always, show workings clearly. (7 marks)
3. Refer to point 3 above.
a) Is the Skyfull brand an asset, and should Skyfull Partnership

recognise the brand on the statement of financial position
as at 31 October 20X11? Your answer should clearly explain
whether each part of the Framework definition and
recognition criteria is met or not met. (8 marks)
b) Marshall says to you: “I have seen ‘goodwill’ on some large
companies’ balance sheets. Is the Skyfull brand part of our

goodwill? Why are those companies able to recogn ise
goodwill?” Answer both of Marshall’s questions, giving
clear reasons. (4 marks)
4. Refer to all of the information in the question. Prepare the
statement of changes in equity of Skyfull Partnership for the year

ended 31 October 20X11. No total column is required.Assume
current accounts treated as equity. (10 marks)
5. Royce says to you: “I have noticed an account called ‘retained
earnings’ in company financial statements, but not in
partnership financial statements. Does this mean that partners
in a partnership cannot leave profits in the business?” Answer
Royce’s question. Briefly explain your answer. (2 marks)
QUESTION 13.2 (B)

Ignore VAT.
Gogo Gear CC is a bicycle shop run by members Dirk and Johann.
The business was incorporated as a close corporation on 1 January
X9 and has been operating at a profit each year. The following
balances were obtained from the books of Gogo Gear CC at 31
December X4:
R
Members' contributions (1 Jan X4) 270 000
Equipment at cost 128 100
Accumulated depreciation − equipment (31 Dec X4) 34 275
Land and buildings 210 000
Surplus on revaluation of land reserve (1 Jan X4) 30 000
Investment at cost: 22 500 ordinary shares in Pedal Planet (Pty) 27 000
Ltd
Long-term loan from member − Dirk 18 000
Short-term interest free loan to member − Johann 6 000
Inventory (31 Dec X4) 30 450
Bank 36 000
Trade and other payables 27 735
Gross pro t 91 500
Sundry expenses 32 500
Rent received 18 600
Dividends received from Pedal Planet (Pty) Ltd 5 100
Retained earnings (accumulated profit) (1 Jan X4) 38 940
Except for items 5, 6 and 7 below, all transactions for the year have
been recorded and posted to the general ledger.
1. The two members of Gogo Gear CC are Dirk and Johann. Their
contributions were made in the ratio of 2 : 1 respectively, but
their members’ interest ratio is 1 : 1. The members’ contributions
are fully paid up.
2. Sundry expenses consist of the following:

Dirk is a technical expert and has connections in the bicycle
trade, and therefore is paid an additional salary amount of R4
000 per annum in cash. This is not included in the R8 000 salary
amount above, but is included in the sundry expense amount
given.
3. During the year, the CC lent Johann a further R2 100 and he
repaid R3 300 on the above short-term loan.
4. On 31 August X4 the CC needed short-term finance and
borrowed an additional R6 000 from Dirk. This amount is
included in the long-term loan from member − Dirk.
5. In terms of the founding statement, interest is calculated on
long-term loans from members at a rate of 10% per annum. Such
interest accrues and is credited to the members’ short-term loan
accounts on 30 June and 31 December each year. The relevant
interest entries have not been posted during the X4 financial
year.
6. Dirk and Johann resolved on 31 December X4 to make a
distribution of R16 000 (excluding dividend tax) to themselves,
payable on 15 January X5, and that this would be credited to the
members’ short-term loan accounts. This entry has not yet been
recorded by Gogo Gear CC.

7. The taxation expense of R45 000 (excluding dividend tax) must
still be recorded for the X4 financial year.

1. Prepare the general journal entries to record the additional
information given in points 5 to 7, including the effect of
dividend tax. (11 marks)
2. Calculate the profit after tax for the year ended 31 December X4.
3. Prepare the transactions with members’ statement (that (7 marks)
would be disclosed at the bottom of the Statement of
comprehensive income) for the year ended 31 December X4.
4. Prepare the equity and liabilities section of the Statement (5 marks)
of financial position for Gogo Gear CC as at 31 December X4.

(9 marks)
QUESTION 13.3 (B)

Carla Adonis sells fashion clothing, trading as Carla Fashions. Her
financial performance before taking into account transactions not in
her capacity as owner for the last two financial years ended 31
August X3, were as follows:
X3 X2
R'000 R'000
Sales 1 100 900
Cost of sales (400) (330)
Gross profit 700 570
General expenses (140) (110)
The owner's equity section of the statement of financial positions of
Carla Fashions, at 31 August of each year under review, were as
follows:
X3 X2
R'000 R'000
Opening balance 1 745 1 500
Additional capital (31 August X3). 800
Pro t for the year 560 460
Cash drawings (516) (215)
Closing balance 2 050 1 745
Carla has considered converting her business into a close
corporation. In order to help her to understand the accounting
implications, she has asked you to redraft the affected parts of the
financial statements for the periods under review, assuming that the
business operated as Carla Fashions CC as from 1 September X1,

with Carla as the only member.
It was agreed that R1 000 000 of the capital balance at 1 September
X1, would be treated as a loan from Carla and the rest as a member's
contribution. Subsequent capital contributions should also be viewed
as a loan from Carla. The cash received by Carla (cash drawings),
would be structured as follows for close corporation purposes:
Salary to Carla R200 000 per
annum
Interest on loan from Carla (interest on the 10% per
member’s contribution 5%) annum
Distributions to Carla (net of dividend tax) R80 000 per
annum
The balance of the cash drawings must be treated as a repayment of
the loan from Carla.
Taxes must be accrued, but are assumed to be unpaid to date. A tax
rate of 30% applies to the profits of a close corporation and a
dividend tax rate of 20% to dividends declared. The tax rate
applicable to Carla in her personal capacity is 40%.
1. Assume that the business is a close corporation. Prepare the
following journal entries for Carla Fashions CC, in respect of the

year ended 31 August X2:
1.1 To record the capital balance (of R1 500 000) on 1 September
X2. (2 marks)
1.2 To record the cash drawings (of R380 000). (3 marks)
1.3 To record the income tax. (2 marks)
(Ignore narrations.)
2. Prepare the following financial statements for Carla Fashions
CC:
2.1 Astatement of comprehensive income for the year ended
31August X3. (4 marks)
2.2 A statement of change in equity for the years ended 31
August X2 and X3. (5 marks)
2.3 A statement of change in loan from member for the year
ended 31 August X3. (2 marks)
Bonus question
3. Calculate the total amount of tax payable (clearly indicating tax
due by the business and due by Carla in her personal capacity)

in respect of the year ended 31 August X3, if Carla trades as:
3.1 Carla Fashions. (1 mark)
3.2 Carla Fashions CC. (1 mark)

14 Statement of cash
flows
Judy still dreams about her products being sold all over the world,
but she has realised that before she can expand overseas, she
needs to ensure that all local opportunities have been fully
utilised. The business has been extremely profitable over the last
two years. Her profit for the year has grown by 25% per annum
and she feels that in order to continue growing at this rate, she will
need to access new customers. One of the ways to grow her
business in South Africa is to open more branches of her selling
outlets. She is thinking of opening a business in Knysna as the
Garden Route is becoming extremely popular, both with tourists
and with the South African market. Judy has a sister, Shirley, who
lives in Knysna and has agreed to run the business for her.
Judy has looked into the costs of setting up the new shop and
has realised that she will need quite a bit of cash on hand to carry
her through the initial set-up period. She remembers how her
business in the V&A Waterfront took some time before it
generated cash.
Judy's sister cannot understand what the problem is. “Judy, I
can't really understand why you are concerned about where the
cash is going to come from. Your business is really profitable.
Surely the profit for the year will be enough to cover the extra cash
you need?”
Judy replied, “Shirley, my business is making a good profit, but
that does not necessarily mean that it is generating enough cash
to be able to set up the new business. The profit that my business
makes is calculated according to the accrual concept. The cash
that my business is generating is shown on the statement of cash
flows. The statement of cash flows represents the actual cash
coming in and going out of my business, showing me where the
cash has come from and how it has been used in the business.”
Shirley replied, “I understand what profit is − income less
expenses. We spoke about that yesterday. But I'm a little unclear
about the statement of cash flows. Do you have time to explain it
to me in more detail? It seems to be an important area for me to
understand if I am going to help you run the business.”
Learning objectives
• Explain the purpose of a statement of cash flows
• Describe the information reported in a statement of cash flows
• Understand the major classifications on the statement of cash flows: operating,
investing and financing activities
• Prepare a statement of cash flows according to the direct and indirect methods
• Do a basic analysis of the statement of cash flows of a business.
Understanding Shirley's problem
Let’s help Shirley understand the statement of cash flows and see
how operating cash flows differ from profit.
14.1 An introduction to the statement of

cash flows
In Chapter 2 we learnt that only keeping a record of the money a
business receives and pays out is not by itself an adequate account of
business operations. Specific information about a business must also
be reported. The financial position of the business is reported in the
statement of financial position. The financial performance is
reported on the statement of comprehensive income or SPLOCI.
Changes in equity are reported on the statement of changes in
equity.
The profit a business earns is the income earned during a given time
period less the expenses incurred in order to generate that income. The
net cash inflow of the business in a given time period is the cash that
the business has received less the cash that the business has paid
during that period. It is the difference between the cash balances at
the beginning and end of the period.
Go and watch Statement of Cash Flows − Introduction: This video explains
the principles underlying the Statement of Cash flows.
Below is an example of the kind of information that would be
reported in the statement of cash flows of a business. It is useful to
compare this information with what you are used to seeing in the
calculation of profit or loss on the statement of comprehensive
income.
Statement of Included in profit calculation on the Statement of

cash flows comprehensive income
Sources of
cash
• Cash • Income earned (includes cash and credit sales)
received
from
customers
or clients
• Cash • Pro t or loss on sale of asset (not the cash received on

received disposal of asset) − pro t is the difference between the
from carrying amount and the amount for which the asset is
property, sold
equipment
or other
assets sold
• Interest or • Interest or dividend earned (regardless of whether it has

dividends been received)
received on
investments
• Loans taken • Loans do not appear on the statement of comprehensive

out income − they are liabilities
• Equity • Equity (shares) does not appear on the statement of

(shares comprehensive income
issued)
Uses of cash
• Cash paid • Cost of sales appears on the statement of comprehensive
to suppliers income − this represents the cost of the goods sold and
(for not the inventory purchased or paid for in cash during the
inventory) period
• Cash paid • The purchase of assets does not appear on the statement
for the of comprehensive income Depreciation, which is the
purchase of allocation of the cost of the asset over its useful life, will
new assets appear on the statement of comprehensive income
or
investments
• Operating • Operating expense incurred (not necessarily paid)

costs paid
in cash
• Interest paid • Interest incurred (not necessarily paid)

on borrowed
funds
• Tax paid • Tax expense incurred (not necessarily paid)
• Loans • Repayments of loans do not appear on the statement of

repaid comprehensive income
14.1.1 Profit calculation versus cash flow

The statement of comprehensive income reflects the profit that
Judy’s business made during the financial period. The profit figure
does not represent the cash that the business has received.
Depreciation and bad debts are taken into account in the calculation
of profit for the year. These expenses are examples of non-cash flow
expenses as they have not actually been paid in cash during the
period − they have not and will not give rise to cash flows. (We’ll
look at this concept a little later in the chapter.)
Information recognised on the statement of comprehensive
income could include accrued business expenses, such as the unpaid
December telephone account. These are expenses that have been

incurred but not paid. They differ from the non-cash flow expenses
in that there will be a cash flow in the future − next year, when they
are paid.
Judy’s business could also have earned interest or rent that the
business has not received − accrued income (income that has been
earned but has not, as yet, been received). This would also give rise
to cash flows in the future.
The calculation of profit would exclude any expenditure such as
insurance that Judy business has paid in advance. This is a prepaid

expense, which means that although the cash has been paid, no
expense has been recognised. The prepaid expense is an asset on the
statement of financial position as it will give rise to future economic
benefit as a result of the payment made in the past.
Similarly, any cash received in advance of providing the goods or
unearned or deferred income)

services will be reflected as a liability (
and not as income. It is a liability, as the entity has an obligation to
provide the goods and services in the future as a result of receiving
cash. Although cash has been received, no income has been
recognised.

transactions
In terms of the accrual concept, income and expenses are recognised
in the financial period to which they relate, which is not necessarily
the period in which the cash flow takes place. The accrual concept
indicates that income is recognised when the goods and services are
provided and that expenses are recognised when goods and services
are consumed. Cash flows can take place before, at the same time, or
after the income or expense is recognised.

Something to do 1
Tiny Tots Traders is a business that sells children's clothing. The business had
stationery on hand amounting to R2 000 as at 1 January X2. It purchased
stationery amounting to R10 000 on credit during the year and had stationery on
hand amounting to R3 000 at year-end (31 December X2). The business records
all stationery in the Stationery expense account. Tiny Tots owed the stationery
supplier R4 000 at 1 January X2 and R2 500 at 31 December X2.
1. Prepare the ledger account for Stationery for the year ended 31 December
X2.
2. What amount will be recognised in the statement of comprehensive income
for the year ended 31 December X2?
3. How much cash did the business spend on stationery during the year ended
31 December X2?
4. Briefly explain why the two amounts are different.
5. Which amount do you think will affect the statement of cash flows of the
business?
Check your answers
1.
2. R9 000 will be recognised as an expense in calculating profit. It is calculated on

the accrual basis and is unrelated to the cash amount paid during the year.
3. The cash payment for stationery during the year amounted to R11 500. This was
the R4 000 outstanding at the start of the year, paid during the year to the
creditor, and R7 500 of the amount bought during the year. Tiny Tots bought
stationery for R10 000 during the year but still owed R2 500 at the end of the
year. This means that the business had paid R7 500 (R10 000 − R2 500) of this
amount.
Let's look at the Stationery account and the Trade payables account again to see
if we can identify the cash flow during the year.
None of the entries recorded in the Stationery account will appear on the
statement of cash flows. This is because the stationery of R10 000 was
purchased on credit, and the R9 000 going to the Profit or Loss account
represents what has been used during the year and not what has been paid. The
R11 500 in the Trade payables account will appear on the statement of cash
flows, because the R11 500 represents the actual amount paid for the stationery.
4. The difference between the expense recognised in calculating profit and the cash
flow amount arises because of four factors:
Firstly, not all the stationery bought during the year was used (and therefore
expensed) during the year.
•
Secondly, not all the amounts purchased during the year were paid for during
the year.
•
A third complication is that the expense includes amounts used this year but
purchased last year (stationery on hand at the beginning of the year).
•
Finally, the cash flow would include purchases made last year that were paid
for this year (Trade payables at the end of last year).
•
5. The R11 500 representing the actual cash flowing out of the business will affect
the statement of cash flows of the business.
14.2 What is a statement of cash flows?

A statement of cash flows is a statement that reflects all the cash
flows of a business in a standardised format. It is a summary of the
cash receipts and payments of the business during the year. Using a
standard format when preparing the statement of cash flows makes
it easier for users to understand the information and make
comparisons with other companies.
14.3 When should a statement of cash

flows be prepared?
A statement of cash flows should be prepared every time a company
or organisation prepares financial statements. It is an essential part
of the financial statements as it explains how much of the accrual
profit has actually been converted into cash.
Although the statement of cash flows is drawn up at the end of
the financial period and looks at the changes that have happened
during the past year, this information is still useful to predict the
amount, timing and certainty of the future cash flows.
14.4 The purpose of the statement of cash

flows
Why is it necessary to report a company's cash flows?
The information provided by the statement of cash flows is useful as
it provides information about the ability of the business to generate
cash, and how and where the cash has been used. The statement of
cash flows supplements the information about the business’s
financial position (statement of financial position) and its financial
performance (statement of comprehensive income).
To pay creditors, interest and operating expenses, a business
needs sufficient cash on hand to make these payments when they
fall due. Many small businesses focus only on the statement of

comprehensive income in making decisions about how fast the
business should grow. They become too concerned about trying to
grow the profit or sales of the business. This can become a problem if
the business does not have enough cash available to fund the
growth. A business can increase its sales by selling more on credit.
This will increase the amount of sales income recognised in the
calculation of profit but will not necessarily increase the amount of
cash that the business receives. If the business bought the inventory
(that had been sold) for cash, it will actually have less cash, which
may lead to cash flow problems when other expenses such as
interest, wages and rent have to be paid.
If the business is unable to pay its interest expense or repay
creditors, it could find itself being closed down by the bank (the
technical term is liquidated).
Users of the statement of cash flows use the information to assess
the quality of the profit − the extent to which the profit recognised
on the accrual basis has actually been received in cash. In your
future accounting studies, you will discover there are a number of
choices a company can make when selecting its accounting policies.
This selection can influence the profit recognised but does not
change the amount of cash received or paid. Cash flows from
operation of different companies may therefore be more comparable
to investors than the profit figure.
The statement of cash flows provides information which enables
Judy to:
• See whether her business generates cash from its operations
• Assess whether her business is able to pay interest on borrowed
funds, and settle outstanding debt
• Assess whether the business is able to pay its short-term debts

• Plan future cash expenditure based on the cash she has available
and by determining the source of the cash in her business
• Have information about the cash effects on the business of
decisions to buy or sell assets.
14.5 What information does a statement

of cash flows present?
Let's look at the types of cash inflows and outflows we would expect
to find in most businesses.
*A company share issue occurs when new shares are issued, in
which case, the company receives the cash. A sale of shares takes
place between shareholders and does not affect the cash flow of the
business.
14.6 How is the information presented in

the statement of cash flows?
The GAAP accounting statement that prescribes how cash flow
information is presented is known as IAS 7. IAS 7 requires cash
flows to be classified into operating, investing and financing

activities. The classification of inflows and outflows of cash into
operating, investing and financing activities provides users of the
financial statements with enough information to understand how
each of these activities impacts the cash balance of the business.
GAAP statement IAS 7 allows for the reporting of cash flows from
operations on either the direct or indirect method.
Let’s look at what these terms mean.

Operating activities are the daily activities in the business that
generate the revenues and expenses. These are the core activities of
the business. For a café, the core activities would be everything
involved in buying and selling the goods in the shop. For a
hairdresser, all the revenue generated from and expenses incurred in
cutting and styling clients’ hair would be as a result of core activities.
In Judy’s business, the core activities include the activities involved
in producing the bags (the cost of making the bags) and the activities
involved in selling the bags (the money received when the bags are
sold and costs such as rent, wages and telephone spent in trying to
sell the bags).

The Cash from operating activities section has two parts:
• The cash from operations section, which shows how much cash
was generated from (or utilised by) operations
• Cash flows relating to interest, taxation and dividends.
Cash from operations section
Cash Cash outflows

inflows
Cash sales Payments to suppliers of inventory
to
customers
Cash Payments to employees for salaries and wages Payments to
collected suppliers of services provided, such as rent, electricity, and so
from on
debtors
Refunds Cash refunds to customers
from
suppliers
What will the cash from operations figure tell Judy?

The cash from operations can be seen as the heart of her business. In
order for Handbags for Africa Ltd to be sustainable over the long
term, the business must be able to generate cash from its operations.
The cash which Judy’s business is able to generate from
operations is an important measure of whether the business is able
to generate enough cash to pay interest, repay loans, pay dividends,
and make new investments (such as the new venture in Knysna)
without having to find other sources of finance, such as putting in
more of her own money (equity) or taking out a loan (debt).

Other inflows and outflows from operating activities
Tax refunds received Tax paid

Interest received Interest paid
Dividends received Dividend paid
What do you notice?

Cash flows from operations include receipts from sales and payments
to suppliers and employees. These are the cash flows from the core
activities of the business.
Cash flows from operating activities include receipts and payments
of dividends and interest and tax.
Did you know?

While most companies show interest and dividends as operating cash flows,
companies are also allowed to show them as financing (interest and dividends
paid) or investing (interest and dividends received). As issuing share capital gives
rise to a financing cash inflow, there is some logic in showing the dividends paid
on those shares as a financing cash outflow. Purchasing shares (in another
company) is shown as an investing activity, so showing dividends received as a
cash flow from investing activities also makes sense.
Most companies see the initial cash flows (buying shares or issuing shares) and
the subsequent cash flows (dividends) as separate issues and therefore show the
subsequent payments as operating cash flows.

The cash flows from investing activities report on the cash received
and paid relating to non-current assets. These activities include cash

used to purchase property, plant and equipment and other
investments and cash received from the sale of any of these assets.
The net cash flows (difference between the inflow and outflows of
cash) from her investing activities will show Judy how much cash
she has spent on resources that will generate future income and cash
flows, such as investments made to maintain and expand operating
capability.
Cash outflows and inflows from investing activities must be
shown separately. Even if the proceeds of the sale of one asset are
used to pay partially for the cost of another asset, the two flows must
be shown separately, as they relate to two separate decisions.
Some examples of inflows and outflows from investing activities
Cash inflows Cash outflows

Proceeds from sale of property, plant and Payments to purchase
equipment and other non-current assets property, plant and equipment
(including intangible assets) and non-current assets
Proceeds from selling equity investments Payments to purchase equity
(shares) in other companies securities (shares) of other
companies

Financing activities are the activities which change the capital
structure of a business ( changes in equity and non-current liabilities).

The net cash flow from the financing activities will show Judy
whether and the extent to which the operating and investing
activities have been financed by outside sources (equity and loans).
This information is useful in that it tells Judy the extent to which she
has used outside sources of finance to fund her business activities.

Current financing cash inflows imply future cash outflows in the
form of dividends (for shares) and interest (for loans). Remember
that if we take out a loan we have to pay back the loan some time in
the future (cash outflow), and we also have to make regular interest
payments (cash outflows) over the life of the loan. If we have sold
shares, the shareholders may expect a dividend in the future as
compensation for investing in the company. When the dividends are
paid, there will be a cash outflow.
Some examples of inflows and outflows from financing activities
Cash inflows Cash outflows

Proceeds from issuing equity (for Redemption of shares (repurchase of
example, ordinary and preference own shares) Payment of share issue
shares) expenses
Proceeds from issuing debentures Redeeming debentures
Proceeds from other short- or long- Repayments of short- or long-term
term borrowing borrowing
While most companies show interest and dividends paid as
operating cash flows, companies are also allowed to show them as
financing activities. Issuing share capital gives rise to a financing
cash inflow, so there is some logic in showing the dividends paid on
those shares as a financing cash outflow. Most companies see the
initial cash flows (buying shares or issuing shares) and the
subsequent cash flows (dividends) as separate issues and therefore
show the subsequent payments as operating cash flows.
14.6.4 Direct and indirect methods of reporting

operating cash flows
The direct and indirect methods differ only in how they report on
cash flows from operations. The cash from/to operating activities,
cash from/to investing activities and cash from/to financing
activities are reported in the same way under both methods (see
section 14.7 for an example of the statement of cash flows using both
the direct and the indirect method).
Did you know?

The direct method reports on the gross cash flow of an entity, while the
indirect method reports on the net cash flow of an entity.
GAAP statement IAS 7 encourages the reporting of cash flows from
operations by the direct method (although the indirect method is
allowed as an alternative), and is the most frequently used method
in South Africa (we’ll look at these methods in greater detail later in
the chapter).
Direct method Indirect method

Discloses cash receipts Cash from operations calculated by adjusting
from customers and pro t before tax for items that do not involve the
cash payments to movement of cash (depreciation and adjustments
suppliers and employees for accruals) or items that are part of investing or
as two separate cash nancing activities.
ows.
14.7 What does the statement of cash

flows look like?
Remember that this is the preferred method.
Did you know?

The Companies Act 71 of 2008 no longer requires a note relating to the
reconciliation of profit for the year before tax and cash generated from operations
to be disclosed as part of the notes to the statement of cash flows. This note may
be disclosed if a business chooses to do so to provide information to users of the
The following notes can be provided with the direct method:
1. Reconciliation of profit for the year before tax to cash generated

from operations Profit before tax
Adjustments:
+ Interest paid
− Interest received
− Dividends received
+ Depreciation
Operating profit before working capital changes
Working capital changes:
Change in inventory
Change in trade receivables
Change in trade payables
Cash generated from operations
2. Cash and cash equivalents

Cash and cash equivalents consist of the following statement of
X1 X2
Cash

Cash flows from operating activities 1
Pro t before tax
Adjustments:
+ Interest paid
− Interest received
+ Depreciation
Operating pro t before working capital changes
Change in inventory
Change in trade receivables
Change in trade payables
Cash generated from operations
Interest paid
Dividends paid
Tax paid
The following notes are provided with the indirect method:

Cash and cash equivalents
1.
Cash and cash equivalents consist of the following statement of
X1 X2
Cash
What do you notice?

1. The note reconciling profit for the year before tax to cash
generated from operations for a statement of cash flows
prepared using the direct method is the same information that
appears as the cash from operations section on a statement of
cash flows prepared using the indirect method.
2. Investing and financing cash flows are identical on both the
direct and indirect methods.
14.8 Preparing the statement of cash

flows
14.8.1 How do we go about identifying cash flows that
The statement of cash flows is prepared at the end of the financial
year and reports on the inflows and outflows of cash during the
year. A transaction is a cash transaction if either the debit or credit
entry to record the transaction is in the Bank account. If you are
unsure whether a transaction would be recognised on the statement
of cash flows, ask yourself what the journal entry for the transaction
would look like. If either the debit or credit entry went to Bank, the
transaction would appear on the statement of cash flows.
Reviewing each transaction to identify cash flows would be
extremely time consuming, so another option is to reconstruct the
general ledger accounts and identify entries that have affected the
Bank account. To reconstruct the ledger accounts we use the
information provided in the statement of financial position, the
statement of comprehensive income and the statement of changes in
equity for the year.
X2 X1
Property, plant and equipment 72 000 66 000
Cost price 122 000 90 000
Less: Accumulated depreciation (50 000) 24 000
Current assets 128 000 86 500
Inventory 88 000 65 000
Cash 6 500 Nil
Stationery on hand 3 500 1 500
If we look at the statement of financial position provided above we
can see that there is a difference between the X1 and X2 balances for
all of the line items. For example, PPE at cost as at 31 December X1
amounted to R90 000 and at 31 December X2 amounted to R122 000.
We will reconstruct the ledger account to identify what caused the
change, that is, the movement from R90 000 to R122 000, and
whether the change was due to an inflow or an outflow of cash. If
we assume that there was no revaluation and no PPE was sold
during the year, we would be able to calculate that PPE amounting
to R32 000 was purchased during the year (an outflow of cash).
The cash flows will be reported on the statement of cash flows under
the relevant section, that is, operating, investing or financing
activities. We will look at this process in more detail in section 14.8.3.

Assume that the following transactions take place in the first month
of trading of Knysna Curios, a newly established business:
• Capital of R20 000 is invested in the business.
• Inventory costing R25 000 is bought and R15 000 paid in cash.
• Sales amounting to R27 000 take place, of which R12 000 is still
owed by debtors at the end of the month.
• Plant and equipment costing R48 000 is acquired, namely:
Furniture and equipment R13 500
Motor vehicles R34 500
A 10% deposit was paid on the vehicle and the balance of the
purchases of plant and equipment was financed by a loan, which
was paid directly to the supplier of the PPE.
Depreciation is to be provided as follows:
25% p.a. on the vehicle
10% p.a. on the furniture
• At the end of the month, inventory amounting to R7 000 is still on
hand.
1. Prepare a statement of cash flows using the direct method.
2. Prepare a statement of cash flows using the indirect method.

1. Prepare a statement of cash flows using the direct method
Direct method: Statement of cash flows for the month
Cash flows from operating activities

Cash receipts from customers 15 000
Cash paid to suppliers (15
000)
Cash generated from operations 0
Note:
Interest received and paid
Dividends received and paid
Tax paid
− would be shown here to calculate net cash ows from operating
activities
Cash flows from investing activities
Additions to motor vehicles (3 450)
Cash out ow from investing activities (3 450)
Cash flows from financing activities
Increase in capital invested 20 000
Cash in ow from nancing activities 20 000
Net increase in cash [0 − 3 450 + 20 000] 16
550
Cash at the beginning of the month 0
Cash at the end of the month 16
550
Some points to note in completing the statement of cash flows (direct
method)
• The sales amount of R27 000 includes both cash and credit sales.
Total sales were R27 000 during the month. R12 000 has not been
received in cash during the month; therefore R15 000 has been
received. The cash to customers on the statement of cash flows
reflects only the actual cash received from customers (R15 000).
• The purchases amount of R25 000 represents the total amount of
purchases made during the month and includes both cash and
credit purchases. The cash paid to suppliers and employees
would include only the actual cash paid for inventory (R15 000).
This figure would generally also include the cash paid to
employees and cash paid for other operating expenses.
• Although assets costing R48 000 were purchased, we have
recorded only R3 450 as an investing activity. This is because we
borrowed the R44 550 specifically to purchase the assets. The only
cash flow from our business was the R3 450. The bank paid the
loan of R44 550 to the business from which we purchased the
assets. When we start repaying the loan we will reflect it as an
outflow of cash under investing activities.
• The loan of R44 550 was taken out and used directly to finance the
vehicle and furniture purchased. The loan was not paid into the
account of the business purchasing the asset but was paid directly
to the business selling the asset. This has not been recorded as a
cash flow from investing activities (only the cash deposit of R3
450 has been recorded). The loan raised has also not been shown
as a cash flow from financing activities; it has not led to an inflow
of cash into the business.
• The information relating to the purchase of the asset and the loan
that has funded this purchase will be disclosed in the notes to the
statement of cash flows.

2. Prepare a statement of cash flows using the indirect method .
Indirect method: Statement of cash flows for the month

Pro t before tax 8
168.75
Adjustments:
+ Depreciation 831.25
Operating pro t before working capital changes 9 000
Increase in trade receivables (12
000)
Increase in inventory (7 000)
Increase in trade payables 10 000
Cash generated from operations 0
Note:
Interest received and paid
Dividends received and paid
Tax paid
− would be shown here to calculate net cash ows from operating
activities
Additions to motor vehicles (3 450)
Cash out ow from investing activities (3 450)
Cash flows from financing activities *
Increase in capital invested 20 000
Cash in ow from nancing activities 20 000
Net increase in cash [0 − 3 450 + 20 000] 16
550
Cash at the beginning of the month 0
Cash at the end of the month 16
550
*Note that the loan that was taken out to finance the balance of the
acquisition of the motor vehicle is not reflected on the statement of
cash flows as the company did not receive or pay any cash.
Workings: Profit calculation
Depreciation:
Vehicle: 34 500 × 25% × 1/12 = 718.75
Furniture: 13 500 × 10% × 1/12 = 112.50
Some points to note when completing the statement of cash flows

(indirect method)
• The indirect method starts with the profit before tax and adjusts
this figure for any non-cash flow items (depreciation, as well as
the impact of accruals and any item that needs to be presented
separately). Remember that the profit figure on the statement of
comprehensive income is an accrual figure, whereas in the

statement of cash flows we are interested in calculating how
much of the profit actually led to an inflow or outflow of cash in
the business.
• Did you notice in this example that the cash generated from
operations was zero regardless of whether the direct or the
indirect method was used? This figure should always be the
same, regardless of the method used. The direct and indirect
methods are just different ways of getting to this figure (cash
generated from operations).
• The cash flow from investing activities and cash flow from
financing activities look exactly the same regardless of whether
we are using the direct or indirect method.
Let's look at the cash from operations in more detail.

1. Depreciation is an expense on the statement of comprehensive
income. In this example, the expense amounted to R831.25. The
profit has been reduced by the depreciation amount, but
depreciation is a non-cash flow expense. In order to convert the
profit figure to a cash figure, the depreciation is added back to
the profit figure.
2. If the business sells or buys on credit, the Trade receivables and
Trade payables accounts will increase unless the cash has been
received or paid.
3. The interaction between Inventory, Trade receivables and Trade
payables is known as the working capital cycle.
Let's look at the working capital cycle in more detail.
Trade receivables
The Trade receivables account had a zero balance at the start of the
month and a balance of R12 000 at the end of the month. The profit
figure on the statement of comprehensive income will need to be
adjusted by R12 000 (the increase in the trade receivables balance).
The profit figure included the entire sales amount of R27 000. We
have seen that R12 000 of this amount did not lead to an inflow of
cash but led to the increase in trade receivables. R12 000 must be
subtracted from the profit figure to calculate the amount of sales
revenue that was received in cash.
Let's look at it another way.

If trade receivables has increased by R12 000 during the year, this
means that the sales amount on the statement of comprehensive
income includes the R12 000 credit sales but the R12 000 credit sales
have not been received in cash. If we want to convert the profit
figure into a cash figure, we need to decrease the total sales amount
by R12 000 to convert the total sales figure into cash sales.
Inventory
The Inventory account has a zero balance at the start of the month
and a balance of R7 000 at the end of the month. This means that the
Cost of sales figure in the profit calculation (the amount of inventory
actually sold) is less than the amount of inventory purchased. The
increase in closing inventory must be subtracted from the profit
figure as it has led to an outflow of cash (when the inventory was
purchased) but has not been recognised as an expense in the
statement of comprehensive income as the inventory has not been
sold. We have assumed that the inventory purchased was paid for in
cash. If the inventory was bought on credit (which means that it will
not have been paid for), the trade payables adjustment below will
take that into consideration.
Trade payables
The Trade payables account had a zero balance at the start of the
month and a balance of R10 000 at the end of the month. This means
that R10 000 of the inventory purchased has not been paid in cash.
The profit figure on the statement of comprehensive income will
need to be adjusted by R10 000 (the increase in the trade payable
balance). The inventory adjustment above means that the profit
figure has been adjusted for the entire Purchases amount of R25 000;
however, R10 000 of this amount did not lead to an outflow of cash
but led to an increase in trade payables.
The R10 000 needs to be added back to the profit figure. Although
this inventory was purchased, it has not been paid for and therefore
would not have led to an outflow of cash.
14.8.3 Cash from operations on the direct and

indirect method
Judy’s friend Alexander owns a company in Johannesburg called
Creative Clothing (Pty) Ltd, which sells designer women’s clothing.
He is considering expanding his businesses by exporting clothing to
the United Kingdom and wants to know if his business is in a strong
enough cash position to move into a new market. He has asked Judy
to help him by drawing up a statement of cash flows for his business
and explaining to him what it can tell him about his business. He has
provided Judy with the following information:
• The statement of financial position at the end of this year and at
the end of last year
• The statement of comprehensive income for this year
• An extract from the statement of changes in equity.
We will use this information to prepare the statement of cash flows
under both the direct and indirect methods. Remember that the only
difference between the methods is the cash from operations layout.
Creative Clothing (Pty) Ltd

December X2
R
Revenue 560 000
Gross pro t 168 000
Operating expenses (86 000)
Finance costs (3 000)
Pro t before tax 79 000

Extract from Statement of changes in equity for the year ended 31
December X2
Accumulated profit
Opening balance 31.12.X0 30 000
Pro t for the year for the year X1 55 000
Dividends (23 000)
Closing balance 31.12.X1 62 000
Remember that to reconstruct the ledger accounts and identify the
inflows and outflows of cash we use the information provided in the
statement of financial position, the income statement and the
statement of changes in equity for the year. In the examples below
we will identify each figure from the statement of financial position
as (F/P), from the income statement − SOCI − as (I/S) and from the
statement of changes in equity (S/E). The figure that will be reported
on the statement of cash flows is indicated as (C/F).
14.8.3.1 Cash from operations on the direct method
Cash received from customers

Debtors of R20 000 were outstanding from last year and the business
made sales of R560 000 during the year. The maximum the business
could receive in cash from debtors is R580 000 (20 000 + 560 000).
However, debtors amounting to R30 000 are still outstanding at the
end of this year. The actual cash we received from debtors during
the year amounts to R550 000 (580 000 − 30 000).
What if?
What would the amount of cash received from customers be if bad
debts amounting to R3 000 had been written off during the year?
Cash received from customers
Although the business could have received R580 000 from debtors,
R3 000 (bad debts) will never be received and R30 000 is still owed to
the business. The actual cash received this year amounts to R547 000.
Cash paid to suppliers and employees

It is important to remember that the business can be supplied with
inventory and other consumables such as electricity, stationery, rent
and labour (from employees). In calculating the cash paid to
suppliers and employees, we will prepare two calculations. The first
calculation will identify cash paid to suppliers for inventory, and the
second calculation will be to calculate the cash paid to other
suppliers and employees.
a) Cash paid to suppliers for inventory

In order to calculate how much we paid our suppliers (trade
payables) for inventory purchased, we need to know how much
inventory was purchased during the year.
The statement of comprehensive income provides information
relating to the cost of sales. To calculate the purchases amount, the
cost of sales amount is adjusted by the opening and closing
inventory balances (statement of financial position). The business
sold inventory costing R392 000 (Cost of sales figure) and had
inventory of R88 000 on hand. This means that the business could
have purchased inventory costing R480 000 (R392 000 + R88 000)
during the year. The business already had inventory of R65 000 on
hand at the beginning of the year, which means that inventory
costing R415 000 was purchased during the year.
The purchases figure (calculated above) is used in the trade
payables account to calculate the actual cash paid to suppliers for
inventory.
If we look at the Trade payables account, we can see that we had
creditors of R20 000 outstanding from last year. The business
purchased inventory for R415 000 during the year. The maximum
the business could pay creditors in cash is R435 000 (R20 000 + R415
000). However, trade payables amounting to R28 000 are still

outstanding at the end of this year. The actual cash we paid to our
suppliers during the year amounts to R407 000 (R435 000−218 000).
The cost of sales amount of R392 000 represents the cost of the
inventory we sold during the year. The purchases amount of R415 000
represents the cost of inventory purchased during the year. The bank
amount of R407 000 represents the actual cash paid to the suppliers of
inventory (trade payables) during the year.
b) Cash paid to other suppliers and employees

The calculation of cash paid to other suppliers and employees starts
with the operating expenses on the statement of comprehensive
income. (Remember that this is an accrual figure.) To calculate the
actual cash that was paid, we will need to decrease this amount by
any non-cash flow expenses such as depreciation and impairment
expense. If the operating expenses amount included any items that
must be separately disclosed, for example, interest paid, interest
received, dividends paid, dividends received and tax paid, these
amounts will need to be removed (either added to or subtracted
from the operating expenses) to calculate the actual cash paid to
other suppliers and employees. If there were any accrued
income/expenses, prepaid expenses or income received in advance,
we would also need to adjust for these items as well.
Calculation
Operating expenses R86 000

Less: Depreciation (non-cash ow item) (R26 000)
Less: Stationery on hand X1 (R1 500)
Add: Stationery on hand X2 R3 500
Add: Accrued electricity X1 R1 500
Less: Accrued electricity X2 (R4 000)
Cash paid to other suppliers and employees R59 500
The operating expenses amount from the income statement (R86
000) is reduced by this year’s depreciation. We are calculating the
actual amount of cash paid with respect to operating activities.
Although depreciation increased the operating expenses, it is a
noncash flow expense, that is, it will not lead to an outflow of cash.
The cash flow will be R86 000 lower that the expense amount on the
income statement.
In this example we are not given the depreciation amount.
However, we do have information on the statement of financial
position that we can use to calculate this amount. Remember
(assuming that no assets were purchased or sold during the year)
that the Accumulated depreciation account changes by the amount
of the current year’s depreciation. We’ll look at how to deal with
asset disposals later in the chapter.
Why are we adding or subtracting the prepayments and accruals?

The operating expenses amount from the statement of
comprehensive income is an accrual figure. We need to adjust this
figure to calculate the actual cash paid during the year.
Stationery of R1 500 was on hand at the beginning of the year.

This stationery was purchased last year but would have been used
this year. Assuming that the purchase was a cash purchase, the cash
flow occurred last year, but the expense is included in the operating
expenses amount this year. To calculate the cash flow this year, we
need to reduce the operating expenses as they are greater than the
actual cash flow.
Stationery on hand at the end of the year (R3 500) has been
purchased this year but will be used next year. This stationery is not
included in the operating expenses amount but has led to a cash
flow. To calculate the cash flow this year, we need to increase the
amount for operating expenses, as they are less than the actual cash
flow. If the stationery was purchased on credit, it will be included in
the balances on the Trade and other payables account (see inventory
calculation).
The operating expenses that have been paid in cash amount to R59
500.
Accrued electricity at the beginning of the year (R1 500) was used
last year but was paid for this year. The cash flow occurred this year
but the expense was not included in the operating expenses amount.
To calculate the cash flow this year, we need to increase the
operating expenses amount as it is less than the actual cash flow.
Accrued electricity at the end of the year (R4 000) has been used
this year but will be paid for next year. This electricity is included in
the operating expenses but has not led to a cash flow this year. To
calculate the cash flow this year, we need to decrease the operating
expenses amount as it is greater than the actual cash flow.

The total cash paid to suppliers and employees is:
Cash paid to suppliers for inventory 407 000
Cash paid to other suppliers and employees 59 500
466 500
Let's complete the cash from operations section under the direct
method.

Statement of cash flows for the year ended 31 December X1:
direct method
Cash paid to suppliers and employees (466 500)
Cash generated from operations 83 500
14.8.3.2 Cash from operations on the indirect method
Calculating cash from operations on the indirect method
Profit before tax

The indirect method starts with the profit before tax figure from the
statement of comprehensive income of R79 000. This is an accrual
figure and needs to be converted to the cash from operations figure.

The first adjustments made to this figure are the non-cash flow
expenses or income figures that are included in the profit of R79 000
and items that need to be separately disclosed on the statement of
cash flows.
Depreciation
Depreciation decreases profit before tax BUT depreciation is a non-
cash flow expense and will not lead to an outflow of cash − it will
not decrease the cash from operations. To calculate the cash from
operations amount, depreciation is added back to the profit figure.
Interest expense
The profit before tax amount has been decreased by interest expense.
Interest paid (a cash outflow) will be separately disclosed after the
cash from operations amount. Interest expense is added back to
profit before tax so that the interest paid can be disclosed separately
as a cash outflow.
Working capital changes
Let's look at the changes in working capital in more detail.

We’ll need to adjust the profit figure for the changes in working
capital in order to change the accrual figure of R79 000 to the cash
from operations figure.
If you look at the statement of financial position of Creative
Clothing, you will notice that Trade receivables increased by R10 000
− the balance at the end of the year is R10 000 more than the balance
at the beginning of the year. This means that the business received
R10 000 less in cash than the sales generated during the year. The
business made sales of R560 000 but received cash of only R550 000.
We will need to subtract R10 000 from the profit figure because R10
000 of the profit has not been converted into cash as yet.
2. Inventory
Inventory increased by R23 000 − the balance at the end of the year is
R23 000 more than the balance at the beginning of the year (R88 000
− R65 000). This means that the business purchased R23 000 more
than was sold (the inventory purchased amounted to R415 000, but
the cost of sales was R392 000). The profit decreased by the COS
expense amount. The inventory adjustment on the indirect method
converts the COS expense to the amount of inventory actually
purchased during the year.
Purchases were higher than the amount that has been recognised by
cost of sales. We need to reduce the profit figure by an additional
R23 000.
3. Trade payables
The Trade payables increased by R8 000 − the balance at the end of
the year is R8 000 more than the balance at the beginning of the year
(R28 000 − R20 000). The trade payables adjustment on the indirect
method converts the purchases figure to the actual cash paid for
inventory. The business purchased more inventory than the amount

of cash it paid. We can see below that the business purchased
inventory amounting to R415 000 but paid only R407 000. R8 000
must be added back to the profit figure. Remember, in the inventory
adjustment we calculated how much inventory had been purchased,
but R8 000 has not been paid for and has therefore not led to an
outflow of cash.
4. Stationery on hand
The business had stationery on hand of R3 500 at year-end and R1
500 at the start of the year. This means that the business bought more
stationery (cash outflow) than it used (expense reduces profit). The
cash flow is greater than the expense − we decrease profit before tax
by a further R2 000 to calculate cash from operations.
5. Accrued expenses
The accrued expenses closing balance is R2 500 greater than the
opening balance. Profit decreases when we recognise the expense.
Accrued expenses are used this year (profit decreases) but the cash
flow only occurs the following year. Profit has decreased more that
the cash flow. We add R2 500 back to profit after tax to calculate cash
from operations.
Let's complete the cash from operations section under the direct
method.

indirect method
Adjustments:
− Interest expense (3 000)
+ Depreciation 26 000
Increase in trade receivables (10 000)
Increase in stationery on hand (2 000)
Increase in accrued expense 2 500
14.8.4 Cash flows from operating activities, investing

activities and financing activities
The remaining cash flows from operating activities, investing
activities and financing activities are the same on the statement of
cash flows presented under both the direct method and the indirect
method.
14.8.4.1 Cash flows from operating activities
Interest paid
The finance costs on the statement of comprehensive income amount
to R3 000, and there was no interest accrued or prepaid at the

beginning or the end of the year (statement of financial position).
This means that interest of R3 000 was paid during the year.
Dividends paid
The business owed dividends of R8 000 at the beginning of the year
and declared dividends of R23 000 during the year. Of this, R12 000
was still unpaid. R19 000 had been paid during the year (R31 000 −
R12 000).
Tax paid
The business owed tax of R18 000 at the beginning of the year. The
tax expense for the year amounted to R24 000. The business still
owes R24 000 at the end of the year. The business paid R18 000 tax
during the year.
14.8.4.2 Cash flows from investing activities
Purchase of non-current assets

PPE at cost as at 31 December X1 amounted to R90 000, and at 31
December X2 amounted to R122 000. We will reconstruct the ledger
account to identify what caused the change, that is, the movement
from R90 000 to R122 000, and whether the change was due to an
inflow or an outflow of cash. There is no revaluation surplus on the
statement of financial position, which means that there has been no
revaluation of PPE. If we assume that no PPE was sold during the
year, we can calculate that PPE amounting to R32 000 was purchased
during the year (an outflow of cash).
What if?
The statement of financial position indicated that the revaluation
surplus account increased by R12 000 during the year. A revaluation
gain is not a cash flow figure and you will need to adjust the Asset
account to find out how much was spent on acquiring assets. PPE
amounting to R20 000 was purchased during the year (an outflow of
cash).
The increase in the cost of plant relating to an acquisition will be
recognised as an investing cash flow unless there is an outstanding
liability relating to the acquisition of the plant. We will look at
investing activities in more detail in section 14.8.6.

14.8.4.3 Cash flows from financing activities
Decrease in long-term loan
Loans raised (inflow) and repaid (outflow) need to be disclosed
separately in a statement of cash flows. You will need to check that
the R5 000 is actually a repayment of R5 000. The difference between
the opening and closing balance (R5 000) could also be as a result of
both borrowing and repaying loans during the year. For example, if
the business had borrowed R50 000 and repaid R55 000, the net
effect would be a decrease in the loan balance of R5 000. We will
look at financing activities in more detail in section 14.8.7.
Let's complete the entire statement of cash flows for Creative

Clothing using both the direct and indirect methods.

direct method
Interest paid (3 000)
Dividends paid (19 000)
Tax paid (18 000)
Net cash inflow from operating activities 43 500 1
Acquisition of non-current assets (32 000)
Net cash out ow from investing activities (32 000) 2
Decrease in long-term loan (5 000)
Net cash out ow from nancing activities (5 000) 3
Net increase in cash and cash equivalents 6 500 1+2+3
Cash and cash equivalents at beginning of period 0
Cash and cash equivalents at end of period 6 500

indirect method
Adjustments:
− Interest expense (3 000)
+ Depreciation 26 000
Increase in trade receivables (10 000)
Increase in stationery on hand (2 000)
Increase in accrued expense 2 500
Interest paid (3 000)
Dividends paid (19 000)
Tax paid (18 000)
Net cash inflow from operating activities 43 500 1
Acquisition of non-current assets (32 000)
Net cash out ow from investing activities (32 000) 2
Decrease in long-term loan (5 000)
Net cash out ow from nancing activities (5 000) 3
Net increase in cash and cash equivalents 6 500 1+2+3
Cash and cash equivalents at beginning of period 0
Cash and cash equivalents at end of period 6 500
The amounts shown as cash and cash equivalents at the beginning
and end of the period come from the bank information on the
What does Alexander's cash flow tell us?

1. Where the money in the business is being generated
In Alexander ‘s business, sufficient cash is being generated by
operations (day-to-day operations of the business) to pay the
interest on borrowed money and to reward the owners for the
capital they invested in the business (dividends).
2. What the business is doing with the money it has generated
The business has expanded its capacity by acquiring additional
non-current assets. If the business was maintaining capacity, it

would have indicated this on the cash flow by stating
“Replacement of non-current assets”. The business has also
repaid part of its loan.
3. Can Alexander’s business meet its liabilities?
Alexander’s business has a cash balance of R6 500. If we look on
the statement of financial position, we can see that he has a
number of short-term debts that will need to be paid.
Shareholders for dividend 12 000
SARS 24 000
All of these items are short-term liabilities and will need to be
paid within the first two months of the new financial year.
Alexander’s business does not currently have enough cash on
hand to pay these liabilities.
Unless the trade receivables pay within the first 2 months,
Alexander may have to take out a loan (or increase his bank
overdraft) to pay for some of these liabilities when they fall due.
Sustainability of the business: analysing the statement of cash flows

One of the best measures of the sustainability of a business is the
ratio of cash generated during the year to total debt. This will give
an indication of whether the business is generating sufficient cash to
repay its loans.
In Alexander’s example, his cash-to-total-debt ratio is 7% (6
500/88 000). The business has generated sufficient cash to cover only
7% of the total debt of the business.
Businesses have discretionary and non-discretionary cash flows.
Discretionary cash flows are cash flows that the business has the
option of whether to spend or not, for example, expanding their
productive capacity (purchasing non-current assets), or paying

dividends to the shareholders. Some of the cash flows of a business
are non-discretionary. These are cash flows that will have to occur in
order for the business to survive, such as the payment of tax and
interest, and the replacement of their productive capacity. If a
business does not invest money in maintaining its productive
capacity, the business will not be able to generate income.
If we look at Alexander ‘s business, we can see that R51 000 of the
cash outflows were of a discretionary nature (R32 000 to expand the
business and R19 000 to the shareholders). Businesses need to make
sure that they retain enough money in the business and if cash is
short, they need to cut down on discretionary spending.

14.8.5.1 Understanding the difference between cash
from operations and profit before tax
Cash flows from operations will differ from profit for three reasons:
1. Effect of the accrual concept

These are differences that arise because an item can be
recognised on the statement of comprehensive income, and
therefore impact on the profit calculation in a different period
from when the cash flow takes place.
2. Effect of non-cash flow items

These are differences that will never give rise to cash flows.
Examples include depreciation, impairment, and profit or loss
on disposal. A payment to purchase a machine can lead to a
cash flow (investing cash flow), but recognising the depreciation
expense does not lead to a cash flow. Non-cash flow expenses

and income impact on the profit calculation but will not lead to
an inflow or outflow of cash.
Let's look at the journal entry processed to recognise

depreciation.
Neither the Dr entry nor the Cr entry is Bank. The entry will
never give rise to a cash flow. Bad debts provide another
example of a non-cash flow adjustment. The journal entry to
recognise bad debts is as follows:
As with depreciation above, neither the Dr entry nor the Cr
entry is Bank. The entry will never give rise to a cash flow.
3. Separate classification in the statement of cash flows

This category of differences arises from the requirements
specified when presenting a statement of cash flows. Interest
income, dividend income and interest expense will impact on
profit before tax. Items such as interest received and paid, tax
received and paid, and dividends received and paid are
required to be presented separately in a statement of cash flows.
These items are disclosed after the cash from operations amount
is calculated.
Effect of the accrual concept (profit before tax) − a worked example

You have been given the following information regarding Tiny Tots’
first month of trading.

Sales 100 000
Purchases 60 000
Wages 20 000
Depreciation 10 000
1. Assuming that there is no closing inventory, calculate the profit
for Tiny Tots for the year.
2. Assuming that purchases, wages, telephone and sales were paid
or received in cash, how much money would Tiny Tots have in
the bank at the end of the year?
3. Why is the cash in the bank different from the profit figure?
4. If the business had closing inventory of R20 000, how would this
influence the profit?
5. Would the closing inventory influence the amount of cash in the
bank? Explain your answer.
6. Assume that all the sales are on credit and that 40% of the
debtors have not paid by year-end. How would this influence
the profit? How would this influence the amount of cash in the
bank at the end of the year? What would the Trade receivables
balance be at the end of the year? Assume that there is inventory
on hand amounting to R20 000 at the end of financial period.
7. Assume that all the purchases are on credit and that 30% of the
creditors have not been paid by the end of the year. How would
this influence the profit? How would this influence the cash in
the bank? What would the trade payable balance be at year-
end? Assume that there is inventory on hand amounting to R20
000 at the end of financial period.
Let's review the solution.

1. Profit for the year
Tiny Tots has made a profit for the year of R5 000 for the year.
2. Cash in the bank
Cash sales 100 000

Cash purchases (60 000)
Wages (20 000)
Telephone (5 000)
Cash in the bank 15 000
Tiny Tots has R15 000 cash in the bank at the end of the year.
3. Points 1 and 2 above show us that the cash balance and the
profit figure in this example differ because depreciation is a
non-cash flow expense. Remember that depreciation is the
allocation of the cost of the asset over its useful life and is not an
expense that is paid in cash. The outflow of cash would have
occurred either when the asset was bought (assuming it was
bought for cash) or when the loan was repaid (assuming it was
bought on credit). Depreciation is a non-cash flow item because
the transaction does not affect the Bank account. (Neither the
debit nor the credit entry affects Bank.)

4. Influence on profit
Sales 100 000

Less: Cost of sales (40 000)
Purchases 60 000
Less: Closing inventory (20 000)
Gross pro t 60 000
Less: Expenses (35 000)
Wages 20 000
Telephone 5 000
Depreciation 10 000
Profit would be R20 000 higher. In this case, to generate R100
000 sales income, Tiny Tots had to sell only R40 000 worth of
inventory (R20 000 inventory on hand at yearend). In question 1
they sold R60 000 inventory to generate the same amount of
sales revenue (they did not have any inventory on hand at year-
end).
5. Although Tiny Tots has not sold the closing inventory
amounting to R20 000, it still spent the money when purchasing
the inventory. The actual purchase of inventory resulted in a
cash outflow of R60 000, whereas the expense incurred and
recognised in profit occurs only when the inventory has been
used (sold). Remember that we have assumed that all purchases
and expenses (other than depreciation) are paid in cash.
Cash sales 100 000

Cash purchases (60 000)
Wages (20 000)
Telephone (5 000)
6. Even though 100% of the sales were on credit and 40% of the
cash from the sales has not been received, it will not affect the
sales amount recognised in profit. Income is recognised when it
is earned, so the full R100 000 will be recognised on the
statement of comprehensive income.
Sales 100 000

Purchases 60 000
Gross pro t 60 000
Wages 20 000
Telephone 5 000
Depreciation 10 000
However, if all the sales are on credit and 40% of the debtors
have not paid by yearend, it will affect the amount of cash the
business has received. If 40% of the debtors have not paid by
year-end, the business will have received only R60 000 (R100
000 × 60%).
Sales received in cash 60 000

Purchases paid in cash (60 000)
Wages (20 000)
Telephone (5 000)
Cash in the bank (25 000)
7. Even if all the purchases are on credit and 30% of the creditors
have not been paid by the end of the year, it will not affect the
Cost of sales amount recognised in profit. The Cost of sales
expense (purchases less closing inventory) is recognised when it
is incurred (when the inventory is sold) and not when the cash
is paid for the inventory.
Sales 100 000

Purchases 60 000
Gross pro t 60 000
Wages 20 000
Telephone 5 000
Depreciation 10 000
However, if all of the purchases are on credit and 30% of the
creditors have not been paid by the end of the year, it will affect
the amount of money Tiny Tots has paid out. Tiny Tots would
have paid only R42 000 (R60 0000 × 70%).
Sales received in cash 100 000

Purchases paid in cash (42 000)
Wages (20 000)
Telephone (5 000)
14.8.5.2 Additional examples of non-cash flow

income and expenses
14.8.5.2.1 Bad debts

Bad debts written off will appear on the statement of comprehensive
income as an expense. The following entry was processed to write
off the debtor:
We can see from the journal entry that there is no entry in the Bank
account, and therefore the bad debt amount is non-cash flow
expense, and will be treated in the same way as depreciation when
calculating cash from operations on the direct method.
14.8.5.2.2 Impairment expense

The impairment expense discussed in Chapter 11 was the amount by
which the asset was written down to ensure that the carrying value
(cost less accumulated depreciation) reflected on the statement of
financial position was not more than the maximum future benefit
expected to flow from the asset. The following journal entry is
processed to write the asset down:

The impairment loss is an example of a non-cash flow item and will
be treated in the same way as depreciation when calculating cash
from operations on the direct method.
14.8.5.2.3 Profit or loss on sale of non-current asset

The profit or loss made on the sale of a non-current asset is a non-
cash flow item. The proceeds (actual cash received) from the
disposal will appear on the statement of cash flows as an investing
activity.
The profit or loss on disposal amount will be part of the operating
expenses line item on the statement of comprehensive income. Any
profit on sale of asset must be added back to the operating expenses
profit figure and any loss on sale of asset must be subtracted from
the operating expenses figure when calculating the amount of cash
paid to other suppliers and employees.
Something to do 2
A vehicle had originally cost R50 000. On the date of sale, accumulated
depreciation amounting to R35 000 had been written off on the vehicle. The
vehicle was sold for R19 000 cash.
1. Prepare the Asset disposal ledger account entries to record the sale of the
following non-current asset.
2. Assume that the profit on sale is included in the operating expenses amount
(this would be referred to as net operating expenses) on the statement of
comprehensive income. Explain how this information will be treated when
calculating cash from operations on the direct method.
Check your answers
1.
From the Ledger account, we can see that the actual cash flow amount is R19
000. This will appear on the statement of cash flows under investing activities.
2. If the R4 000 profit on disposal has been included in the operating expenses
amount (referred to as net operating costs or net operating expenses (NOE)), the
NOE would be R4 000 less that the operating expenses [NOE = operating
expenses less operating income]. To calculate the cash paid to suppliers under
the direct method we will add the profit on disposal back to the NOE amount.
Something to do 3
You have been provided with the following information regarding Judy's
business. Her business has a year-end of 31 December:
Judy wants to know how much money she received from her debtors (cash from
customers) and how much money she paid to her suppliers and employees
during X1 (cash paid to suppliers and employees).
Check your answer
Remember that Judy's sales on the statement of comprehensive income could be both
cash and credit sales. Judy's purchases could be either for cash or on credit.
We need to use the opening and closing balances for trade receivables, inventory
and trade payables as well as the information from the statement of comprehensive
income to calculate the actual cash paid.
Cash from customers
Debtors of R10 000 were outstanding from last year and the business had sales of
R95 000 during the year. The maximum the business could receive in cash from
debtors is R105 000 (10 000 + 95 000). However, debtors amounting to R8 000 are
still outstanding at the end of this year. The actual cash Judy received from debtors
during the year amounts to R97 000 (105 000 − 8 000).
Cash to suppliers and employees
a) Cash paid to suppliers of inventory

In order to calculate how much we paid our suppliers (trade payables) for inventory
purchased, we need to know how much inventory was purchased during the year.
We'll use the Cost of sales account to calculate the Purchases amount.
Purchases amount to R45 000 (65 000 − 20 000). The business could have
purchased a total of R65 000 (R55 000 + R10 000) inventory during the year. The
business had R20 000 at the start of the year, so they needed to purchase for only
R45 000.
If we look at the Trade payables account, we can see that we had

creditors of R12 000 outstanding from last year. The business
purchased inventory for a further R45 000 during the year. The
maximum the business could pay creditors in cash is R57 000 (12 000
+ 45 000). However, trade payables amounting to R18 000 are still
outstanding at the end of this year. The actual cash we paid to our
suppliers during the year amounts to R39 000 (57 000 − 18 000).
b) Cash paid to other suppliers and employees
Operating expenses 25 000

Adjusted for non-cash ow items and items separately disclosed
Depreciation (7 500)
17 500
The total cash paid to suppliers and employees is:

Cash paid to suppliers for inventory 39 000
Cash paid to other suppliers and employees 17 500
Cash paid to suppliers and employees 56 500
The cash amount of R56 500 paid to suppliers and employees includes the amount
paid to our suppliers for inventory (R39 000) and the amount paid to other suppliers
and employees (R17 500). The cash paid to other suppliers includes the supply of
labour (wages and salaries) and the supply of services (electricity, telephone, water).
Using journal entries to understand a statement of cash flows
Judy would have processed the following entries during X2:
The debits and credits to the Bank account represent the amount of cash flow that
took place during the year, and that is what is included in the statement of cash flows.
Judy's statement of cash flows would show the following if the direct method was used:
Cash from operating activities
Cash received from customers 97 000
Something to do 4
You have been given the following extract from the statement of financial position
and statement of comprehensive income of Barney Ltd. How would you record
the changes in working capital for Trade receivables under the indirect method?
\
Check your answer
Trade receivables decreased during the year − the balance at the end of the year is R5
000 less than the balance at the beginning of the year. This means that the business
received R5 000 more in cash than the total amount of sales it made during the year.
The business made sales of R560 000 but received cash of R565 000. We will add R5
000 to the profit figure because an additional R5 000 that is not recorded in the profit
figure has been received in cash.
Decrease in trade receivables 5 000
Let's look at it another way.
When the closing Trade receivables balance at the end of this year is less that the
closing Trade receivables balance at the end of last year (decreased), it means that
some of the debtors outstanding from last year paid us during the current year. The
current year's sales, as stated in the statement of comprehensive income, will not
include this repayment (as we would have credited sales last year). In order to convert
the accrual profit figure to a cash figure we will need to increase the profit by the
additional cash received.
Something to do 5
You have been given the following extract from the statement of financial
position and statement of comprehensive income of Barney Ltd. How would you
record the changes in working capital for Inventory under the indirect method?
Check your answer
Inventory decreased during the year − the balance at the end of the year is R15 000
less than the balance at the beginning of the year. The decrease in inventory of R15
000 will be added back to Profit for the year as part of the Working capital changes.
Decrease in inventory 15 000
The Cost of sales amount decreases profit, but this recognises only the inventory that
has been sold (used) during the year. If the inventory balance has decreased during
the year, it means that some of the inventory sold this year (and included in Cost of
sales) is inventory that was purchased last year. We are trying to convert the Cost of
sales figure to what was actually purchased this year. R15 000 inventory was
purchased last year (cash flow) and sold this year (expense recognised). COS expense
is higher than the amount of inventory purchased during the year. We need to add R15
000 back to profit to calculate the cash from operations.
Something to do 6
You have been given the following extract from the statement of financial position
and statement of comprehensive income of Barney Ltd. How would you record
the changes in working capital for Trade payables under the indirect method?
The purchases amounted to R415 000.
Check your answer
Trade payables decreased during the year − the balance at the end of the year is R5
000 less than the balance at the beginning of the year. The business paid creditors R5
000 more than the amount of inventory purchased during the year. We can see in the
account above that the business purchased inventory amounting to R415 000 but has
paid R420 000. R5 000 must be subtracted from the profit figure because although
the inventory adjustment included all purchases made this year, we paid R5 000 to
creditors for purchases made last year. The cash flow was greater than the amount of
inventory purchased.
Decrease in trade payables (5 000)
14.8.6 Cash flows from investing activities in more
detail
The cash flow from the purchase and disposal of non-current assets
is recorded in the investing activities section on the statement of cash
flows. It is important to remember that we are interested only in the
actual flow of cash into or out of the business in respect of the
purchase or sale of non-current assets.
Did you know?

The cash spent on non-current assets would be used to maintain operating
capacity by replacing non-current assets or to expand operating capacity of an
entity by purchasing additional assets.
It is important to disclose the replacement of assets and the
expansion of assets separately as it allows the users of the statement
of cash flows to see whether the business is maintaining or
expanding the productive capacity of the business. Remember that if
we did not have this split, the users would not understand the
intention of the owner or manager when they spent money on non-
current assets. It is also important to know how much was spent on
additional assets in order to predict future cash income from using
these assets.
Buying and selling assets during the year
Something to do 7
The following information is an extract from Barney Ltd's statement of financial
position. Calculate the cash inflows and outflows that occurred from investing
activities.
The following additional information has also been provided:
Assume that any Property, plant and equipment purchased has been
purchased for cash.
•
During the current financial year a motor vehicle was sold for R15 000 cash.
The vehicle had a net carrying amount of R12 000. The vehicle originally cost
•
R25 000. A newer model, for which the company paid cash, replaced this
vehicle. No other purchases or disposals took place during the year.
Barney Ltd purchased the land five years ago. It was decided to revalue the
land during the year and a registered agent had revalued the land and
•
building.
• No furniture was sold or acquired during the year.
Check your answer
Barney Ltd bought and sold vehicles during the year. We need to take both these
transactions into account in calculating the cash flows during the year. If we look at the
account above, we can see that the company has purchased a vehicle amounting to
R46 000. This will be a cash outflow on the statement of cash flows.
What was the amount for depreciation on vehicles that was taken to the statement of
comprehensive income?
Remember that if a vehicle was sold, the accumulated depreciation on that vehicle
needs to be taken out of the Accumulated depreciation account and transferred to the
Asset disposal account so that the profit or loss on disposal can be calculated.
The carrying value of the vehicle is R12 000. Remember that the carrying value is
the difference between the cost of the asset (R25 000) and the accumulated
depreciation that has been written off on the asset. In this case the accumulated
depreciation is R13 000 (25 000 − 12 000).
R21 520 of depreciation on motor vehicles has been deducted in calculating the
profit. Remember that the depreciation amount is a non-cash flow item. When we
prepare the section relating to cash from operating activities we will need to make an
adjustment for this non-cash flow item.
The vehicle was sold for R15 000 cash. This is the amount that will appear in the
investing activities section of the statement of cash flows as Asset disposal. This is an
inflow of cash into the business. The profit on disposal will appear on the statement of
comprehensive income but it is a non-cash flow item. When we prepare the cash from
operating activities section, we will need to make an adjustment for this non-cash flow
item.
The balance on the Land account increased from R67 000 to R127 000. This increase
was not due to the purchase or replacement of additional land but to a revaluation of
the existing land. This means that although the value of the asset has increased, it is
not due to an outflow of cash. The increase of R60 000 will not appear on the
statement of cash flows.
How do we know that this entry is a non-cash flow item?
Let's look at the journal entry that would be processed when the land was re-valued.
We can see that neither the debit entry nor the credit entry will be posted to the Bank
account. This means that the transaction has not led to a cash flow. The surplus on
revaluation of land is a noncash flow item.
There has been no purchase or sale of furniture during the year. This means that there
has been no inflow or outflow of cash relating to furniture during the year.
The depreciation amount that has been taken to the statement of comprehensive
income for Furniture is R2 594. Remember that the depreciation amount is a non-cash
flow item. When we prepare the cash from operating activities section we will need to
make an adjustment for this non-cash flow item.
14.8.7 Cash flows from financing activities in more

detail
Share capital
In the chapter on companies we learnt that share issue expenses had
to be written off to the Share capital account.
Something to do 8
James, a friend of Judy, has a printing company called Print Express Ltd in
Observatory, Cape Town. His printing business is a public company and he has
recently issued
10 000 shares at R5. All the shares have been taken up and he has incurred
share issue expenses of R7 500.
Record the transaction in the general ledger of Print Express Ltd.
Check your answer
Share issue expenses are written off to the Share capital account.
Let's see what the Share issue expenses account would look like .
The important point to note is that there has been a cash outflow of R7 500.
Let's look how this would be recorded on the statement of cash flows.
The share issue is a financing activity. On the statement of cash flows we will show the
net proceeds from the share issue. The net proceeds from the share issue amount to
R42 500 (50 000 − 7 500).
Financing activities
Net proceeds from share issue R42 500
This information would appear on the statement of cash flows. The share issue
expenses have been paid and are an outflow of cash (as part of its financing activities).
For a diagram that summarises the statement of cash flows, see page
560.
Something to do 9
Assume that the interest-bearing loan on the statement of financial position
shows an opening balance of R25 000 and a closing balance of R20 000. You
have been told that the business raised a loan amounting to R70 000 during the
year. Prepare the interest-bearing loan account and identify any inflow and
outflows of cash that occurred during the year.
Check your answer
The business raised a loan amounting to R70 000 (inflow of cash) and repaid a loan
amounting to R75 000 (outflow of cash).

• The statement of cash flows reflects the actual cash flows into and
out of the business.
• The statement of cash flows can be drawn up according to the
direct or the indirect method.
• The statement of cash flows shows the cash flows from
operations, from operating investing and financing activities.

• The statement of cash flows is useful to look at when comparing
businesses, as it is not influenced by the choice of accounting
policies.
What's next?
In the next chapter, Judy learns how to evaluate all the information
that she has disclosed on the financial statements so that she can
better understand how well her company has performed.
Useful web links
<www.bitpipe.com/tlist/Cash-Flow.html>
<www.itweb.co.za/sections/moneyweb/2009/0902242300.asp>
<www.moneyweb.co.za/mw/view/mw/en/page67?
<southafrica.smetoolkit.org/sa/en/content/en/102/Cash-Flow-Triage>
<southafrica.smetoolkit.org/sa/en/content/en/4736/Case-Study-I-wish-
I-had-done-this-from-thebeginning>
<www.toolkit.com/small-business-guide/sbg.aspx?nid=p06 − 4144>
Source: [Online]. Available: <www.kpmg.co.za/images/naledi/pdf>
(as adapted). [Accessed 28 January 2009].

QUESTIONS
QUESTION 14.1 (B)

Outdoor Stores is an adventure group that offers personalised
adventure vacations, both to the domestic and international market.
The owner has been given the option of buying up a small
competitor that has been extremely successful in attracting the
Japanese market. The competitor is asking a cash price of R350 000.
Outdoor Stores is able to raise a loan of R150 000 and requires a
positive cash balance of R50 000 at the start of next year. The
business had R24 000 in the bank account at 1 January 20X9. There
was no capital expenditure during the year, however the owner
withdrew R10 000 for personal use.
Income statement for the year ended 31 December 20X9

R
Income
Fees 464 400
Less: expenses
Various 253 300
Net income 211 100
The following balances were extracted from the balance sheet of

Outdoor Store.
31 December 20X8 31 December 20X9
R R
Prepaid expenses 12 150 0
Accrued expenses 0 31 200
Unearned fee income 51 400 47 150
Accrued fee income 0 337 500
Assume that the 20X8 prepaid and unearned items became expenses
or were earned in 20X9, and the accrued items were either received
in cash or were paid in 20X9.
Determine whether Outdoor Stores has sufficient cash on hand to
purchase the new business venture.
QUESTION 14.2 (C)

Ignore VAT.
Assume a company income tax rate of 28%.
Assume dividends tax of 20%.
Fly-a-Flag Ltd is based in Gauteng. The company started operations
in November 20X5 manufacturing and selling flag memorabilia for
sports fans around the world. Fly-a-Flag Ltd has a year-end of 31
October. You have been provided with the following information:

Fly-a-Flag Ltd: Statement of financial position (extract) as at 31
October 20X11
20X11 20X10
Non-current assets
Property, plant & equipment 11 321 600 15 635 000
Current assets
Inventory 1 046 533 1 125 060
Equity
Share capital − Class A 46 638 500 ?
Revaluation surplus ? 1 700 000
Loans 2 770 000 ?
Current liabilities
Trade payables 823 060 896 710
Accrued interest expense ? ?
Shareholders for dividends ? 515 625
SARS (Income tax ) 300 000 200 000
SARS (Dividends tax) 45 000 10 000
Commission income received in advance 10 250 14 365
1. Fly-a-Flag Ltd consistently applies a 60% mark-up on cost. The
company reported cost of sales expense of R21 161 710 for the
year ended 31 October 20X11, which included R620 000 of
inventory write-downs due to damage and loss.

2. Net operating costs for the year ended 31 October 20X11
included, amongst others
Depreciation expense R1 632 000
Impairment expense ?
Dividend income 420 000
3. Property, plant and equipment (PPE) consists of land, buildings
and machinery. The land is measured using the revaluation
model and is not depreciated. Both buildings and machinery are
measured on the cost model. Buildings are depreciated on the
straight line method at 10% per annum and machinery on the
diminishing balance method at 20% per annum.
4. The land was acquired on 15 November 20X6 for a cost of R3
750 000. On 31 October 20X8, the land was revalued for the first
time by an independent property expert. The next valuation
took place on 31 October 20X11. This valuation showed that due
to the decline in property prices over the last three years, the
property’s fair value had fallen to 60% of the fair value on 31
October 20X8.
5. The only loan owed by Fly-a-Flag Ltd on 1 November 20X10 had

been granted by Fly With Us Bank on 1 February 20X9. Loan
repayments of R50 000 each are paid every six months on 1
August and 1 February until the loan is settled in full. On 31
October 20X11, the business had five installments remaining on
this loan.
6. On 1 July 20X11, the business took out a further loan from Fly
With Us Bank in order to fund local expansion. The loan
agreement stated that loan payments be made in equal quarterly
installments (i.e. one installment every three months) starting on
1 October 20X11. The bank agreed that a total of 15 installments
be made after which the loan would be settled in full.

7. The lending policy of Fly With Us Bank states that for all long
term loans, interest is charged at a fixed rate of 9%, payable in
arrears on the same dates as loan repayments. The two loans (in
points 5 and 6 above) are recorded in the same loans account in
the general ledger of Fly-a-Flag Ltd. The bookkeeper records all

interest payments as interest expense when paid. All relevant
reversals were recorded on 1 November 20X10.
8. On 1 November 20X10, there were 2 062 500 Class A shares in
issue. These shares had been issued at an issue price of R7 each.
Total share issue costs of R400 000 had been incurred.
9. During the year ended 31 October 20X11, in preparation for the
20X14 Soccer World Cup in Brazil, Fly-a-Flag Ltd was approved

by Brazil’s minister of trade and industry to set up a factory in
the northern region of Brazil. The directors decided to finance
this expansion through an issue of Class A shares to the public.
On 1 March 20X11, 3 000 000 shares were offered to the public at
an issue price of R12 each. On 30 June 20X11, the closing date
for applications, 85% of the shares had been applied for. The
share issue was underwritten by Flagship for a commission to
be paid on 1 August 20X11, the date that shares were issued.
Other share issue costs amounted to R879 000 and were paid on
3 November 20X11. This is the only share issue that has taken
place since the shares were issued on incorporation of Fly-a-Flag

Ltd.
10. An interim dividend of 30 cents per share was declared on 30
April 20X11 and a final dividend of 50 cents per share was
declared on 31 October 20X11. It is company policy to declare
interim and final dividends on these set dates and to pay
dividends one month after declaration date. All of the dividend
income of R420 000 was received from South African companies
during the financial year.

Operating profit for the year ended 31 October 20X11 amounted
11.
to R4 845 000, which was equal to 95% of taxable income.
Interest expense for the year was R106 650. All of this interest
expense related to the loans described in additional information
points 5, 6 and 7 above.
1. Refer to additional information point 1.
Prepare the trading account as it would appear in the general

ledger of Fly-a-Flag Ltd for the year ended 31 October 20X11.
Ignore dates. (4 marks)
2. Refer to additional information points 3 and 4.
Prepare the general journal entry/ies that would be processed
by Fly-a-Flag Ltd on 31 October 20X11 in respect of land. Show

closing entries. Ignore dates and narrations. (8 marks)
3. Refer to additional information points 5, 6 and 7.
a) Prepare the loans account as it would appear in the general

ledger of Fly-a-Flag Ltd for the year ended 31 October
20X11. (6 marks)
b) Prepare the accrued interest expense account in the general

ledger of Fly-a-Flag Ltd for the year ended 31 October
20X11. (7 marks)
4. Refer to additional information points 8 and 9.
a) Prepare the share capital − class A account as it would

appear in the general ledger of Fly-a-Flag Ltd for the year
ended 31 October 20X11. (6 marks)
b) Calculate the percentage that was agreed on by Flagship

and Fly-a-Flag Ltd for underwriter’s commission. (2 marks)
5. Refer to ALL of the above information.
Prepare the operating activities section of the statement of cash

flows of Fly-a-Flag Ltd for the year ended 31 October 20X11 on
the indirect method. (19 marks)
6. Refer to your answer in part 5 above.
Explain WHY you chose to treat the following items as you did
in the operating activities section of the statement of cash flows:
a) Depreciation expense (2 marks)
b) Bad debts expense (2 marks)
7. Refer to ALL of the above information.
Prepare the financing activities section of the statement of cash

flows of Fly-a-Flag Ltd for the year ended 31 October 20X11. You
are NOT required to provide headings. (4 marks)
QUESTION 14.3 (B)

The following is an extract from the statement of financial position of
Vuka Ltd. A summarised statement of comprehensive income for the

current year ending 31 July X2 is also given for analysis.
X2 X1
R'000 R'000
Share capital 3 600 2 000
Trade payables (for inventory) 1 150 900
Accrued telephone expenses 20 25
Prepaid rent 10 8
Inventory 2 000 1 000
Accrued interest expense 15 12
Non-current assets at carrying amount 769 850
Shareholders for dividends 180 150
1. The following amounts are included in operating expenses:
R'000
Depreciation expense ?
Interest expense 60
2. No non-current assets were sold or purchased during the year.
3. On 29 July X2, the directors of Vuka Ltd declared a final
ordinary dividend of 15 cents per share payable on 21 August
X2.
Prepare only the cash flow from operating activities section of the
Statement of cash flows of Vuka Ltd for the year ended 31 July X2,
insofar as the given information allows, using the direct method.
Exclude the reconciliation note of profit before tax with cash

generated from operations.
“Wow! I can hardly believe that my small business has grown into
a company that is recognised as the leading manufacturer and
retailer of leather products in the country!”
Judy has come a long way since we first introduced her to
accounting concepts. Do you remember that her accounting
system at one time consisted of a record of money received and
paid? She now has to comply with sophisticated accounting
regulations that govern how she presents her financial
information.
“I really appreciate that accounting regulators have created
universal rules for presenting information,” she told her friend
Tracey. “This allows me to compare the information in my
company's financial reports to any other company's reports. It also
reduces room for errors in judgement. I really like the idea of being
able to read a set of company financial statements wherever I go
in the world.”
“Now that my company is on the map and doing really well, I
would like to learn more about investments. At a recent
shareholders' meeting, some of the shareholders suggested that
we consider applying for venture capital to assist with our 10-year
expansion plan. Did I tell you that we plan to go global and start
producing international designs here in South Africa? We'll be able
to generate 50% of the capital we need from the cash generated
by current operations. The rest will need to be attracted from
investors.”
“I'm interested in finding out more about how these suppliers of
finance decide whether to invest in a business or not. What tools
do they use to help them decide whether a business is going to do
well or not? I will need to know how to value the business I've
created if I ever want to sell my share, and it will also be useful
when I am thinking about buying shares in other companies,” she
continued.
“The financial statements are a good start, I'm sure. They are
reliable and relevant. But how do I use them to work out how well
a business is really doing? Knowing the profit doesn't seem
enough. There must be more to these financial reports than meets
the eye.”
Learning objectives
• Explain the objectives of financial analysis
• Compare different techniques for analysing and interpreting financial statements
• Calculate key ratios for evaluating all aspects of a business, including performance
and capital structure
• Describe the results of the analysis, with suggestions for improvement or
explanation of the causes
• Consider the benefits and limitations of financial analysis.

Judy has sensed that the financial information presented in the
financial statements reveals more over time than just the profit of a
business. By analysing the information more deeply and
understanding the relationship between different pieces of
information, we are able to create a more complete picture of a
business. This picture can help to plan for the future and evaluate
the performance of a business. It can also be used to decide whether
or not to invest in a business.
Judy would like to know more about how the information
contained in the financial reports can be analysed. Because she is
interested in attracting additional investment to the business, she
needs to know what potential investors will be looking for when
they decide whether or not to invest in her business.
How could financial analysis be used to solve the problem?

Judy could use financial analysis to determine whether her
company’s financial performance is above or below average when
compared to similar companies or to the whole industry in which
Handbags for Africa Ltd operates.
15.1 What is financial analysis?

Financial analysis is a process that extracts relevant information
about a business from all the information that is available and
converts it into a more useful format. The information is interpreted
to meet a specific need.
Our focus will be on examining how the information contained in
the financial statements can be interpreted to evaluate a business.

The techniques that can be applied will be presented without a
specific user or purpose in mind. This means that you will need to
decide which techniques to apply in whatever scenario faces you.
15.2 The purpose of financial analysis

Remember that the objective of a business is to maximise the wealth
of the owner. This is achieved if the net asset value of the business
increases owing to business operations − the business makes a profit.
If we review the financial statements, we can see if the business has
achieved this owing to decisions made in the paste. If we want to
make decisions about what we think will happen to the business in
the future, we will do a financial analysis of the business.
The objective of financial analysis is to assess the overall financial

performance and current position of a business and use this
information to evaluate the quality of the decisions made by
management to determine the expected future earnings and
understand better the associated risks. This has a number of uses in
practice.
The need could be to determine the financial health of a business
for the purpose of investing in it, or it could be to determine the
ability of a business to pay back its debt in the long term, for the
purpose of granting a loan. There are many uses and many users of
financial analysis, many of which will be considered in this chapter.
15.3 Who uses financial analysis?

Investors are an example of a group who would use financial
analysis as a tool for evaluating the financial health of a business.

There are many other users who use the financial statements for
various other purposes:
• Shareholders and potential shareholders may be interested in the

current and future profitability and liquidity of their existing or
potential investment
• Suppliers of short-term funding ( creditors) may be interested in

the ability of the company to repay debts
• Suppliers of long-term funding ( lenders) may be interested in the

ability of a company to repay interest and capital
• Employees may be interested in the long-term profitability to be
able to decide whether they will have a job in the future
• Auditors do tests to see whether the financial statements fairly

represent the position and performance of a company
• SARS is interested that the correct income taxation and VAT is
being paid
• Academics and research analysts may be interested in measuring

the expected returns or value of a business relative to the risks
associated with the business
• Customers might want to determine the reliability of their
suppliers
• Suppliers might want to know their future growth opportunities
which are influenced by the financial position of its buyers.

Whenever a business is being evaluated, an important factor that
needs to be considered is risk.

Risk is the probability that an expected outcome will not be realised.
For example, you have R1 000 to invest. If you invest in shares in a
company you may expect a return of 15% p.a. If you invest in the
money market, you expect a return of 7%. This is the expected (or
potential) return which could end up being different from the actual
return the investment earns. The risk is that the actual return is less
than the expected return. The choice to invest in shares will be seen
as riskier than investing in the money market as the probability that
the actual return will be less than the expected return is greater than
for the investment in the money market.
The performance of a business (the returns generated from
operation or the profit for the period) must be considered in relation
to its risks. The higher the risk of an investment, the higher the
expected return, as the likelihood of receiving that return is less.
It is useful to understand some of the risks affecting the financial
outcomes in a business. Understanding risk helps us to view the
results of our analysis of a business in relation to the risk associated
with the business.
15.4.2 Some of the risks affecting business

operations
Business risk is the risk reflected in the operations of the business.
This risk is the result of all the unexpected outcomes that could
affect the sales and costs in the business. Businesses with a high
percentage of fixed costs have a higher business risk. This is because
fixed costs (like rent) do not decrease if the sales of the business
decrease. Another way of looking at this is to say that even if there
are no sales i.e. no income, the business will still need to pay rent for
the month.
Financial risk is the risk faced by a business as a result of the
choice of how much debt or equity funding (financing structure) to
use. The risk is that the business will not earn enough from its
operations to be able to cover the interest owing on the debt. This
risk increases when the earnings decrease, because a decrease in
earnings means that it is more likely that the business will not be
able to cover the interest payments. Businesses that only use equity
funding will not be exposed to any financial risk.
15.5 Using financial analysis to evaluate

the business
A variety of techniques is available. Broadly, they can be divided
into two main approaches:
• Comparability
• Ratio analysis.
Usually a combination of the approaches is used; however, the
choice depends on the analyst and the purpose of the financial
analysis.
Consider again the qualitative characteristic of comparability. For
information to be useful for making decisions, it must be
comparable. Viewed on its own, an amount has little meaning. For
example, if you were presented with the fact that a company had
achieved sales of R250 000, what conclusions could you draw? This
result does not reveal much at all. Any measurement on the financial
statements will acquire meaning when it is compared with another

measurement. Can you think of measures against which we can
compare actual results?
Previous financial period

The most obvious comparative measure is the results obtained in a
previous financial period. The financial report presents comparative
financial statements so that a meaningful analysis of the information
can be conducted.
So if you were to consider the following: Sales last year were R200
000 and this year R250 000, what conclusions could you draw? Now
that you have something against which to compare the sales of R250
000, you can conclude that sales have increased by R50 000.
Something to do 1
Calculate the percentage increase in sales from last year to this year.
Check your answer
The increase is R50 000. The sales last year were R200 000. The percentage increase
is 50/200 × 100 = 25%.
Using the previous year’s amounts is one way of making the current
year’s amounts comparable. What other comparisons of financial
information can be made?
Company to company
The results of a company can be compared to those of other
companies to see whether the company is performing relatively
better or worse. These companies could be competitors in the same
industry or they could be other companies in which money is to be
invested for the purposes of earning a return. Managers would be
interested in finding out how competitors are performing and
investors or research analysts would be interested in working out
different returns from different investment alternatives.
Company to industry
The results of a company can be compared to the averages of the
industry in which the company operates. Earlier you identified the
sectors into which companies are divided. The averages of all the
individual results of companies operating in a sector or industry can
be compared to the individual company results to see whether the
company is performing above or below average.
How could Judy use this comparison to assist her in understanding

her business better?
Judy could compare the results of her company to those of other
companies that manufacture and sell leather goods. This will help
her to see whether her company would be relatively more or less
attractive as an investment when compared to other similar
companies.
To be able to compare financial information between two
companies, they must be prepared on a similar basis using the same
rules. This is one of the major advantages of International Financial
Reporting Standards. They enable comparison between companies
(even across countries), as their financial statements would be
prepared using the same accounting rules.

15.5.1.1 Comparability: a worked example
We’ll analyse the financial statements of Handbags for Africa Ltd,
the company presented in Chapter 12.

ANNUAL FINANCIAL STATEMENTS
6. Distribution to shareholders
9. Inventories
X6 X5
R R
Finished goods 1 744 000 2 472 000
Work in progress 1 715 000 1 236 000
Raw materials 201 000 288 400
Consumables 90 000 123 600
3 750 000 4 120 000
10. Trade receivable
X6 X5
R R
Trade receivable 26 778 570 24 528 570
Allowance for doubtful debts (850 000) 0
25 928 570 24 528 570
Trade receivables comprises amounts receivable for the sale of
goods for which the credit period ranges from 60 days to 80

days. The allowance for doubtful debts is an estimate of
amounts considered to be irrecoverable.
12. Share capital

The share capital of the company at 31 December was as
follows:
X6 X5
Authorised
5 million Class A shares
500 000 15% R20 Class B shares
Issued
2 190 000 Class A shares 31 980 000
1 700 000 Class A shares 21 500 000
150 000 15% R20 Class B shares 3 000 000 3 000 000
Total issued capital 34 980 000 24 500 000
Class A shares have the right to vote and no fixed dividend.
Class B shares have no voting rights and the right to a
cumulative fixed dividend.
The directors are authorised to allot all or any of the remaining
unissued shares on such terms and conditions as they may
determine. This authority will remain in place until the next
annual general meeting.
13. Trade payable, provisions and accrued charges

Trade payable and accrued charges are made up of amounts
outstanding for trade purchases and ongoing costs. The credit
period for trade purchases is between 15 and 30 days.
Let’s start analysing Handbags for Africa’s financial statements by
comparing the information for the two years presented. We’ll
consider two techniques that standardise the information being
compared so that we are comparing like with like. They are common
size financial statements, and common base-year financial
statements.
15.5.1.2 Common size financial statements

One way of improving the comparability of financial statements is to
show individual line items on the statement of financial position as a
percentage of total assets and on the statement of comprehensive
income as a percentage of total sales. This means that total assets on
the statement of financial position will be 100% and every other line
item on the statement of financial position is expressed as a
percentage of 100. In the statement of comprehensive income, total
sales will be 100% and every other line item will be expressed as a
percentage of 100.
Let’s apply this process to the financial statements of Handbags for
Africa. The amounts will have to be restated as percentages of total
assets or total sales.

What do you notice?
It is easy to compare each line item as a percentage of sales.
• If Cost of sales in X5 is 65%, this means that of every R100
received in revenue, R65 is spent on cost of sales. Cost of sales
expense has increased from the previous year (X5: 65.00% and X6:
69.07%).
• Net operating costs have, however, decreased from the previous
year (X5: 22.06% and X6: 18.92%).
• Interest income has increased and interest expense has decreased
from the previous year.

What do you notice?
• All the assets are stated as a percentage of total assets, and all the
equity and liability accounts are stated as a percentage of total
• Cash and Cash equivalents is a greater percentage of total assets
in X6 (16.55%).
• Share capital and retained income (the owner’s contribution)
represent a greater percentage of total equity and liabilities in X6

(41.82% and 20.33%), while long-term loans have decreased as a
percentage in X6 (20.32%).
The financial statements are easy to read and compare in this format.
This is because the information is displayed as percentages instead
of as numbers. This is particularly useful when comparing
companies of different sizes or two years of the same company, if it
changed its size (through acquisitions and disposals).
By looking at the percentages we can easily see the percentage
point increase or decrease from one year to the next. This is useful in
helping analysts to identify trends. It is easier than if rand amounts
have been used.
Did you know?

Percentage point change means the actual change in percentages. Therefore,
the change is calculated by subtraction or addition. If the gross profit changed
from 34.99% to 30.92%, it decreased by 4.08 percentage points.
Percentage change means the percentage by which the amounts changed. It is
computed using fractions. In the gross profit example, the percentage change
would have been 4.08% / 34.99% × 100% = 11.66% decrease.
You might also have heard that the Reserve Bank announces changes in the
repo rate of x basis points. 100 basis points are 1 percentage point.
We could use common size financial statements when comparing
one company to another, as well as when comparing one year to
another in the same company. This method highlights the
relationships of numbers to each other rather than the actual rand
values.
15.5.1.3 Common base-year financial statements

Another useful way of comparing financial statements over many
time periods is to choose a base year and express all the line items in
that year as 100%. All line items in future years would then be
expressed as percentages of the base amount. This analysis is useful
only for comparing information over time.
Common base-year analysis is also called trend analysis, a trend
being a movement over time. A trend could indicate a pattern that
may be expected to continue in the future. For example, if debtors
have increased by 5% every year for the past five years, there is an
upward trend in debtors. This could be useful information for
planning purposes.
Let’s apply this process to the financial statements of Handbags for
Africa Ltd, and use X5 as the base year. The amounts in future years
will have to be restated as percentages of the base year (X5). These
financial statements are also called indexed statements.
What do you notice?

Let’s look at the revenue information.
So revenue in X6 is 102.81%.
• We can see that although revenue increased by only 2.81%, Cost
of sales increased by 9.26%
• Net operating costs are significantly lower in X6 (11.86%)
• Interest income has increased and interest expense has decreased
in X6.
What do you notice?
• Share capital and retained income (the owner’s contribution) have
increased by 48.83% and 38.78% respectively during X6, while
long-term loans have decreased by 22.73% in X6.
The same benefits as for common size financials are apparent. The
example has shown us that comparisons provide useful information
on direction, extent and rate of change, as well as on trends.

Another way of improving the comparability of financial statements
is to calculate and compare financial ratios.

Ratios are expressed as percentages, multiples or time periods,
thereby avoiding differences in size and rand amounts from one
period to the next or between companies. This overcomes the
problem of comparing different companies and different time
periods.

If you had to sell 10 tickets to a concert, and you had sold 5, while
your friend had sold 8, you could compare your selling ability by
expressing the amounts as ratios.
Your sales are 5/10 × 100, or 50%, and your friend’s sales are 8/10
× 100, or 80%. The ratio of ticket sales is 50 : 80 (or 5 : 8). This means
that your friend has sold 60% (3 [8 − 5]/5 × 100) more tickets than
you.
If your friend was selling clothes with a total selling price of R1
000 and she had already realised sales of R600, then her sales would
be 600/1 000 = 60% of the total available for sale.
Can you compare your ticket sales with her clothing sales? In this
example we are comparing the number of tickets to the value of
clothing sold, clearly not similar items. If you say you have sold 5
tickets, and your friend says she has sold R600 worth of clothes,
there would be no way of comparing your activities. But if you say
you have sold 50% of your available stock and your friend says she
has sold 60% of her available stock, it is far easier to compare your
selling ability. Because we are using ratios, the size of the business or
rand amount of the transaction does not matter. The ratio reduces
the amounts to percentages, which are much more easily
comparable.
This example illustrates the usefulness of ratios as a technique for
making amounts easier to compare.

We have presented the most commonly-chosen ratios in this
textbook. For each ratio we will consider the following:
• How it is calculated
• What it measures
• How it is expressed
• What it reveals.
15.6.2 Liquidity
One of the main concerns in a business is the ability to pay accounts
as they become due. Liquidity refers to the speed with which current
assets are converted into cash. This cash is then used to finance
short-term debt, such as amounts owing to suppliers. A company
with enough liquid assets is more likely to settle debts on time.
To measure liquidity, we will compare the size of current assets to
current liabilities. Why? Current assets are usually easily convertible
into cash and this cash is used to settle short-term debts (current
liabilities).
15.6.2.1 Current ratio
Current ratio = current assets/current liabilities
This ratio is expressed as “times”, because the current assets are 2
times greater than the current liabilities. The higher the current ratio,
the more likely the company is able to pay back its debts on time. So
from the creditors’ point of view, a high ratio is good.
Is this good from all points of view? What about shareholders?
Money tied up in current assets could mean a lower return to

shareholders because the money is not earning a good return while
tied up in inventory, trade receivables and cash.
Something to do 2
Some current assets have a higher return than others do. Can you think of
an example?
Check your answer
Credit card customers in large retail firms are a good source of income when interest is
charged on their accounts. Interest of between 25% and 30% can be charged on these
balances. When the debtors' balances in these companies are high, they represent a
large source of income and a future source of finance.
15.6.2.2 Acid test ratio (quick ratio)

Can you think of an amount included under current assets in the
current ratio that might not be easily convertible into cash?
Inventory! Inventory is often the least liquid asset, because it
takes longer to convert into cash. Large stocks of unsold inventory
could be an indication that customers are not buying, and this could
mean that the inventory may be unwanted. Other reasons for large
inventories include:
• Damaged goods
• Overproduction or purchasing in excess of demand.
Whatever the reason, high inventory levels can affect the ability of a
business to pay back its debts. For this reason, it is useful to exclude
inventory from the evaluation of liquidity. This is what the quick
ratio achieves.
Acid (quick) ratio = (current assets − inventory) / current
liabilities
Once again, the ratio is expressed as “times”, and the higher the
ratio, the greater the amount of current assets (less inventory) in
relation to current liabilities, and the more likely the company will
pay back its debts on time.
The higher the stocks of inventory in a business, the greater will
be the difference between the current and quick ratios
Who would be interested in the liquidity position of the business
and these ratios?
• Creditors
• Banks
• Potential lenders.

The primary purpose for being in business is to generate profit by
successfully managing the assets used in the business (a process
referred to as asset management). Assets are by definition income-
generating items. We need to be able to measure how successfully
assets have been used to generate profit in the business.
These measures are sometimes called turnover measures or asset

utilisation measures. They measure how efficiently or productively
assets are used to generate sales.
Think about this 1

If two companies selling the same product had the same sales amount on their
statement of comprehensive income for the period, but one company invested
R100 000 in inventory and the other invested R200 000 in inventory, which
company would be regarded as more efficient?
Check your answer
The company that invested R100 000 in inventory would be regarded as more efficient
because it has been able to generate the same level of sales with half the investment
in inventory.
We’ll consider how effectively assets have been used in the business
by evaluating the efficiency of debtors, creditors, inventory, and
non-current assets.
15.6.3.1 Days inventory on hand

First we look at how fast the business can sell products.
If the cost of goods sold is R1 000 and closing inventory is R200,
how long do you expect it will take to sell off the closing inventory?
If R1 000 worth of goods were sold over a year, then R200 worth of
goods will be sold over 20/100 = 1/5 of a year.
We can translate this into days by calculating 1/5 × 365 = 73 days.
Let’s express this in the form of a ratio we can use to calculate the
number of days that inventory is expected to be held before being
sold:
Days inventory on hand = Inventory / Cost of sales × 365
The ratio will be expressed in days.
Another interpretation of this ratio is that if no additional
inventory were purchased, there would be sufficient inventory on
hand for the next × days of sales, in this example for the next 73
days.
The higher the ratio, the more cash is tied up in “idle” inventory.
Note, however, that a ratio that is too low may result in possible
stock-out problems.
15.6.3.2 Inventory turnover ratio

The efficiency of inventory management can also be expressed by
measuring the number of times the existing inventory was sold
during the year. This is shown by the following ratio:
Inventory turnover ratio = Cost of sales / Inventory
With a cost of sales of R1 000 and inventory of R200, the inventory
turnover ratio is 5 (R1 000/R200). The business turned over or sold
its existing inventory 5 times during the year.
This is known as the inventory turnover ratio. Notice that it is the
inverse of the days inventory on hand, and is expressed as “times”.
The lower the inventory turnover ratio, the more cash is tied up in
holding “idle” inventory. A business with a turnover ratio of 2 has
sold out its inventory only twice during the year. This means that
they are holding a lot of inventory. Note, however, that a ratio that is
too high (holding small amounts of stock) may result in possible
stock-out problems.
15.6.3.3 Debtors collection period (in days)
How quickly does the business collect the cash from credit sales? If
credit sales for the period are R100 000, and the trade receivable
balance in the financial statements is R20 000, how many days will it
take to convert the trade receivables balance into cash?
The answer is 73 days. Do you see why?
If R100 000 worth of sales are on credit, and the unpaid debts at the
end of the year are R20 000, then we can expect that debts remain
unpaid for:
20 000 / 100 000 = 1/5 × 365 = 73 days
This implies that it takes 73 days to collect the debts. It reflects the
number of days that sales are tied up in debtors before being
converted into cash.
This can be expressed with the following ratio:
Debtor collection period (in days) = Trade receivables / Credit
sales × 365
This ratio is expressed in days.
The shorter the period, the more quickly the business receives the
cash and is able to reinvest it in the business. Debtors should be
managed to ensure that the debt is collected within the credit term
period offered to customers. Remember that if these terms are too
short, the impact on sales might be negative.

15.6.3.4 Creditors' payment period
This measures the time we take to pay creditors.
Creditors’ payment period ratio = Trade payables / Credit
purchases × 365
This ratio is expressed in days, and usually we would want to have
this ratio as high as possible, while still being within the creditors’
settlement period (the credit limit given by out creditors). The longer
it takes to pay trade payables, the better it is for the company, as
trade payables are a cheap source of finance if we pay within the
specified credit period (0% interest during that period).
Think about this 2

Do you think that the closing balances for inventory, debtors and creditors are
the best measures to use when calculating the asset management ratios?
Check your answer
The reason we use closing balances is that we were trying to find out how long it would
take to collect the current debtors balance, pay off the current creditors balance, and
sell the existing inventory (the current balances are the closing balances shown on the
statement of financial position). In the same way as when we evaluate the return on an
investment, we usually compare the income earned on the investment to the
investment made at the beginning of the period in which the income was earned.
It may be more accurate to use the average of the opening and closing balances for
each item we are analysing as that approximates the average amount during the year.
In the ratios, regardless of whether we use closing balances or an average of opening
and closing balance, what is important is that we are consistent for each year so that
we can compare the ratios we calculate.
15.6.3.5 Working capital cycle
The debtors' collection period and the days inventory on hand ratios
measure the time delay between the purchase of inventory and the
collection of cash from the sale of inventory, assuming that we sell
inventory on credit. If we add the two ratios, we see how long cash
has been tied up in inventory and trade receivables. Note that for
cash sales the delay would be equal to the days inventory on hand
ratio.
This is part of the working capital cycle. Do you remember what
other item completes the working capital cycle? It is trade payables.
What if we did not pay cash for the inventory on day 0 but had to
pay for it only later, for example, on day 90? What is the difference
now between when cash leaves the business and when we receive
cash?
Let's look at the working capital cycle of a trading business

Note that it is possible for a company to have a negative working
capital cycle. Think of a company like Pick n Pay, which buys on
credit and sells for cash. They receive money from sales before they
have to pay their trade payables. This is what is meant by a negative
working capital cycle.
15.6.3.6 Total asset turnover rate

We have looked at how to measure the efficiency of specific assets.
Now let’s look at the efficiency of the asset base as a whole. This will
show us how well all the assets have been used to generate sales.
Remember that the point of having assets is to provide future
economic benefits or a return.
First, we’ll consider the sales generated for every rand invested in
total assets. This is expressed as follows:
Total asset turnover rate = Sales / Total assets
This ratio is expressed as “times”. The higher the ratio, the more
efficiently total assets have been used to generate sales.
15.6.3.7 Fixed asset turnover rate

We can also consider how efficiently fixed assets have been used to
generate sales. This ratio is shown below:
Fixed asset turnover ratio = Sales / Property, plant and
equipment
This ratio is expressed as “times”. The higher the ratio, the more
efficiently fixed assets have been used.

Who would be interested in these ratios?
• Managers
• Shareholders
• Suppliers/creditors.

The more debt used in a business to finance operations, the greater
the financial risk of the business. If a business has too much debt,
they may have difficulty in repaying loans and interest. This will
affect the ability of the business to obtain further loans and might
result in liquidation. The interest charge on high debt levels will also
affect profit and therefore the return to shareholders.
So why do businesses take on debt? Remember that there is the
potential of increasing profits by using the additional assets funded
with the borrowed funds. Another advantage of using debt instead
of equity finance is that debt provides access to finance without
affecting the rights of existing shareholders.
The amount of debt used in a business will determine the extent
of financial leverage the business has. Leverage is best illustrated by
means of an example.
Something to do 3
The following statement of financial position reflects the planned investments by
Social Investments Ltd's management for the next year:
Where is the money going to come from?

The finance required is R8 million. This could be raised through an offer of
shares or by borrowing money. The decision that needs to be made is how much
debt and how much equity to use to finance the new investments.
This decision will be based on the costs and benefits associated with the
different alternatives.
Assume that there are only three possible alternatives for financing the
investments.
What is the effect of each alternative on the return to shareholders if the interest
on the debt is 15% and the profit earned before interest is R2 million?
Check your answer
What do you notice?

The option that uses the most debt offers the highest return to
shareholders. This is the positive effect that increasing debt can have
on profit. This is known as leverage. The more leverage, however,
the greater the financial risk. This is illustrated below.

The best option in this case would have been if no debt had been
used − where debt has been used, the profits go to zero or become
negative. This is because the fixed interest must be paid, regardless
of the size of profits. This is the negative effect of increasing debt.
From the above example, you can see that financial leverage
increases risk and the probability of future returns. The downside of
increased risk is that the business may not be able to pay the interest
on the debt, especially if profits are low.
Note:
Debt is not necessarily “bad” for a company. If managed correctly, it can actually
increase returns.
15.6.4.1 Debt ratio

To measure the financial risk of a business, we need to look at how
much debt has been used to finance assets. By comparing total debt
to total assets, we can work out the percentage of debt used to fund
the assets of the business.
Here’s a simple example to illustrate the point. If a business had
total assets of R10 000 and total debt of R3 000, then the percentage
of assets financed by debt is 30% (3 000/10 000).
This is known as the debt ratio.

Debt ratio = Total debt / Total assets × 100
Total debt includes current and non-current liabilities.
The ratio is expressed as a percentage, and the higher the
percentage, the higher the relative proportion of debt and therefore
the financial risk.
15.6.4.2 Debt−equity ratio

Another measure of financial risk is the percentage of debt relative
to equity that has been used to finance a business. We compare long-
term debt to equity because long-term debt and equity are regarded
as the permanent capital of the business. Short-term debt is used to
finance working capital.
If the total assets of a business are R10 000, equity R7 000 and
interest-bearing debt R3 000, then the percentage of debt relative to
equity would be:
3 000 / 7 000 × 100 = 42.86%
This means that for every rand invested by shareholders, 42.86 cents
have been borrowed. This is known as the debt−equity ratio.
Debt−equity ratio = long-term liabilities / Total equity × 100
Total equity includes capital and reserves reported on the statement
of financial position.
The ratio is expressed as a percentage, and the higher the
percentage, the higher the relative proportion of debt and therefore
the financial risk.

15.6.4.3 Interest cover (times interest earned)
When a business uses debt, there is a fixed interest cost that needs to
be paid by the business. This ratio measures how well the interest is
covered by the profit from operations. The higher the interest cost
relative to profit earned, the greater the financial risk of the business.
This relationship between profit and interest, known as the interest
cover ratio, is expressed below:
Interest cover ratio = Profit before interest and tax / Interest
expense
Profit before interest and tax includes all income earned less
expenses incurred for the period other than interest expense and
taxation.
The ratio is expressed as “times”. The higher the ratio, the greater
the ability of the business to meet the interest payments, and the
lower the financial risk.
Who would be interested in information about debt management?
• Creditors
• Investors.
15.6.5 Profitability
Remember that the objective of a business is to maximise the return
on shareholders’ investments. This means generating as high a profit
as possible.
15.6.5.1 Gross margin on sales

This ratio measures the mark-up percentage of goods sold. In other
words, after covering Cost of sales, how much of sales is left to
absorb other expenses?
Gross margin on sales / Gross profit percentage = Gross profit /
Sales × 100
Remember that gross profit = sales less cost of sales.
This ratio is expressed as a percentage. The higher the ratio, the
better − more sales revenue is left after covering the cost of sales. A
decreasing gross profit margin could mean that the selling price has
been lowered, but this may not be a bad thing for a company if the
volume of sales has increased.
15.6.5.2 Net margin on sales/profit margin

To calculate the profit margin we’ll use the following ratio, known
as the profit ratio or net margin on sales ratio:
Net margin on sales / Profit percentage / Profit margin = Profit /
Sales × 100
Remember that profit = gross profit less operating expenses plus
other income.
Other income means income a business earns from activities that
are not part of its normal day-to-day activities. For example, if Judy
earns interest on her bank account, we cannot include this interest
income as a sale. Sales will include only income from Judy’s main
business of selling bags, suitcases and briefcases. Other income is not
included in the calculation of gross profit.

This ratio is expressed as a percentage. The higher the ratio, the
better − more sales revenue is left after covering all expenses and
including other income.
Be cautious when interpreting the margin, as a low profit margin
is not necessarily bad. A business could increase sales volume by
reducing the selling price, and this decision is likely to decrease the
profit margin due to a reduced gross profit margin.
Some companies will naturally have higher profit margins than
others. Can you think of any examples? Trading stores like retail
outlets will generally have lower profit margins than specialist
businesses like professional consulting firms. This means that when
you are measuring profitability you need to be aware of the industry
within which the business operates.
Did you know?

Pick n Pay had an operating profit margin on turnover of only 3.48% in 2009,
yet it is considered to be a very successful company.
Companies in established industries with lots of competition will
have lower profitability than companies in new industries with less
competition. This is because companies in new industries do not
have to cut prices due to pressure from competitors.
15.6.5.3 Return on assets

When evaluating the performance of the business, one of the main
issues to consider is how profitably the assets have been used by the
business.
If R10 000 has been invested in assets, and the profit earned is R2
500, then 25c has been generated in profit for every rand invested in
assets. The return on assets ratio amounts to 25% [R2 500/R10 000 ×
100].
There are a number of variations on how to calculate the return
on assets, using different numerators and denominators. Each ratio
reveals something different about the profitability of the assets
considered.
• Return on total assets ratio = profit after tax/total assets × 100
• Return on non-current assets ratio = profit after tax/non-current
assets × 100
• Return on assets before interest but after tax = (profit after tax +
interest × (1 − tax rate))/total assets × 100
• Return on assets before interest and tax = profit before interest
and tax/total assets × 100.
Return on assets before interest but after tax

This is the best ratio to use when comparing different companies.
This is because adding back the interest expense removes the effect
of different financing structures so that only the operating activities
of different companies are compared. As taxation is an operating
expense, it is included. Interest is tax-deductible. When calculating
profit, interest is deducted as an expense. Taxation is then deducted
from profit to arrive at profit after tax. This is illustrated using
hypothetical amounts below:
1. Assume a company tax rate of 28%.
2. Assume that profit equals taxable profit.
Profit before interest 1 000

Interest (200)
Profit before tax 800
Taxation (224)
Profit after tax 576
To calculate profit after tax, but before interest, we need to add back
interest.
Do you see that the interest expense has reduced the tax
provided? Because interest is an expense, 28% of the interest expense
is given back in the form of a tax deduction. The tax deduction is
28% of R200 = R56. The tax expense on the statement of
comprehensive income has been reduced by R56 as a result of
interest. We need to add interest back to the profit after tax amount.
The interest expense after tax is R200 − R56 = R144:
Interest × (1 − tax rate)
= 200 × (1 − 0.28)
= 200 × 0.72
= 144
Return on assets before interest and tax

This ratio is particularly useful when comparing companies in
different countries, because it removes the effect of different tax
situations and different financing decisions.
15.6.5.4 Return on equity (ROE)

Return on equity measures how well the shareholders’ investment in
the business has performed. It is important to remember that this
ratio is based on the accounting information about the business and
should not be compared to market information about other
investments. We’ll review market ratios a little later.

Return on equity is calculated as follows:
Return on equity (ROE)
= Profit attributable to ordinary shareholders / Ordinary
shareholders’ equity × 100
Why do you think we include only ordinary shareholders’ equity in
this ratio?
The preference shareholders in the company receive a fixed
dividend of 15%. This is their return on equity.
For all profitability ratios, the same general interpretation rule
applies. The higher the ratio, the more profitable the business is.

The ratios we have discussed up to now enable us to perform a Du
Pont analysis. This system, first used by the Du Pont Chemical
Corporation in the USA, uses the accounting ratios we have learnt to
help us better understand return on equity. Remember that the
return on equity is the ratio that reveals whether the business has
achieved its objective of maximising shareholder returns.
The flowchart below shows all the ratios for X6 that lead us to the
return on equity and explains the relationships that form the return
on equity measure.
The flowchart shows how the statement of comprehensive income
and statement of financial position flow into the return on equity
measure. We can see that return on equity is made up of two ratios,
return on assets and the equity multiplier. This is derived as follows:

The return on assets can also be split into two ratios, profit margin
and total asset turnover. This is shown on the next page:
We can see that the return on equity is made up of three ratios:
Return on equity = Profit margin × Total asset turnover × Equity
multiplier
The three components above, namely the profit margin, the total
asset turnover and the equity multiplier, are three levers the business
can use to improve the return on equity. The business can become
more cost efficient (profit margin) can improve the volume of sales
per rand in assets (asset turnover) or can leverage the business by
using more debt (equity multiplier). Remember that the profit
margin of a company provides information on how well the
business managed its costs to that the largest amount of sales income
is left over as profit. The total asset turnover provides information
about how efficiently the assets were used by the business to
generate sales. The equity multiplier provides information about the

use of debt to fund the assets of the business i.e. the financial risk of
the business.
The Du Pont analysis is therefore a useful system for identifying
what items contributed to a high or low return on equity and is also
useful for comparing different companies or the company with the
industry.

Accounting data always gives a historical perspective on the
company’s performance, so it is useful, where possible, not only to
rely on ratios that use the financial statements when analysing a
company’s financial performance.
Where a company is listed, we can use financial indicators (such
as the share price) on the stock exchange on which the company’s
shares are listed.
This group of ratios uses information from the share market as
well as information reported in the financial statements −
particularly the market price of the share. For publicly-listed
companies, this is the price at which the share is traded on the stock
exchange.
15.6.7.1 Earnings per share (EPS)

This measure shows how much each share in issue has generated in
earnings during the year.
This ratio uses the profit on the statement of comprehensive
income as an indicator of earnings. The weighted average number of
shares is the number of shares on hand on average throughout the
year.
Earnings per share = Profit attributable to ordinary shareholders
/ No of shares in issue
The higher the EPS, the better the business is as an investment from
a shareholder’s perspective. Whether the increase in EPS is due to an
increase in profit or a decrease in the number of shares in issue, the
effect is that the return available for each share is higher.
15.6.7.2 Earnings yield

Earnings yield shows the relationship between the company’s share
price and earnings per share. The result is a percentage that indicates
the accounting return on the current value of the share investment.
The ratio is stated as follows:
Earnings yield = Earnings per share / Market price of share at
end of year × 100
A decrease in earnings yield could arise because earnings per share
have gone down (which is bad news) or because the market thought
the company had good prospects and investors were willing to pay
more for the share (which is good news). Therefore, the earnings
yield cannot be interpreted without understanding why the yield
has moved.
15.6.7.3 Price earnings ratio (P/E ratio)

This is one of the most widely-used ratios in financial analysis. It
measures the price that investors are willing to pay for each rand of
reported earnings. The P/E ratio is calculated by dividing the
current share price by the last reported annual earnings per share.
Price earnings ratio (P/E ratio)
= Market price of share at end of year / Earnings per share
A P/E ratio of 8 indicates that the market is prepared to pay about 8
times the earnings per share for one share.
The current share price is compared with earnings per share to
see whether the share is over- or undervalued. If the resulting P/E
ratio is higher (lower) than the industry norm adjusted for company
specific factors, the share may be overvalued (or undervalued). The
P/E ratio on its own does not reveal much. It must be compared to
the P/E ratios of other companies in the same industry, to the
market in general, or to the historical P/E ratios of that company to
identify the movements.
If shareholders are willing to pay more for a share than it is
“worth” (using the earnings per share as a measure of “worth”),
then it must mean that future earnings are expected to increase. The
higher the P/E ratio, the greater the expectation that the company’s
performance will improve and earnings will rise.
A good example is Microsoft. Several years ago, when Microsoft
dominated the information technology market, its P/E ratio was
over 100. By 2000, Microsoft’s revenues were growing at a slower
rate, even though it was still one of the largest companies in the
world. The result was a P/E ratio of 40.
A low P/E ratio does not necessarily mean that a company’s
shares are undervalued. It could mean that the company’s earnings
have slowed down as the company becomes more established in the
market. The ratio also might be lower than the industry norm as a
result of other company-specific factors. This ratio varies widely
between companies and industries.

15.6.7.4 Dividend yield
The dividend yield ratio indicates what percentage of the share price
has been distributed as a dividend. This ratio would be of interest to
users who wish to measure the realised return from the investment.
Dividend yield = Dividends per share / Market price of share at
end of year × 100
The earnings yield, on the other hand, shows the total return on the
share, because it uses the profit attributable to shareholders to
measure the income earned on the investment. The profit for the
year, which is the amount available for distribution, is used as the
basis for measuring the earnings yield. This ratio measures the total
income return to shareholders, both realised and unrealised.
15.6.7.5 Return to shareholders

Another way of calculating the return to shareholders is by
analysing only market figures. This has the advantage of removing
all accounting data from the analysis. One way of doing this is to
calculate the total return to shareholders as the amount received as a
dividend plus or less the movement in the share price. Let’s
investigate this statement further.
Think about this 3

1. What investment does a shareholder make in the company?
2. How do we measure the value of this investment using the market, not
the financial statements, as our source?
3. What direct (realised) income do shareholders receive on their
investment?
4. What indirect (unrealised) return is earned on the investment over time?
Check your answers
1. A shareholder purchases shares in the company.

2. The market price of shares indicates the value of shares over time.
3. Dividends.
4. Capital gain − this is the result of an increase in the market price of the shares,
which can be realised when shareholders sell their shares (or a capital loss if the
market price of the share decreases).
Do you remember how we measure the return on an investment?
Return = Return on investment / Investment × 100
How can we translate this into a formula that measures the return to
shareholders over the year using the market data inputs describes
above?
We need to answer the following questions:
1. What is the investment?
2. What is the total return on the investment?
The answers are:
1. The investment is the market price of the share (share price) at
the beginning of the year.
2. The return is made up of two components: firstly, the realised
portion, which is the dividend received, and secondly, the
unrealised portion, the increase (or decrease) in share price over
the year.
We can measure the return to shareholders using the following
formula:
Return to shareholders = (Dividend received + Increase in
market price of share) / Market price of share at beginning of
year × 100
To calculate the increase in the market price we need to compare the
market price at the beginning and end of each year.
15.6.7.6 Market-to-book ratio

This ratio reflects market capitalisation (current share price ×
number of shares issued) to carrying value of assets. It is a measure
of assets such as knowledge, value of brand names, employees,
assets that are not recognised at their market value, or other public
value perceptions that are not recognised on the statement of
financial position. The relationship between these two valuations is a
measure of how significant the difference is.
It is calculated as follows:
Market-to-book ratio = Market value per share / Carrying value
of net assets per share
The market value of listed shares can be obtained from the JSE web
page (<www.jse.co.za>) or from business newspapers.
Carrying value or book value per share = Total equity or net
assets / Total number of shares in issue

The higher the ratio, the larger the difference between the market
value and the carrying value and the more unrecorded assets and
other benefits are perceived to exist. While the market-to-book ratio
can give us some indication of the premium, we must interpret it
with caution, because there are various reasons for the existence of
this difference.
15.6.7.7 Dividend cover

The last ratio we’ll calculate measures how many times earnings
cover the dividend paid out to shareholders. A high ratio will
indicate that a large percentage of earnings is retained in the
company and reinvested on behalf of the shareholders. The ratio can
be expressed in two ways:
Dividend cover = Earnings per share / Dividend per share
Dividend cover = Profit after tax / Dividends

You are now ready to begin the analysis of Handbags for Africa Ltd.
First we’ll compute the ratios and then discuss what these ratios
tell us about the business and how the company’s performance
could be improved. We’ll record all the ratios on a worksheet, which
we will use later for an in-depth analysis.
15.7.1 Liquidity
We can calculate the liquidity ratios for Handbags for Africa Ltd by
looking at the current assets and current liabilities on the statement
of financial positions for the two years presented.
1. Current ratio
X6 X5
Current assets 43 601 177 28 672 370
Current liabilities 12 989 020 15 801 519
Current ratio = 3.35 times = 1.81 times
2. Quick ratio
X6 X5
Current assets 43 601 177 28 672 370
Inventory 3 750 000 4 120 000
Current liabilities 12 989 020 15 801 519
Current ratio = 3.06 times = 1.55 times
The table has columns for comparing the results from each financial
year. You could also add a column for the particular industry, if you
had enough information about it, to compare the company results
with those of the industry.
Ratio X6 X5
Current ratio 3.35 1.81
Quick ratio 3.06 1.55
Note:
The quick ratio will always be lower than the current ratio, because current assets
are reduced by the inventory amount when calculating the quick ratio. In section
15.7.7 the information revealed by the ratios will be discussed in more detail.
15.7.2 Asset management (efficiency) ratios

Next we consider how efficient Handbags for Africa used its
debtors, creditors, inventory and non-current assets?
We’ll make the following assumptions when calculating these
ratios:
1. 40% of sales are on credit.
2. 60% of purchases are on credit.
a) Days inventory on hand
X6 X5
Inventory 3 750 000 4 120 000
Cost of sales 85 657 057 78 395 467
Days in year 365 365
Days inventory on hand = 16 days = 19 days
The business inventory is on average on hand for 16 days, which
means that the current inventory levels would last for 16 days if no
additional inventory is purchased.
b) Inventory turnover
X6 X5
Cost of sales 85 657 057 78 395 467
Inventory 3 750 000 4 120 000
Inventory turnover = 22.84 = 19.02
times times
The existing inventory was sold 22.84 times during the current year.
c) Debtors' collection period

Remember that we assumed that 40% of sales are credit sales.
X6 X5
Trade receivables 25 928 570 24 528 570
Credit sales 123 999 879 × 40% = 120 607 873 × 40% =
49 599 952 48 243 149
Debtors' collection period = 191 days = 186 days
On average it takes 191 days to receive the money from debtors.
d) Creditors' payment period

Are credit purchases reported in the financial statements? No. How
will we calculate credit purchases? Do you remember how gross
profit (the profit from trading) is calculated? The formula is Sales
less Cost of sales. Remember that purchases are included in the Cost
of sales calculation.
Here are the steps needed to calculate purchases.
Step 1: Identify the components of Cost of sales and calculate

purchases
Cost of sales = Opening inventory + Purchases − Closing
inventory
The opening inventory for X5 is not shown on the statement of
financial position. This amount would have been reported as closing
inventory in the X4 financial statements.
In the example, assume that opening inventory in X5 was R4 900
000.
X6 X5
Opening inventory 4 120 000 4 900 000
Add: Purchases Unknown Unknown
Less: Closing inventory 3 750 000 4 120 000
= Cost of sales 85 657 057 78 395 467
Purchases is calculated by restating the formula for Cost of sales:
Opening inventory + Purchases − Closing inventory = Cost of sales

Restated:
Purchases = Cost of sales − Opening inventory + Closing inventory
In the example:
X5 Purchases = 78 395 467 − 4 900 000 + 4 120 000

= 77 615 467
X6 Purchases = 85 657 057 − 4 120 000 + 3 750 000
= 85 287 057
Step 2: Calculate credit purchases

The percentage of credit purchases may be mentioned in the
directors’ report. If it is not, use total purchases. Remember that
credit purchases in Handbags for Africa are 60% of total purchases.

X5 Credit purchases = 0.6 × 77 615 467
= 46 569 280
X6 Credit purchases = 0.6 × 85 287 057
= 51 172 234
Now that we have calculated Purchases and know Creditors, let’s
work out the creditors' payment period.
X6 X5
Trade payable 2 665 740 2 850 000
Credit purchases 51 172 234 46 569 280
Creditors payment period = 19 days = 22 days
e) Total asset turnover
X6 X5
Sales 123 999 879 120 607 873
Total assets 83 649 877 75 358 570
Total asset turnover = 1.48 times = 1.60 times
f) Fixed asset turnover

Investments are excluded from this ratio as they are used to generate
interest and dividends, not sales.
X6 X5
Sales 123 999 879 120 607 873
Property, plant and equipment 39 768 700 46 416 200
Fixed asset turnover = 3.11 times = 2.59 times
15.7.3 Debt ratios (financial leverage)

After analysing the asset efficiency, we turn to investigate the
financing of these assets. Let’s calculate the debt ratios for Handbags
for Africa Ltd.
a) Debt ratio
The liabilities section of the statement of financial position is
presented below.
Remember that total debt includes long- and short-term debt.
Therefore, it is calculated as follows:
X6 X5
Long-term liabilities 17 000 000 22 000 000
Trade payable 2 665 740 2 850 000
SA Revenue Service 1 321 839 2 599 837
VAT control 14 000 18 000
Short-term borrowings 5 000 000 5 000 000
Shareholders for dividend 3 767 441 3 361 438
Accrued expenses 220 000 180 000
Bank overdraft 0 1 792 244
Total debt 29 989 020 37 801 519
The debt ratio is calculated as follows:
X6 X5
Total debt 29 989 020 37 801 519
Total assets 83 649 877 75 358 570
Debt ratio = 35.85% = 50.16%
b) Debt−equity ratio
An extract from the equity and liabilities section of the statement of
financial position is shown below. While debt for the purpose of
calculating the debt ratio includes short-term debt, here we consider
only long-term debt.
X6 X5
Capital and reserves 54 640 857 38 557 051
Long term loan 17 000 000 22 000 000
Debt−equity ratio 31.11% 57.05%
c) Interest cover (times interest earned)
X6 X5
Pro t before tax 13 602 216 11 970 958
Add back interest expense 3 873 379 4 770 000
Pro t before interest and tax 17 475 595 16 740 958
X6 X5
Interest expense 3 873 379 4 770 000
Interest cover (times interest earned) = 4.51 times = 3.50 times
15.7.4 Profitability ratios

We begin the profitability analysis by looking at the gross profit and
profit percentages.
a) Gross profit percentage
X6 X5
Sales 123 999 879 120 607 873
Less Cost of sales (85 657 057) (78 395 467)
Gross pro t 38 342 822 42 212 406
X6 X5
Gross pro t 38 342 822 42 212 406
Sales 123 999 879 120 607 873
Gross pro t percentage = 30.92% = 34.99%
b) Profit percentage
In this example, profit after tax is the same as the profit attributable
to ordinary shareholders.
X6 X5
Pro t attributable to ordinary shareholders 8 921 247 7 830 116
Sales 123 999 879 120 607 873
Pro t percentage = 7.19% = 6.49%
c) Return on assets
After analysing profit in relation to sales, we turn to the profitability
of assets used by the business.
Various ratios are applied to the example. There are many other
ways to calculate the return on assets. A discussion of some of these

was given above but we’ll select only one for the final worksheet.
i) Return on total assets ratio
X6 X5
Pro t after tax 8 921 247 7 830 116
Total assets 83 629 877 75 358 570
Return on total assets ratio = 10.66% = 10.39%
ii) Return on non-current assets ratio
X6 X5
Pro t after tax 8 921 247 7 830 116
Non-current assets 39 768 700 46 416 200
Return on non-current assets ratio = 22.43% = 16.86%
iii) Return on assets before interest but after tax ratio
X6 X5
Interest (3 873 379/4 770 000 × 0.72) 2 788 833 3 434 400
Pro t after tax 8 921 247 7 830 116
Pro t before interest after tax 11 710 11 264 516
080
Pro t before interest after tax 11 710 11 264 516
080
Total assets 83 649 75 358 570
877
Return on assets before interest but after tax = 14.0% = 14.95%
ratio
iv) Return on assets before interest and tax ratio
X6 X5
Total assets 83 649 877 75 358 570
Return on assets before interest and tax ratio = 20.89% = 22.21%
d) Return on equity
Let’s look at how the investment of shareholders’ equity has
performed.
X6 X5
Ordinary shareholders' equity 53 640 857 37 557 051
Return on equity = 16.63% = 20.85%

For the calculation of market ratios, we’ll need the market values of
Handbags for Africa’s shares. In our example we’ll assume that the
market price at the end of each of the last three years is:
a) Earnings per share

The following note relating to earnings per share (EPS) has been
extracted from the financial statements in the example.
5. Earnings per share

The calculation of the earnings per share is based on the pro t of R8 921
247 (X5: pro t of R7 830 116) and a weighted average number of
ordinary shares in issue during the year of 1 945 000 (X5: 1 700 000).
We’ll use the values provided in the notes to calculate earnings per
share.
X6 X5
No of shares in issue 1 945 000 1 700 000
Earnings per share ratio = 458.67 cents = 460.59 cents
What do you notice?

These amounts have been presented below the statement of
comprehensive income. Why? To provide users with relevant
information about the return on the shares held by shareholders.
b) Earnings yield ratio

Let’s calculate the earnings yields for the last two years in the
example:
X6 X5
Earnings per share 4.5867 4.6059
Market price of share at end of year 36.68 34.99
Earnings yield ratio = 12.5% = 13.16%
In what sector of the economy would Handbags for Africa operate if
it were listed? The clothing and textiles industry.
We assume that the clothing and textiles industry has an average
P/E ratio of 7.5, which means that investors are willing to pay 7.5
times the annual earnings in these companies when purchasing
shares.
Let’s calculate the P/E ratio for Handbags for Africa Ltd.
c) Price earnings ratio
X6 X5
Price earnings ratio = 7.99 times = 7.59 times
d) Dividend yield
The following note appears in the financial statements of Handbags
for Africa Ltd:
We’ll need to use the total dividend per Class A share to calculate
the dividend yield.
X6 X5
Dividends per share 1.474 1.448
Dividend yield = 4.02% = 4.14%
e) Return to shareholders
X6 X5
Closing price 36.68 34.99
Less opening price 34.99 33.70
Increase in market price of share 1.69 1.29
Dividend per share received 1.474 1.448
Return to shareholders 9.04% 8.12%
f) Market-to-book ratio
The following note has been extracted from the financial statements
and indicates the number of Class A shares in issue:
Issued
X6: 2 190 000 Class A shares 320 000
32 000 000
X5: 1 700 000 Class A shares 21 500 000
X6 X5
Total equity (excluding Class B shares) 50 640 857 34 557 051
Number of shares 2 190 000 1 700 000
Carrying value per share 23.13 20.32
Let’s calculate the market-to-book ratio:
X6 X5
Market value per share 36.68 34.99
Carrying value per share 23.13 20.32
Market-to-book ratio = 1.58 times = 1.72 times
g) Dividend cover
Lastly, we’ll calculate the dividend cover.
X6 X5
Dividend per share 147.4 144.8
Dividend cover = 3.11 times = 3.18 times

Do you remember our objectives for performing ratio analysis?
When performing a ratio analysis, we need to consider the following
for each ratio:
• How it is calculated
• What it measures
• How it is expressed
• What it reveals
• How the company’s performance could be improved.
So far we have calculated and expressed the ratios, as well as shown
what each ratio measures.
In order to complete the analysis we need to consider what the
results tell us about the company’s performance and how
improvements could be made in the future.
Below is the full record of all the ratios we have calculated. The
point of using ratios is not calculating the numbers, but analysing

the results of doing those calculations. In the next section, we’ll
explain what the ratios tell about the business.
Ratio X6 X5
Liquidity
Current 3.35 1.81
Quick 3.06 1.55
Asset management
Debtors collection period 191 days 186 days
Creditors payment period 19 days 22 days
Days inventory on hand 16 days 19 days
Inventory turnover ratio 22.84 times 19.02 times
Total asset turnover 1.48 times 1.60 times
Fixed asset turnover 3.11 times 2.59 times
Debt management
Debt ratio 35.85% 50.16%
Debt−equity ratio 31.11% 57.05%
Interest cover 4.51 times 3.50 times
Pro tability
Gross pro t margin 30.92% 34.99%
Pro t margin 7.19% 6.49%
Return on total assets 10.66% 10.39%
Return on non-current assets 22.43% 16.86%
Return on assets before interest after tax 14.00% 14.95%
20.89% 22.21%
Return on total assets before interest and tax
Return on equity 16.63% 20.85%
Market
Earnings per share 458.67 cents 460.59 cents
Earnings yield 12.5% 13.16%
Price earnings ratio 7.99 times 7.59 times
Dividend yield 4.02% 4.14%
Return to shareholders 9.04% 8.12%
Market-to-book ratio 1.58 times 1.72 times
Dividend cover 3.11 times 3.18 times

What do the ratios that we have calculated tell us about the
business? We will answer this question by looking at each of the
groups of ratios in turn.
15.7.7.1 Liquidity
The current ratio has increased significantly, with the quick ratio also
showing a large increase. This has happened because the current
liabilities have decreased (by R2 812 499 or 17.8%) together with a
strong increase in current assets (by R14 928 807 or 52%).
A high current ratio shows that the company has sufficient short-
term assets available to repay its current obligations. It is important
that we do not just accept a high current ratio as being an indication
that the company is in a strong position of liquidity but that we look
at the quality of the assets recognised as current assets. What we

mean by “quality” is that the assets are easily convertible into cash
and that there is little risk of not being able to realise cash quickly
from the asset. A high current ratio is an indication of liquidity only
if we think that the company can easily realise the assets (convert the
assets into cash).
Generally, inventory is considered the least liquid current asset,
while cash is the most liquid one, we use this information to analyse
the “quality” of current assets.
A high acid test ratio increases the quality of the current ratio
because inventory is one of the less liquid assets − it is difficult to
convert into cash quickly. Therefore an increasing quick ratio
indicates that the company is becoming more liquid. Inventory as a
percentage of current assets shows that inventory forms a small
percentage of current assets in both years (X6: 8.6%; X5: 14.4%). The
difference between the quick ratio and the current ratio increased as
current assets, excluding inventory, increased by R15 298 807 or
62.3%. This shows that inventory as a percentage of current asset
decreased, making the nature of current assets more liquid.
There is also an increase in cash and cash equivalents which make
up 31.8% of current assets in X6 and 0% in X5. This increases the
quality of the current ratio because cash and cash equivalents are
immediately available for settling current liabilities. This is a
significant improvement from the previous year, when no cash was
on hand as the company had a bank overdraft.
In this example, a large percentage of total current assets is made
up of Trade receivables (X6: 59.5% and X5: 85.6%). When Trade
receivables forms a large percentage of the current assets, the
liquidity of the company depends on the quality of this debtor
balance. In other words we need information about when the
business expects to collect the debts and whether the debtors will
pay in the expected time period.

We can look at the debtors' collection period to get an idea of debt
management. We calculated that the company takes 191 days (X5:
185 days) to collect the moneys owed by customers. This is a
significant period of time, as usually debtor days are from 30 to 60
days. In the notes to the statement of financial position we are told
that the authorised credit terms for debtors are 60 days and the
credit terms for creditors are 90 days.
What does this mean?

The collection period shows that the debtors are not being well
managed. The liquidity shown by the positive current ratio would
be questionable if Handbags for Africa Ltd was not holding
significant cash and cash equivalents. Currently, the company is
holding sufficient cash to pay its current liabilities without having to
collect any moneys from the debtors or sell any inventory (cash: R13
847 607; current liabilities: R12 989 020).
We also see that creditors have to be paid within 60 days. The
company’s actual creditors' repayment period is between 19 and 22
days. This raises the question of why the company is paying its
suppliers before the creditors require payment. This management of
debtors and creditors could produce cash flow problems if the
company is relying on the cash collections from debtors to pay their
creditors. Handbags for Africa Ltd has large cash resources in the
current year and therefore the poor management is not causing cash
flow problems. However, poor management of debtors and creditors
could cause liquidity problems in the long term. This is because the
company is essentially funding the debtor purchases out of its own
resources until the debtor pays. In addition early payment of
creditors means that the company is paying over cash to suppliers
on which it could have earned interest until the payment date
required in terms of the creditors’ terms (90 days).

Although the business is in a good liquidity position, to improve
liquidity and to prevent liquidity problems in the future the business
could do the following:
• Offer debtors an incentive discount to settle their debts earlier
• Charge interest on long outstanding debtor balances
• Manage the debtors to ensure that all payments are received
within the terms set
• Negotiate longer settlement terms with creditors without
compromising the relationship with these creditors
• Pay creditors only when the payment is required in terms of the
negotiated terms
• Increase cash sales in the short term, which could be achieved by
increased advertising, a sale of existing goods, or a cash discount.
15.7.7.2 Asset management

The working capital cycle is a good starting point for evaluating the
efficiency with which current assets have been managed.
Do you remember how to calculate it?
Debtors’ collection period + days inventory on hand − creditors
collection period
X6 X5
191 + 16 − 19 188 days
186 + 19 − 22 183 days
This cycle measures how long cash is tied up in working capital. A
company always needs a balance of the various components of
working capital, for example, low levels of cash could lead to

difficulties in paying accounts when they fall due. If the control over
debtors is too tight, it could cause a reduction in sales. Low
inventory balances might cause a stock-out situation, which affects
current and potentially future sales. On the other hand, if these
balances are too high, the return on the assets will be lower.
An ideal way of managing working capital is to match the timing
of the cash flows of the current assets and liabilities. For example,
inventory that is expected to be sold in three months should be
purchased with borrowings that need to be repaid in three months.
This reduces the risk of there being insufficient cash to settle the
liability. This method will require a great deal of estimation and
judgement, so it is not foolproof. Experience gathered over time will
be the best teacher, as managers learn what impact their choices
have on the return generated by the assets they have invested in.
Going back to the example, we see that the working capital cycle
has increased. This is largely the result of the increase in the debtors'
collection period (X6: 191 days; X5: 186 days). The debtors figure
increased by a larger percentage (5.7%) than is justified by the credit
sales increase (2.8%). It will need to be investigated whether this is a
temporary problem or whether the collection policy is not working.
It is a cause for concern that the debtors collection period is 191 days
while the company’s credit terms allow a maximum of 60 days.
Currently, the business is not using creditors to finance its
debtors, because the debtors period is excessively long and the
creditors period is unnecessarily short. The creditors' repayment

period decreased from 22 days to 19 days. In both years, Handbags
for Africa Ltd did not use the full 90-day payment period, which
shows that the working capital is not managed efficiently.
The days inventory on hand is low and decreased during the past
year (X6: 16 days; X5: 19 days), indicating that inventory is held by
the business for a very short period before it is sold. The low levels
of inventory are good because the company has not spent money in
making inventory that is simply stored in a warehouse waiting to be
sold. However, low inventory levels also present a risk of a stock-out
situation, where the company has no inventory on hand to sell to
customers, and customers could take their business elsewhere.
If the company had increasing inventory balances, management
would need to investigate to see what the cause is. If the increase
was due to a decrease in demand for existing stock, then a decision
would need to be made about how to sell this stock.
The overall impact of working capital components’ management
is that Handbags for Africa Ltd has an unacceptably long working
capital cycle. It takes 188 days from the time the company purchases
the inventory to when the cash for the sale is collected. This means
that the company has to fund its operations for 188 days before
payment for the sale is received. We have identified the main
problem with the company’s working capital management as being
poor debtor management (the debtor collection period being too
long) and poor management of creditors (with the company not
making use of the 90-day payment period).
Some suggestions for improvement are:
• Prepare an age analysis of debtors to determine which debtors
have exceeded their credit terms. Enforce payment from these
debtors.
• Offer debtors an incentive to settle their accounts early, for
example, a discount on early settlement or an interest charge on
late settlement.
• Ensure that there are strong communication channels set up
between the company and its debtors.
• Pay off creditors’ accounts when they have been outstanding for
90 days to make use of the credit terms offered. Make sure that
payment terms are not exceeded so that the company maintains
positive relationships with creditors.
• Analyse existing stock to see how long finished goods have
remained unsold. Develop a strategy for selling off this unwanted
stock without losing too much profit.
The asset turnover ratios indicate that non-current assets, in other
words, property, plant and equipment, have been relatively more
efficient in generating sales in X6, as the fixed asset turnover ratio

increased from 2.59 to 3.11.
The total asset turnover is a lot lower than the fixed asset
turnover, another indicator that working capital management is the
problem, as including the current assets has reduced the turnover
ratio significantly from 3.11 to 1.48 (X5: 2.59 to 1.60). This shows that
the increase in total assets (11%) did not lead to the same percentage
increase in sales (2.8%). While current assets increased by 5.2%, non-
current assets decreased by 14.3%. The increase in the investment of
assets, mostly in current assets, may not have been justified, because
sales have not increased in line with the investments.
15.7.7.3 Debt management

These ratios are difficult to comment on without more information
about industry norms, the optimal capital structure, and financing
decisions made within the company. Managers must maintain an
optimal level of debt and equity that will determine the company’s
capital structure. When choosing the mix of capital within a
business, the degree of financial risk that the business is willing to
take must be considered. The use of leverage (through increasing
debt) may increase returns, but also increases financial risk.

The only deduction we can make from the debt ratios is whether
they have increased or decreased, and whether this makes the
business more or less risky as an investment.
In the example, the debt ratio has decreased from 50% to 36%,
indicating that relatively more equity is being used to finance the
business in X6 than in X5. Total equity increased by 46.6%. In
addition, the company repaid R5 000 000 long-term debt during the
year, resulting in a 20% decrease in long-term debt.
If the company had shown an increase in the debt ratio, this
would mean that relatively more debt was being used to finance the
business in X6 than in X5 and this would increase the financial risk
of the company, but could also increase returns to shareholders.
The debt−equity ratio has decreased for the same reasons as the
debt ratio. In X6, 31 cents of long-term debt have been used for every
R1 of equity invested, compared to 57 cents in X5.
The interest cover has increased from 3.5 to 4.51, because of a
lower interest expense (by 18.8%) and higher profit before interest
and tax (by 4.4%) in X6. The interest expense decreased because the
business had less debt (remember that a portion of the long-term
loan was repaid in X6). Profit before interest and tax covers the
interest commitment 4.5 times, indicating a very low risk that the
company would not be able to meet its interest payments as they fall
due.
If the interest cover falls below 2, the financial risk is very high. In
such a case, if profits fall in the next year the business may be unable
to cover the interest expense.
15.7.7.4 Profitability
The decline in the gross profit margin indicates that the increase in
the cost price has not led to an increase in the selling prices. This
could be because the company operates in a price sensitive market,
so that selling prices cannot be increased when costs increase. Sales
increased by 2.8%, while cost of sales increased by 9.3%. The result is
a decrease in the gross profit margin. This will need to be monitored
to see which costs have increased and if they can be reduced in
future (through negotiations with suppliers) or if these costs can be
transferred to consumers or reduced in the future.
The fact that sales have increased by 2.8% in X6 is a cause for
concern. Although sales increased, the increase has not kept up with
inflation. In South Africa inflation is high relative to other developed
countries in the world and had an average inflation rate of 8 to 9.5%
in 2008. If inflation is 8.5%, then sales should automatically have
increased by 8.5%. Instead, sales have only increased by 2.8%. The
reasons could be lower demand or inappropriate stock buying or
pricing policies.
The gross profit margin can be improved by:
• Increasing selling price combined with aggressive marketing
• Decreasing costs.
The net margin on sales (profit) has increased slightly, which
indicates that business expenses (other than cost of inventory sold)
have decreased or other income has increased. A more detailed
analysis of the statement of comprehensive income shows that
operating costs decreased by 11.9%, which may be the result of good
management of business expenses. Despite the decreased gross
profit margin, these movements result in a higher profit margin.
The return on non-current and total assets (measured with profit

after tax) has also increased, which means that assets have been
relatively more profitable in X6 than in X5. Some non-current assets
were sold in X6 (non-current assets decreased by 14.2%), which
explains the large return difference between the years. The

remaining assets generated a higher profit, thereby increasing the
return.
If we consider the return on total assets (measured before the

impact of interest and tax), the return has even decreased.
Finally, we turn our attention to the return on equity, which has
decreased from 20.85% to 16.63%. Remember that the company
should increase shareholder returns.
Management would have to investigate the reasons for the
decrease in shareholders’ return carefully. At first glance it appears
that management could find some of the reasons for the decrease in
the return on equity in the poor working capital management
(supported by the return on total assets in comparison to return on
non-current assets), the lack of sales growth, the decreasing gross
profit margin, and the question of whether the capital structure of
the company is appropriate. We discussed the positive effect of
leverage and perhaps management should have considered
introducing more debt into the capital structure instead of reducing
the debt percentage.
15.7.7.5 Market ratios

Earnings per share has decreased marginally, although the profit
increased by 13%. This is because, the number of ordinary shares in
issue increased by 490 000 shares. The increase in the number of
shares means that, although the profit increased, there were more
shareholders to share in the profit, resulting in lower earnings per
share (even if the pie increases, if the number of people you have to
share with increases, you may get a smaller slice of the pie).
Remember that this ratio measures the accounting, not the market
return.
The earnings and dividend yields have decreased marginally,
showing a decreased return to shareholders based on the market
value of their investment. The dividend yield decreased by 2.9%,
while the earnings yield decreased by 5%. This indicates that more
profits have been retained for investment in the company. Increased
earnings retention is not necessarily bad for shareholders, because
the company could be planning future expenditure to grow the
business. If high dividends are paid, the company may not have
enough money to invest in expansion projects and will need to
borrow at a much higher cost. The dividend cover of 3 indicates that
the company has enough earnings to cover the dividend. If the
dividend cover were less than 1, this would mean that the company
is not earning enough in the current year to pay dividends. It would
be using past profits to pay the current dividend, which, depending
on the situation, might have negative effects on the future
profitability of the company.
The price−earnings ratio has increased, indicating that investors
are willing to pay more per rand of share price for a share in the
company. This is because investors sense that the company has
potential to grow and expand, so they are willing to accept lower
returns at present in order to buy into higher future expected
returns.
The market confidence is also reflected in the return to

shareholders, as the share price increased during the current year.
This increase is at a faster rate than the previous year’s increase.
Although the dividend per share went down, the total return to
shareholders grew.
The market-to-book ratio shows that the share on the market is
worth 1.58 times its carrying or accounting value. This represents the
premium investors are willing to pay in order to purchase shares in
the company. Note that this premium decreased over the past year,
which may be due to the lower asset return. However, we need more
information before arriving at a conclusion.
Overall, the company seems to be a good investment. The
accounting rates of return are favourable and the market appears to
value the investment.
15.8 The benefits of financial analysis

Imagine you are setting up your own business. One of the first tasks
you will have is setting your financial goals. Once you know why
you are in business, you need to work out how much profit you
need to generate in order to stay in business. Setting these goals or
targets is an essential part of the planning process. It does not
happen only when the business is set up − targets have to be
reviewed on a regular basis. As time passes and conditions inside
and outside the business change, targets may have to be reset.
One of the most common measures of performance is the return

on equity. A required or targeted return on equity is determined
when the financial targets are set. In future trading periods the
actual return on equity will be measured and compared with the
targeted ratio. This is one example of how financial analysis can be
used for internal evaluation purposes.

Imagine you were considering buying shares in a company. How
would you know what company to invest in? You could call an
asset manager, who places money in investments with expected

high returns on behalf of clients. An asset manager would have
access to resources and information that you would not. For
example, they would have access to the results of detailed analyses
performed by research analysts of specific companies in specific
industries. These analysts constantly monitor the performance of
companies. A research analyst would usually specialise in a
particular sector or industry, for example, leisure or gold or retail.
One of the tools used by research analysts to evaluate company
performance is financial analysis.
Whether an analysis is conducted internally or externally, it helps
the analyst, whoever that may be, to extract meaningful information
from the financial statements. This information can be used to
evaluate the past, assess the current situation, compare to other
sources of information, or make predictions about the future.
Something to do 4
There are many sectors into which companies are divided. Look on the share
transaction pages in the business section of your local newspaper to see the
sectors in which shares are traded.
Check your answer
Some of the sectors are:

Gold Financial Services
Diamonds Platinum Clothing and Textiles Food
Metals and Minerals Furniture and Appliances Retail
Paper Retail
Steel Hotels and Leisure
Banks Building, Construction and Engineering
Information Technology Healthcare
Telecommunications Transport
Education and Staffing Property.
15.9 Limitations of financial analysis

Although financial analysis has a number of benefits, its limitations
have to be kept in mind when drawing conclusions from the
analysis. Some of the limitations listed below arise because most
ratios are calculated from accounting data.
Inflation / Historic cost

Financial statements are usually prepared on the historic cost basis,
which means they are not adjusted for inflation. This could mean
that the values of some assets are understated and ratios that use this
information may, as a result, be less reliable.
Monetary values
There are many aspects of a business that cannot be measured in
monetary terms. The value of intellectual property, people and
knowledge is not shown on the statement of financial position, but
may be reflected in the share price or value of the company. These
qualitative factors must be taken into account when performing an
analysis.
Judgements
Many accounting estimates are made to arrive at the information in
the financial statements, for example the rate at which to depreciate
assets. There are also choices in accounting policy that will affect the
outcome on the financial statements, for example using FIFO instead
of weighted average to measure inventory.
The fact that different companies use different accounting policies

and procedures and use subjective judgement and estimation makes
comparisons difficult.
Unusual events
There may be income or expenses or acquisition and sales of assets
affecting the financial statements that are unusual. This will affect
comparison from one year to the next and between companies
because these unusual items will distort the trends in the figures.
Generalisation and summaries

The accounting data which is analysed is in an aggregated and
summarised form. While this may make interpreting the statements
a easier as you will not be bogged down in unnecessary detail, some
valuable information might be lost.

• Financial analysis helps us to understand the impact of business
decisions on the financial performance and financial position of a
business.
• Financial analysis extracts relevant information to meet specific
needs of users.
• Information contained in the financial statements can be
interpreted to evaluate a business and make informed decisions
about the future potential and associated risks of the business.
• The results obtained from the analysis must be comparable.
Comparability ensures that information is useful for the purpose
of making economic decisions.

To ensure comparability, financial information must be
•
standardised. This is achieved through creating common size or
common base year financial statements.
• Financial ratios can be calculated and used to compare the results
of a business over time or the results of different businesses.
• Ratios make amounts easier to compare.
• Ratios are classified into groups that provide information about a
business that is important to help users make decisions.
• There are shortcomings to using ratios that must be considered
when performing an analysis.
What's next?
In the next chapter we are going to look at accounting for non-profit
businesses and clubs.

QUESTIONS
QUESTION 15.1 (A)

The following are extracts from the statements of comprehensive
income and the statements of financial position of Kagiso's Paving in

respect of the financial years X3 and X4:
Extract from Statement of comprehensive income

R'000 R'000
X4 X3
Sales 1 548 000 1 176 000
Cost of goods sold 1 024 200 705 600
Interest expense 24 000 30 000
Pro t before tax (after interest) 351 000 231 600
Pro t after tax 245 700 162 120
Extract from Statement of financial position

R'000 R'000
X4 X3
Ordinary stated capital 180 000 180 000
Accumulated pro t − END of year 851 820 606 120
Long-term debt (10% p.a.) 500 000 300 000
Inventory 240 000 192 000
Trade receivable 232 560 200 640
Cash 52 800 45 600
Trade payable 257 700 144 000
Non-current assets at carrying value 1 264 160 791 880
1. Calculate the ROE for the business for the X3 and X4 financial
years. (2 marks)
2. Analyse the ROE figure. Indicate what it says about the
efficiency, profitability and risk of the business. (10 marks)
QUESTION 15.2 (B)

ABC Limited
Statement of Comprehensive Income for the year ended 31 March
X2
X2 X1
Rm Rm
Sales revenue 10 064.70 9 836.10
Cost of sales 6 396.15 6 341.85
Gross pro t 3 668.55 3 494.25
Operating costs 3 180.90 3 108.90
Operating pro t 487.65 385.35
Dividend income 5.25 1.65
Interest received 13.20 10.20
Pro t before nancing costs 506.10 397.20
Financing costs 108.45 138.90
Pro t before taxation 397.65 258.30
Taxation 140.10 76.95
Pro t after taxation 257.55 181.35
Earnings per ordinary share (cents)

Attributable earnings 454.35 315.75
Headline earnings 456 321
Dividend per share 308.28
Assume that:
• 75% of all sales are on credit.
• All purchases are on credit.
• Inventory as at 31 March X0 amounted to R1 855.1m.
Share price:
31 December X2 R33.21
31 December X1 R26.55
Answer the following questions:
1. What is the percentage change in sales between X1 and X2?
2. 2.1 Calculate the gross profit percentage on sales for X1 (1 mark)
and X2. (2 marks)
2.2 Has the gross profit percentage changed? Provide TWO
reasons that could cause the gross profit percentage to
change. (2 marks)
2.3 Briefly explain what the gross profit percentage in X2
means. (1 mark)
3. 3.1 What is the profit percentage on sales for X1 and X2? (2 marks)
3.2 Has the profit percentage changed between X1 and X2? If
so, provide TWO reasons why the percentage changed.
3.3 Briefly explain what the profit percentage in X2 (3 marks)
means. (3 marks)
4. Calculate the following.
4.1 Days inventory on hand. (2 marks)
4.2 Debtors collection period. (4 marks)
4.3 Creditors payment period. (4 marks)
5. 5.1 What is the length of the business’ working capital cycle?
5.2 Briefly explain why the working capital cycle has (2 marks)
changed from X1 to X2. (4 marks)
6. What do you understand by the following terms:
6.1 Days inventory on hand. (1 mark)
6.2 Creditors payment period. (1 mark)
6.3 Debtors collection period. (1 mark)
7. 7.1 Calculate the total asset turnover on productive assets for X1
and X2. (2 marks)

7.2 Briefly explain what the total asset turnover represents.
8. 8.1 Calculate the current ratio and the asset test ratio for (2 marks)
X1 and X2. (4 marks)
8.2 Briefly explain the difference between the current ratio and
the acid test ratio. (2 marks)
8.3 What type of companies would use the asset test ratio?
8.4 What are these ratios attempting to measure? (1 mark)(1 mark)
9. Briefly explain what you understand by the following terms
9.1 Gearing. (1 mark)
9.2 Financial risk. (1 mark)
9.3 Capital structure. (1 mark)
10. 10.1 Calculate the debt ratio for X2. (1 mark)
10.2 Briefly explain what the ratio means with respect to ABC
Limited. (1 mark)
10.3 Why would the bank be interested in this ratio? (3 marks)
10.4 Would you include trademarks and other intangibles in this
ratio if you were interested in calculating the debt cushion?
Briefly explain your answer. (2 marks)
11. 11.1 Calculate the times interest earned for X1 and X2. (2 marks)
11.2 Briefly explain what the ratio for X2 indicates about the
business. (1 mark)
11.3 Which other financial statement should you look at before
deciding what this ratio indicates about the business?
Briefly explain why it is important to look at this statement.
12. ROE = NM × AT × EM (2 marks)
12.1 Indicate what each of the elements in the calculation above
represents. (3 marks)
12.2 Calculate the NM, AT and EM for the business for the X1
and X2 financial years. (6 marks)

12.3 Calculate the ROE for the business for the X1 and X2
financial years. (1 mark)
12.4 Analyse the ROE figure. Indicate what it says about the
efficiency, profitability and risk of the business. (3 marks)
13. 13.1 Calculate the return to investors (shareholders) for the year
ended 31 December X2. (2 marks)
13.2 Briefly explain what the return to investor consists of.
14. 14.1 Calculate the price earnings ratio (PE ratio). (1 mark)(2 marks)
14.2 Briefly explain what the PE ratio indicates about the
perception the market has of the business. (1 mark)
15. What percentage of the profits has been paid out as a dividend?
(1 mark)
QUESTION 15.3 (C)

You are an investment analyst with Gallen Ray. You have been
asked to review the financial statements of African Oxygen Limited

(see the Appendix at the end of the questions) for a client. They
would like you to comment on the following areas when you report
back to them at the next meeting.
1. Briefly discuss how effectively African Oxygen Limited managed

its working capital in X2 and X1. Support your answer with at
least three working capital ratios, and provide two possible
reasons for any change from the previous year. Assume all sale
and purchase of goods are on credit. The closing inventory on

hand as at 30 September X0 amounted to R210 762 000. (See
notes 14, 19 and 26.) (14 marks)
2. Calculate the gross profit percentage on sales of goods for the
X2 and X1 years. Provide two reasons for the difference between
the current year’s and the previous year’s gross profit
percentages. (See note 26 and the statement of comprehensive

income.) (8 marks)
3. Assume that you are the newly-appointed loans manager at
LowRisk Bank and that African Oxygen Limited has applied for a
loan. The debt ratio for African Oxygen Limited is 59.2%.
3.1 Briefly explain what this ratio indicates. (1 mark)
3.2 Briefly explain why the bank would use this ratio in
deciding whether or not to loan African Oxygen Limited

money. (3 marks)
4. Assume that in total African Oxygen Limited has issued 330 300
808 Class A shares. The shares are currently trading on the JSE
at R85.
4.1 What is the net asset value of African Oxygen Limited?

4.2 Calculate the net asset value per share. (2 marks)(1 mark)
4.3 Calculate the market capitalisation of African Oxygen

Limited. (2 marks)
4.4 Mention TWO possible reasons that the market
capitalisation of African Oxygen Limited differs from the net

asset value of the business. (2 marks)
APPENDIX:
Extract from financial statements of African Oxygen Limited
[Used with the permission of African Oxygen Limited, a member of
the Linde Group.]

Receivables are carried at anticipated realisable value. An estimate is
made for doubtful receivables, based on a review of all outstanding
amounts at year-end. Bad debts are written off during the period in
which they are identified.

Non-profit
16 organisations and
club accounting
Craig James has been actively involved in training business people
in the SMME (small, medium and micro enterprises) sector since
completing his BCom degree at university. He has set up a
nonprofit organisation called Education for Africa. The company
offers management training and other business advice to small
business operators. The company was set up in Port Elizabeth
because a great deal of its work is in the rural areas in the former
Ciskei and Transkei. Craig had initially planned to work in a large
corporate company, but after travelling through Africa and South
America after completing his studies, he realised that he would
prefer to work in a non-profit organisation, where the people were
making an enormous difference to the quality of life of ordinary
South Africans. He realised that he had not spent much time at
university concentrating on non-profit organisations. Craig knew
that the underlying accounting concepts would not change just
because the business format was different, but decided to develop
a better understanding of reporting for a non-profit organisation.
Xolile Mhlongo is a university friend of Craig who has started up
a soccer club in Motherwell, Port Elizabeth. He is extremely
pleased that Craig is back in South Africa as he has a few
questions that he would like someone to help him answer. Xolile
keeps a record of all the soccer club's activities, but has no idea
how to summarise what has happened in the last year. He also
wants the students who play soccer at the club to learn something
about keeping financial records for the club. He believes that this
knowledge will be useful for them in many different areas in their
lives. He wants Craig to explain how to summarise all the
transactions that have happened and show the students in the
club how to keep financial records of all the club transactions.
Learning objectives
• Understand the difference between a non-profit organisation and a profit-orientated
organisation
• Understand and prepare the different forms of financial reports generally used by
non-profit organisations, such as the Statement of Receipts and Payments and the
Income and Expenditure statement
• Understand what coupons are, why they are often used by clubs, and how to record
the relevant transactions
• Prepare Subscription Fee accounts for clubs
• Prepare the financial statements of non-profit organisations and clubs.
Understanding Craig and Xolile's problems

Understanding Craig's problem
Craig does not know how to present the financial statements of a
non-profit organisation. He is aware that the underlying accounting
concepts will not change, but that the reporting of certain
information will be different from that of a private or public
company. We’ll see how the presentation of financial information
changes when we consider a non-profit enterprise.
Understanding Xolile's problem

Xolile is part of a club that is involved in some activities that have
financial accounting implications. Although he keeps a record of all
these activities, he does not summarise them into any meaningful
format that could be useful to the members of the club. We’ll
discover how to maintain a record of transactions of a club and how
to report on these transactions.
16.1 What are non-profit organisations?

A non-profit organisation is a trust, company or other association
usually established for a public purpose, the income from which is not
distributable to its members.
As their name suggests, these organisations are not profit-driven so
they do not have shareholders who expect a return on their
investment. The organisational structure of these entities is not much
different from that of other companies, but the reason they are in
business is very different from the profit-motivated operations of
other companies.
These organisations usually have objectives that seek to serve
social, humanitarian or environmental needs. They can be organised
in many different forms. Some examples are:

• Clubs, for example, a soccer club or golf club
• Societies, such as the Society for the Blind, SPCA
• Charities, for example, the Red Cross
• Trusts or funds, for example, the Nelson Mandela Children’s
Fund or the Desmond Tutu Peace Centre.

Some well-known non-profit organisations are listed below. A discussion of each of
their missions and activities is included for your interest.
Cape Information Technology Initiative (CITI) (<www.citi.org.za>)
Cape Information Technology Initiative (CITI) is a non-profit company that promotes
the development of the information technology (IT) cluster in the Western Cape.
They are building a database of participants in the IT industry in Cape Town,
throughout South Africa and abroad. CITI is helping to transform the Western Cape
into a global information technology hub and the IT gateway to Africa.
In order to achieve this aim they focus on:
IT cluster marketing and networking
IT business development
•
IT skills development
•
influencing IT policy.
•
Life Line (<www.lifeline.org.za>)

Life Line provides a 24-hour crisis intervention service at no cost to all sectors of
the community throughout South Africa regardless of race, religion or social
standing.
A wide range of other services is offered by the various Life Line centres
throughout South Africa, depending on the needs of the communities they serve.
These include:
AIDS call centre
Childline (Life Line Western Cape, Eastern Cape and Namibia)
•
SANDF Hotline, a crisis line for defence force members and their families
•
(Johannesburg)
•
Teen Line, a counselling service for teenagers (Life Line West Rand, Vaal
Triangle and Welkom)
•
A 24-hour rape response team

STOP Woman's Abuse Line
•
Face-to-face counselling by appointment.

•
•
World Wide Fund for Nature (WWF) (<www.wwf.org>)
The vision of the World Wide Fund for Nature (WWF) is to save life on earth, and
more specifically, to save endangered species and the wild places that are vital to
the health and survival of our planet.
WWF has five million members around the world who support this vision. WWF-SA
is a non-governmental organisation which acts as a funding conduit to facilitate
environmental and biodiversity conservation. This is achieved through fundraising
for priority projects, and not by acting as a conservation implementing agent. Their
main function is to provide a channel for funds and to use these funds for
conservation. WWF-SA is currently supporting some 150 projects.
16.2 How are non-profit organisations

regulated?
For various reasons, non-profit organisations are often formed as a
company, which implies that the organisation is regulated by the
Companies Act. If a non-profit organisation is registered as a
company, the name of the organisation will end with NPC (short for
“non-profit company”) instead of “Ltd”, which applies to other
companies.
The Companies Act 71 of 2008 identifies two types of companies

− profit companies and non-profit companies. A non-profit company
is incorporated for public benefit and the income and property are
not distributable to its incorporators (the people who started the
non-profit company). The term “non-profit company” was
introduced in the Companies Act 71 of 2008. Prior to this, companies
that did not have a profit motive were referred to as “section 21
companies”.
The Companies Act 61 of 1973 did not provide sufficient
guidelines to non-profit organisations, and the Non-profit

Organisations Act 71 of 1997 (NPO Act) was drafted in response to
the huge increase in the number of section 21 companies.

These types of organisations were historically labelled non-
government organisations, as they were given very little support
from any government authorities. They worked largely in isolation,
bearing their administrative and operating burdens on their own,
usually with little expertise in management. Many of the members
worked without any payment.
These organisations are now far more visible in the mainstream
economy and are now also supported by a legislative framework
that ensures that their work is transparent and carried out with
integrity.
16.3 What accounting rules govern non-

profit organisations?
Non-profit organisations would have to comply with the GAAP
standards relevant to non-profit organisations. Such organisations
would not have a choice as to the treatment of donations and grants
received from the government − they would have to regard these
items as income, not capital. They would also have to show all
income earned in respect of their activities as revenue with costs
incurred to generate that revenue as cost of sales and service. In the
case of a non-profit organisation registered under the NPO Act but
not registered as a company, there would be more flexibility in
reporting, as is shown in the example later in the chapter.
Non-profit organisations registered under the NPO Act must:
• Keep accounting records of income, expenditure, assets and
liabilities.
• Within six months after the end of the financial year, draw up
financial statements, which must include at least a statement of
income and expenditure for that financial year, and a statement

of financial position showing its assets, liabilities and financial
position at the end of that financial year.
Other requirements for non-profit organisations

Within two months after drawing up the financial statements, a
written report must be compiled by an accounting officer and
submitted to the organisation stating whether or not:
• The financial statements of the organisation are consistent with its
accounting records
• The accounting policies of the organisation are appropriate and
have been appropriately applied in the preparation of the
• The organisation has complied with the provisions of the Non-
profit Organisations Act.
Requirements for a non-profit company

If the organisation is incorporated, which means registered as a
company (non-profit company), it then has to comply with the
requirements of the Companies Act 71 of 2008. In terms of that Act,
compliance requires the following:
• Financial records have to be kept
• Financial statements have to be prepared within 6 months of the
financial year-end
• A simplified form of accounting standards can be used to prepare
the financial statements. This is known as GAAP for SMEs (small
and medium enterprises)
• A new development in the Companies Act 71 of 2008 is that an
audit is no longer required
• An annual return will have to be submitted to the registrar of
companies (financial statements are not required).

16.4 What rules govern the formation of
non-profit organisations?
In a non-profit organisation, a trust deed and memorandum of
association are required to register the organisation. These are
known as the constitution of the organisation.

The constitution must:
• State the organisation’s name.
• State the organisation’s main and ancillary objectives.
• State that the organisation’s income and property are not
distributable to its members or office-bearers, except as
reasonable compensation for services rendered (office-bearer
means director, trustee or person holding an executive position).
• Make provision for the organisation to be a body corporate and
have an identity and existence distinct from its members or office-
bearers.
• Make provision for the organisation’s continued existence even
when there is a change in its membership or office-bearers.
• Ensure that the members or office-bearers have no rights in the
property or other assets of the organisation as a result of their
being members or office-bearers.
• Specify the powers of the organisation.
• Specify the organisational structures and mechanisms for its
governance.
• Set out the rules for convening and conducting meetings,
including quorums required for and the minutes to be kept of
those meetings.
• Determine the manner in which decisions are to be made.
• Provide that the organisation’s financial transactions must be
conducted by means of a banking account.

• Determine a date for the end of the organisation’s financial year.
• Set out a procedure for changing the constitution.
• Set out a procedure by which the organisation may be wound up
or dissolved.
• Provide that, when the organisation is being wound up or
dissolved, any assets remaining after all its liabilities have been
met must be transferred to another nonprofit organisation having
similar objectives.
Other issues that may be addressed in the constitution include:

• The circumstances in which a member will no longer be entitled
to the benefits of membership
• Termination of membership
• Membership fees
• A provision that members or office-bearers are not liable for any
of the obligations and liabilities of the organisation
• A provision for making investments
• The purposes for which the funds of the organisation may be
used
• Provision for acquiring and controlling assets.
16.5 Accounting for non-profit

organisations
As you may already have realised, the objectives of non-profit
organisations are very different from those of other organisations.
This will have implications for the way in which we report on these
organisations.
The differences between profit and non-profit organisations are as
follows:
• There are members, not shareholders, in non-profit organisations,

and they are not entitled to receive a distribution of any income
earned.
• There is no share capital, because there are no shareholders. Any
surplus funds appear in the General Funds account on the

• The main sources of revenue are from members’ contributions or
donations, not from sales or services rendered.
• The accounting records are often not as sophisticated as other
businesses and may be maintained on a cash basis.
• The income statement is referred to as the Statement of Income

and Expenditure.
• Profit is referred to as a surplus and a loss is referred to as a
deficit.
• A Statement of Receipts and Payments is prepared together with
the other financial statements to summarise all cash transactions
for the period.
Let’s look at a set of financial statements for a well-known
international non-profit organisation. Below are the statement of
financial position (balance sheet) and income and expenditure
statement of the South African division of the World Wide Fund for
Nature.
World Wide Fund for Nature (SA)
Extract from notes to the annual financial statements for the year
ended 31 March X1
2. Freehold properties
X1 X0
R R
Freehold properties at cost or valuation: 85 317 058 77 257 108
Nature reserves 54 943 792 47 032 142
Southern African Wildlife College 29 663 012 29 619 403
Protea Heights farm, Stellenbosch 710 254 605 563
The management of all properties except for Protea Heights has
been transferred by WWF-SA to relevant conservation
authorities
3. Computer equipment
Year ended 31 March X1
Opening carrying amount 123 810 90 410

Additions 77 041 93 121
Transferred to projects (9 878) −
Depreciation (64 776) (59 721)
Closing carrying amount 126 197 123 810
At 31 March
Cost 746 680 679 516
Accumulated depreciation 620 483 555 706
Carrying amount 126 197 123 810
4. Motor vehicles

At 31 March
Cost 446 972 446 972
5. Farm implements

Additions 1 692 −
Disposals (1 044) −
At 31 March X1
Cost 96 298 106 892
6. Investments
Funds managed by nancial institutions at 26 277 22 779

cost price 717 801
Funds managed by nancial institutions at 27 243 23 789
market value 420 396
The Foundation changed its policy regarding the treatment of
investments during the year under review (note 10).
The investment is classified by management as available for
sale.
7. Funds
The accumulated funds have been earmarked as follows where
applicable:
• General fund − representing funds available for projects and
administration.
• Property fund − representing funds already applied in the
acquisition of conservation properties.
• Projects fund − representing funds available for projects, or
which have been earmarked for projects or types of projects,
or have been allocated to specific projects.
• Capital fund − representing contributions to the 1001: A
Nature Trust fund, from which only the income can be used
for projects and administration.
What do you notice?

• The total equity and liabilities section of the statement of financial
position is called the total funds and liabilities section.

• Equity consists of specially named funds instead of share capital
and reserves. Each fund, except the general fund, has been
earmarked for specific types of expenditure.
• A general fund accumulates the surplus reported in the Income

and Expenditure Statement.
• The Income and Expenditure Statement consists of income and
expenditure.
• Income is derived from sources other than operating activities.
The main sources of income are:
− Subscriptions and donations
− Income from international aid agency
− Interest and dividends
− Bequests − amounts given to the organisation by donors, often
in terms of their wills
− Surplus from Protea Farm − this is the surplus (income
generated by the farm less the expenditure incurred by the

farm) derived from one of WWF’s income-producing activities.
As you can see, there is some new terminology that we need to
understand when preparing financial statements for non-profit
organisations. We’ll build our understanding by preparing financial
statements for Craig and Xolile’s organisations.
They have the following questions about their organisations,
which we will answer before looking at the accounting issues that
distinguish non-profit organisations from other entities.
16.5.1 What financial activities should be performed

in the business?
Someone should be appointed to carry out the following tasks:
• Collecting and paying out cash, and banking cash
• Keeping a cash book or record of transactions
• Paying suppliers of services such as training
• Maintaining a list or register of members indicating members’
details
• Calculating fees due and sending statements to members for fees
due
• Performing regular reconciliations of the Bank account to the
bank statements.
16.5.2 What reports do non-profit organisations

compile?
• Statements of Receipts and Payments (cash transactions)
• Income and Expenditure Statement
• Statement of financial position.

Let’s look at the reports of Education for Africa for the year ended 28
February X2.
Statement of receipts and payments for the year ended 28

February X2
Opening cash balance 4 489
Add Receipts 137 380
Subscriptions 24 950
Corporate sponsorships 68 000
Grants 25 000
Proceeds from fund-raising 3 550
Donations 15 880
Less Payments (128 179)
Telephone (5 112)
Furniture (7 905)
Training fees (98 458)
Printing and material costs (16 704)
Closing cash balance 13 690
Income and expenditure statement for the year ended 28 February

X2
Income 32 950
Subscriptions 25 000
Surplus from fund-raising 2 950
Donations 5 000
Expenses 22 221
Depreciation (1 581 + 2 659) 4 240
Telephone 3 440
Training fees 8 458
Advertising 2 669
Stationery and printing 3 414
Surplus for the year 10 729
Statement of financial position as at 28 February X2

Assets
Non-current assets
Furniture and equipment 21 200

Bank 13 690
Training course investment 6 400
Subscriptions in arrears 350
Total assets 41 640
Funds and liabilities

General fund 41 465
Balance at beginning of year 13 456
Add Surplus for the year 10 729
Add Donations (R15 880 − R5 000) 10 880
Add Training course fund 6 400
Current liabilities
Subscriptions in advance 175
Total funds and liabilities 41 640

The following items appear on the financial statements of Education
for Africa:
Subscriptions
These are the annual payments made by members of the
organisation.
Sponsorships
This is money received from outside the organisation. Sponsors
pledge money to charities or non-profit organisations to carry out a
specified activity. In Education for Africa, an annual six-month
training course is run for small business owners in the townships.
This course is sponsored by large companies, and Craig spends a
few weeks each year visiting companies to secure sponsorships for
events planned in the following year. The sponsors require the
funding to be used for the training course only.
Grants
These are donations, similar in concept to sponsorships, usually
given by government bodies in the form of concessions or money.
Craig is given money every year by the local education authority
to run a programme for students at Fort Hare University to
empower them with financial literacy skills.

Donations
These are amounts received from anywhere outside the
organisation. They may be from individuals or companies and may
vary in amount from large once-off amounts to small once-off or
annual amounts.
Inflows from fund-raising

This is another source of funds for non-profit organisations, and is
derived from fundraising activities. Craig, for example, ran a
business awareness day at the local university. Service providers to
small business set up exhibitions on campus. The intention of the
project was to raise awareness amongst small business owners of the
services available to them. The stallholders paid a fee for the right to
exhibit their service.
Let's look at the accounting treatment of each of these inflows.

• Subscriptions received are reported in the Statement of Receipts
and Payments
• Subscriptions earned are reported in the Income and Expenditure
Statement
• Subscriptions received but not yet earned are reported in the
Statement of financial position as subscriptions in advance

(income received in advance − a liability)
• Subscriptions earned but not yet received are reported in the
Statement of financial position as subscriptions in arrears (accrued

income − an asset).
An account needs to be kept of all information relating to
subscriptions to ensure that complete and accurate information is
reported in the financial statements. An example follows to show
how this information is recorded in a control account.
Example
On 1 March X1 Education for Africa had the following balances:
Total cash receipts for the R24 950
year
Subscriptions in advance R250
Subscriptions in arrears R375
The organisation has 1 000 members who pay an annual
membership fee of R25. This fee entitles them to a weekly newsletter
and free access to the financial advisory services offered by
Education for Africa. Members are liable for subscriptions on the
first day of the financial year, 1 March.
At the end of March X2 14 members were in arrears and seven
had paid their X3 subscription. Let’s look at how this information
would be recorded in the general ledger account:
1. At the beginning of the year, the balances that appear in the
statement of financial position are transferred to the
subscription account:
Alternatively a single Subscriptions account could be kept. This
would eliminate the need to transfer amounts out of the other
accounts, so it would save time.
2. The cash received from members is recorded.
3. The subscriptions received in advance are recorded. These are a
liability, because the members are owed a year of membership
and all the benefits associated with it by the organisation. In the
example, seven members had paid their fees for the following
year. The fees received in advance are 7 × R25 = R175.
4. The subscriptions not yet paid by the end of the year are
recorded. These are an asset, because the members owe the
organisation fees for the membership they have enjoyed for the
past year. In the example, 14 members had not yet paid their
fees for the current year. The fees in arrears are 14 × R25 = R350.
5. The amount recognised as income from subscriptions is
calculated and recorded as a debit to the Subscriptions account
and a credit to Income and Expenditure at the beginning of the
financial year, the date on which it is due for payment. The
Income and Expenditure account is similar in principle to the
Profit or Loss account of a company.
If separate accounts had been used for showing the statement of
financial position amounts in arrears and advance at the end of
each year, then the Subscriptions control account would look
like this:

If an organisation earns income from special income-raising events,
it is useful to report the income from each of these events on
separate Income and Expenditure Statements. This would mean that
there would be an income and expenditure statement for each
income-producing activity. Examples of such activities are:
• Bar or restaurant, for example, in a club
• Shop, for example, a charity shop
• Carnival or bazaar, for example, a fund-raising function
organised by a church.
The profit from each activity would be reported on the general
Income and Expenditure Statement as the surplus from that activity.
This is particularly relevant where an activity is a once-off event
(such as a carnival), as it would be impossible to predict the future
income of the organisation without showing this revenue separately
from the income that is generated on an annual basis.
Education for Africa would record the information from the fund-
raiser in the following way. The total cash received from stallholders
is recorded as a cash receipt and shown in the statement of cash
receipts and payments as “proceeds from fund-raising”.
The profit from the event is recognised as a fund-raising surplus
on the Income and Expenditure Statement. Let’s see how the income
from the event was calculated.
Expenses relating to the event were R600. These are not shown
with general expenses because they relate specifically to the fund-
raising event.
The fund-raising surplus is calculated on an Income and
Expenditure statement and is posted to the general Income and
Expenditure statement.
Fund-raising Income and Expenditure Statement for the year

ended 28 February X1
Income
Income from fund-raising 3 550
Expenses
Advertising (250)
Posters and stationery (200)
Transport costs (150)
Surplus 2 950
16.5.7 Accounting for sponsorships, grants and

donations
When large sums are received, a decision needs to be made about
how these amounts should be accounted for. Provision should be
made in the constitution of the organisation for the treatment of
large inflows of gratuitous (free) funding. (If the organisation is
required to apply GAAP − it is a non-profit company rather that a
non-profit organisation − the entity has no choice but to recognise
the donation as income.)
If the amount is treated as income, it will increase the surplus for
the year. The surplus is reported on the Income and Expenditure
Statement and added to Accumulated Funds on the statement of
financial position.
If the amount is treated as capital, it will increase the
Accumulated Funds balance for the year, and be reported on the
Statement of financial position.
There is no conceptual argument for treating amounts as either
income or capital.
If a large amount is received once off and is not therefore
expected to recur, then it would make sense to treat the amount as
capital. This would avoid distorting the current year’s surplus. If, on
the other hand, the amount is received annually, then it would make
sense to show it as a contributor to the annual surplus.
If the amount received was to be used to finance general
operating expenses, then it would be treated as income. If, however,
it will be used to finance the purchase of assets, in other words, for
capital expenditure, then it would generally be treated as capital.
If the amount received is to be used for a specific purpose, then it
would not flow through the Income and Expenditure Statement.
Instead a Special Fund account would be set up that would be
reported separately from the general funds.
If the amount is for general use within the organisation, then it
can be treated as either capital or income, therefore crediting either
the General Fund account or the Income and Expenditure account.
Summary of accounting for sponsorships, grants and donations
General use:
1. Treat as income if recurring or used to finance general
operational expenses:
2. Treat as capital if once-off or used to finance capital
expenditure:
Specific purpose:
3. Treat as a special fund, which is a type of equity fund:
The General fund (equity) account has been used to fund various
assets or expenditure, whereas a special fund (equity) can be used to
fund only specified assets or expenditure.
Let's look at how the sponsorships, grants and donations were

treated by Education for Africa.
16.5.7.1 Sponsorships
During the current year, companies gave Education for Africa a total
of R68 000 earmarked for a special training course. You will notice
that this amount does not appear on the Income and Expenditure
Statement. Why?
Because the amount has been designated to be used for a special

purpose, it is shown separately in a special fund. This ensures that
the funds are used only for their intended purpose, and that they are
not used to fund general expenditure. The special funds can be
placed in interest-earning investments until they are special needed.
This has the advantage of earning additional income that can be
used for the project.
A fund set aside for a special purpose will usually have rules
attached that specify how the fund and income derived from it are to
be used.
It is important to remember that these funds are treated
separately from the general income, expenditure and capital
accounts. If the money from these funds is invested, then that

investment is also shown separately from other assets on the
In Education for Africa, the sponsorships received amounted to R68
000. This money was used to fund a training course costing R65 000
in training fees.
When the money was received on 1 March X1 it was invested in a
fixed deposit for six months, earning interest of 10% p.a. After six
months the money was used to pay training fees.
When the funds were received, Bank was debited and the
Sponsorships account was credited with R68 000. Let’s look at how
this money needs to be accounted for:
1. The money received and recorded as “sponsorships” is
transferred to a special fund indicating clearly that the money
can only be used to pay for the training course.
2. The cash received is transferred to a fixed deposit. In the records
the amount was initially recorded as a debit to the Bank
account. This amount is then transferred to the Training course
investment account.
3. After six months the interest earned on the fixed deposit
amounted to R3 400 (10% of R68 000 for six months). This is
recorded as follows:
4. The course is offered and the expenses of R65 000 will be
covered by the funds in the fixed deposit. Assuming that the
expenses are paid for from the Bank account, money will be
transferred from the Training course investment back into the
Bank account.
5. The R55 000 for the course is part of the total amount of R98 458
paid for training expenses during the year. As R65 000 of
training fees is paid for from the Training course fund, the
difference of R33 548 is paid for by the organisation and is a
general operating expense. The R65 000 must be transferred out
of (credited to) the expense account and set off against the
special fund account that was created to fund the course. This
means that the cost of this training course will not be shown on
the Income and Expenditure Statement with other general
expenses. This is because it is not a general operating expense.
A separate income and expenditure statement is prepared to
show the income and expenditure relating specifically to the
training activities. This is done to draw attention to that activity
and separate it from the other activities in the organisation.
Something to do 1
Balance the Training course special fund and Investment fund accounts.
What do you notice?
Check your answer
The balance on each of these accounts is the same! This is because the amount (R6
400) in the investment account (assets) is equal to the funds in the equity account that
can still be used to fund training.
Think about this 1

How will these balances be reflected in the financial statements?
Check your answer
The special fund account will appear in the funds section in the statement of financial
position, showing a credit balance of R6 400.
The investment account will appear under current assets in the Statement of
financial position. The R65 000 is not reported on the Income and Expenditure
Statement as this cost was fully covered by the sponsorships received.
Have a look at Education for Africa's Statement of financial position again to review the
disclosure of this special fund.
Let's look at what would happen if the cost of the course had been higher than the
available funding.
Assume that the cost of the course in this case was R75 000.
What do you notice?

The cost of the course is R75 000. Only R71 400 of this amount is
covered by the special funds account.
There will no longer be a fund or investment account in the
Statement of financial position at the year-end in this example,
because all funds have been used for their special purpose. There
will, however, be an effect on the Income and Expenditure
Statement. Can you work out what that is?
The course costs R75 000. Of this, R71 400 has been covered by
special funds. The remaining cost of R3 600 is an expense that must
be covered by the organisation’s general funds. The R3 600 will

therefore be shown on the Income and Expenditure Statement for
the year.
16.5.7.2 Grants
During the year Craig received an amount of R25 000 from the
provincial department of education for a literacy programme run at
a local university.
This money was not invested and was used to cover the cost of
trainers on the programme. A special fund must be created to show
the receipt and allocation of the grant received. The total cost of
trainers was R26 500. This will be shown in the general ledger as
follows:
The result is that there is no effect on the Statement of financial
position because all the funds received have been allocated to the
literacy programme.
The effect on the Income and expenditure statement is a training
cost of R1 500 (R26 500 − R25 000). This will be included with other
training fees on the statement.
Something to do 2
Calculate the amount from the Training fees account that will be transferred to
Income and Expenditure at the end of the current year. Check that this amount
agrees with the amount reported in Education for Africa's Income and
Expenditure statement.
Remember that the statement of receipts and payments in section 16.5.3
shows a cash receipt for training fees of R98 548.
Check your answer
16.5.7.3 Donations
In the example, donations of R15 880 were received. Of this amount,
R5 000 was from regular donors in the business community, while
the balance was other once-off donations. It has been decided to treat
the once-off donations as capital and the regular donations as
income. This is accounted for in the general ledger as follows:
In the Statement of financial position, R10 880 will be added to the
General fund.
In the income and expenditure statement, R5 000 will be reported
as income.
We have now completed the review of new terminology
associated with reporting the activities of non-profit organisations.
On the next page is a table summarising the main differences
between non-profit and profit entities.
Non-profit organisations Profit organisations

• Have social or environmental • Have pro t motives
objectives
• Are funded by members • Are funded by shareholders
• Receive contributions in the form • Receive capital from their

of fees from their members shareholders
• Members cannot make any claims • Shareholders earn a return on

against the funds in the their capital invested
organisation
• A surplus or de cit arises from • A pro t or loss arises from

operations and is reported in the operations and is reported in
Income and Expenditure the statement of
Statement comprehensive income
• In ows of capital are reported in • In ows of capital are reported

the Accumulated Funds account in the Stated Capital account
on the Statement of nancial on the Statement of nancial
position position
• In ows of funds include gratuitous • In ows of funds include

amounts in the form of grants and receipts from goods sold or
donations services rendered
• In ows can be classi ed as either • In ows of economic bene ts

capital or revenue depending on are reported as income,
the purpose for which they are to excluding contributions of
be used equity (shares)
• Accumulated funds may not be • Accumulated pro ts may be

distributed to members distributed to shareholders in
the form of dividends
Let’s turn our attention now to the soccer club and use what we have
learnt about nonprofit organisations to prepare the financial
statements of the club for the current year.
16.6 Preparing the financial statements

for a club
Xolile has provided the following information relating to the
Motherwell Soccer Club for the last year:
Receipts
Subscriptions received from members R3 900
The club has 85 members, two of whom transferred to the Gauteng
Tigers Soccer Club during the year, after paying their fees due for
the current year. The receipts include fees of R150 owing from the
previous year and R100 only due in the next year. Fees of R200 are
still owing for the current year. Fees of R400 due on 1 September X1
were received on 1 August X1, in other words, in advance. Fees fall
due on the first day of each financial year.
Grant received from Gold Company Ltd on 1 October X1 R60 000
The lump sum received from Gold Company Ltd is to be used solely
for the purchase of team equipment and team outfits. The money
was deposited in a cheque account and cheques drawn on the

account were used to buy new team jerseys. Bank charges on the
account for the current year totalled R450.
A grant (called the Steve Tshwete Development Fund) received from

the Department of Sport on 1 January X2 R50 000
The capital and income earned on this lump sum are to be used
solely for training new members and the club’s development
programme at the local schools. The club committee decided to
invest the lump sum in a 30-day call account and to transfer
whatever amount is spent monthly on training and development
from this account to the club’s own bank account. Interest receipts
totalled R4 300 have been received to date. The club wishes to name
the fund the Steve Tshwete Development Fund.
Donations received from foreign donors on 1 February X2 R80 000
This lump sum was invested in a six-month fixed deposit earning
interest of 14% p.a. The fund has been named the Global Fund and
only the income from the amount invested may be used for
travelling expenses. The interest was deposited into the club’s own
bank account on 1 August X2 and the capital amount was
transferred to another bank offering a 1% higher annual rate of
return for the next six months. The interest is received six months in
arrears.
Cash received from tickets sold for matches R18 370
The club sells tickets to the public for matches played. Included in
the receipts is an amount of R580 from ticket sales for a match to be
played on 15 September X2.
Cash banked from club tuckshop R22 348

A stock count revealed the following inventory balances at the end
of the years indicated:
31 August X1 R2 462
31 August X2 R6 394
These amounts are reflected at their cost price.
Payments R
Rent of clubhouse 2
000
Wages of cleaning staff 3
750
New team jerseys and equipment 16
000
Bus trip to Gauteng 8
000
Expenditure on training and development 35
000
Payments to trade payables of balance owing at the beginning of the 2
year 180
Cost of inventory bought to sell at the club tuckshop 12
240
Wages of cashier at club tuckshop paid out of cash takings from sales 4
before banked 360
The following additional information was extracted from the X1
statement of financial position:
Bank 12 340
Trade payables for supplies (no balance at the end of X2) 2 180
Rent prepaid (one month's rent) 200
Use this information to prepare the club’s general Income and
Expenditure Statement and Statement of financial position for the
year ended 31 August X2.
Motherwell Soccer Club

Income and expenditure statement for the period ended 31 August
X2
Workings R
Income 36 080
Ticket sales (18 370 − 580) 1 17 790
Subscription income 2 4 250
Tuckshop surplus 3 14 040
Expenses (7 550)
Rent of clubhouse (200 × 12) 2 400
Wages of cleaning staff 3 750
Travelling expenses 4 1 400
Surplus 28 530
Workings:
1. Ticket sales exclude the amount of R580, as it has not yet been
earned
2. The amount of subscription income earned is calculated by
completing and balancing the Subscription account.

3. Calculation of tuckshop surplus
Sales (22 348 + 4 360) (a) 26 708

Opening inventory 2 462
Add Purchases 12 240
Closing inventory (6 394)
Gross pro t 18 400
Less Wages (b) (4 360)
Surplus 14 040
Note:
a) The wages paid to the cashier were from cash sales. This amount is added
back when determining total cash sales.
b) The wages have been deducted from gross profit in order to arrive at the
tuckshop surplus. No other expenses were incurred in the running of the
tuckshop.
4. Travelling expenses
Travelling expenses are covered by the Global Fund. This is an
example of a special fund requiring the capital sum to remain
intact.
Only interest may be used to finance the activities specified
by the donors. In the example, R80 000 was received from
donors and invested for six months at 14% p.a. and for one
month at 15% p.a. We’ll need to calculate the income earned on
the investment to see how much is available for travelling costs.
The bus trip to Gauteng is the only travelling expense and
amounts to R8 000.
Calculation of income earned on fund investment
Donations received on 1 February X2 R80

000
Interest earned on 14% xed deposit (0.14 × 80 000 × 6/12) R5 600
Interest earned on 15% xed deposit (0.15 × 80 000 × 1/12) R1 000
Total income available for travelling costs R6
600
Total travelling cost R8 000

Less Amount funded by Global Fund interest (R6
600)
Amount to be reported in income and expenditure R1
statement 400
The R1 400 will be paid out of the club’s own bank account (see
calculation of bank balance).
Let's complete the Statement of financial position.

First we’ll need to calculate the balances on each of the special funds
in the organisation.
1. Steve Tshwete Development Fund
Grant received on 1 January X2 50 000

Add Interest earned 4 300
Less Expenditure on training and development (35 000)
Balance at 31 August X2 19 300
This is similar to the example in Education for Africa in which
grants and sponsorships were used to fund training costs.
Review the general ledger accounts again if you are unsure
about which transfers are processed at the year-end.
2. Gold Company Ltd Fund
Grant received on 1 October X1 60 000

Less Bank charges (450)
Less Expenditure on team equipment (16 000)
Balance at 31 August X2 43 550
This fund is different from the others we have worked with so
far. The difference is that this fund is used for capital
expenditure, and not to cover expenses. The general ledger is
prepared below to show what transfers are made when the
special fund is used to purchase assets.
The amount spent on equipment must be transferred out of the
special fund (debited), indicating that R16 000 of the R60 000
available has been spent. We cannot credit the Equipment
account, because it is an asset and must be recognised as an
asset. We credit the General Fund account instead.
3. Global fund
Donations received on 1 February X2 80

000
Interest earned on 14% xed deposit (0.14 × 80 000 5 600
× 6/12)
Interest earned on 15% xed deposit (0.15 × 80 000 1 000
× 1/12)
Less Travelling expenditure (6
600)
Balance at 31 August X2 80
000
4. General fund
How do you think the opening balance on the General Fund can
be calculated?
Here’s a clue: look back at the accounting equation, introduced
in Chapter 3.
The opening balance on the General Fund account is calculated
using the accounting equation, Assets = Equity + Liabilities, at
31 August X1.
Balance at beginning of year (assets − liabilities at 31 August 12 572
X1)
Bank 12 340
Rent prepaid 200
Inventory 2 462
Subscriptions in advance (400)
Trade payables (2 180)
12
572
The surplus from the income and expenditure and the amount
used to finance the purchase of equipment is added to the
opening balance.
Add Surplus 28 530

Transferred from Gold Company Ltd Fund 16 000
Closing General fund 57 102
5. Calculation of closing bank balance
Opening bank balance 12

340
Add Receipts (3 900 + 18 370 + 22 348 + 4 360) 48 978
Less Payments (2 000 + 3 750 + 1 400 + 2 180 + 12 240 + (25
4 360) 930)
Closing bank balance 35
388
All cash receipts and payments relating to special funds are
excluded from the calculation of the bank balance.
Note:
The wages paid out of cash takings have been added back to cash receipts
and then taken out again as a payment.
Motherwell Soccer Club
Statement of financial position at 31 August X2
Workings R
Assets
Equipment 16 000
Inventory 6 394
Bank 5 35 388
Cheque account 43 550
30-day call account 19 300
Fixed deposit 80 000
Total assets 200 832
Funds and liabilities

Accumulated fund 4 57 102
Gold Company Ltd Fund 2 43 550
Steve Tshwete Development Fund 1 19 300
Global Fund 3 80 000
Subscriptions in advance 100
Income received in advance 580
Accrued rent (2 400 − 2 000 − 20) 200
Total funds and liabilities 200 832
Note:
The balances on the special fund investment accounts (assets) equal the
balances on the special fund accounts (equity) in the funds section of the

When money is received for a special purpose, a special fund is
created to account for the expenditure.
The money may be invested outside the organisation and earn
interest.
The donor will usually specify how the fund and income derived
are to be used. They may be used in any of the following ways:
• Capital sum to remain intact and only the income earned on the
capital to be used for special purpose, or
• Capital and income may be used, or
• Only capital may be used.
A summary is presented below of the journal entries processed
when special funds are applied to expenditure.
1. When money is received by the organisation and the donor has
stipulated that the donation is to be used solely for the purchase
of a new asset:
Example:
A donation of R50 000 has been received from a donor, specifying
that the money be used to construct a building.
Below are the journal entries to record the donation, assuming
that R40 000 was used to lay foundations for the new building.
The balance of R10 000 indicates that there is still R10 000
funding available from the donor.
2. When money received from a donor may be used to finance
only certain expenses:

Xolile is thinking of opening a canteen at the soccer club, but does
not want to take on the risk of managing the cash flow at the
canteen.
It would be a good idea to consider issuing coupons to members
who wish to use the canteen.

A coupon or token can be used instead of cash to collect goods and
services. Coupons can be purchased for cash and then used when
convenient to purchase goods or services. In the example of the
soccer club, meal vouchers or coupons could be purchased for cash
and then later exchanged for meals. Coupons could be purchased at
a central point and the cash flow carefully controlled. This reduces
the risks of handling cash in the canteen. Fewer controls are needed
because the cash is received at a central location.
Some organisations issue coupons at a discount to encourage
members to make use of them.

There must be control over the issue of coupons and the cash
received when coupons are sold. Records must be kept of the total
value of coupons sold as well as the value of coupons exchanged for
goods. Coupons are usually assigned a nominal or sale value,
sometimes referred to as the face value.

The coupons must be sequentially numbered to help determine
the number of coupons sold and to ensure that all coupons are
accounted for.
Coupons must be assigned a period of use. Upon expiry of that
period, unused coupons may be returned and refunded or in some
cases may lapse (become worthless). If they are not returned, they
will automatically be treated as income and the holder of the coupon
will not be allowed to exchange the coupon after expiry date. These
are known as forfeited coupons.

The sale of coupons must be controlled to ensure that all cash
received is banked. The number of coupons sold and the money
received should be reviewed and reconciled.

When coupons are sold, the value of coupons sold (nominal value) is
credited to the Unredeemed coupons account. The Unredeemed

coupons account is a liability account that shows the value of
coupons that the organisation has an obligation to redeem in the
future. The coupons are redeemed when they are exchanged for
goods.
The cash received from the sale of coupons is debited to Bank. If
the coupons are sold at a discount (the nominal value is R100, but
only R95 is received), the discount allowed on coupons sold (R5) is
debited to Coupon discount, an expense account. When coupons are

redeemed for goods or services, the Unredeemed Coupons account
is debited. This is because the liability is reduced when the coupons
are exchanged for goods.
Forfeited coupons are coupons which have not been used in the
allocated time period. At the expiry date, they are debited to the
Unredeemed Coupons account and credited to the forfeited income
account to show that the liability has been converted to income.
The balance on the Unredeemed Coupons account shows the
remaining liability, representing coupons not yet redeemed at the
end of the period. This will be shown under current liabilities on the
Let's look at an example in which coupons are used in exchange for

meals.
1. On 1 January X1, the balance of unredeemed coupons is R2 800.
These coupons expire on 1 June X1.
2. During the year, coupons valued at R15 000 are sold to members
at a discount of 2%.
3. Coupons worth R13 800 are redeemed during the year. Of this,
R2 400 is from coupons included in the opening balance of
unredeemed coupons.
The Unredeemed Coupons account in the general ledger is
shown below.
The amount received for coupons sold is R14 700, which is 98% of
the nominal value of the coupons (R15 000 × 98%).
The forfeited income is R400 (R2 800 − R2 400). These coupons are
no longer exchangeable after the expiry date of 1 June X1.

• The 2008 Companies Act allows for profit and non-profit
companies.
• Organisations registered as non-profit companies will need to
report according to the relevant GAAP statements.
• Non-profit organisations that are not covered by the Companies
Act will need to comply with the NPO Act.
• Non-profit organisations have similar organisational structures to
companies, but have a very different reason for being in business.
• Non-profit organisations usually have objectives that seek to
serve social, humanitarian or environmental needs.
• The reports presented by non-profit organisations are the cash
receipts and payments statement, income and expenditure
statement, and statement of financial position.
• These organisations receive cash inflows from subscriptions,
sponsorships, grants, donations and fund-raising activities, all of
which need to be accounted for.
What's next?
In the next chapter, we will look at how to prepare accounting
records if the records we are working with are for some reason
incomplete. This could be the result of a fire or other disaster, or the
business may not have kept all the necessary documentation.

QUESTIONS
QUESTION 16.1 (B)

H Sepeng, the Treasurer of the Olympic Sports Club, presented you
with the following information which was extracted from the
accounting records of the club. He also states that the previous
treasurer had not maintained proper accounting records.
Olympic Sports Club

Extract from statement of financial position at 31 May X9
Assets
Current assets
Subscriptions in arrears R525

Current liabilities
Subscriptions in advance R575
The following information was obtained from the bank statements
for the year ended
31 May X10:
Subscriptions:
X8/X9 R400
X9/X10 R24 850
X10/X11 R1 050
Entrance fees (4 × R150) R600
i) It is the policy of the club to record subscriptions as income for
all members on the books at the beginning of each financial
year. New members are required to pay a full year’s
subscription, irrespective of the date of joining.
ii) At 31 May X9 one junior member had paid her X9/X10
subscription of R75.
iii) On 1 June X9 the club had 155 senior and 80 junior members on
its register.
iv) During the year ended 31 May X10, two of the three senior
members whose subscriptions were in arrears at the beginning
of the year paid their X8/X9 subscriptions of R125 per annum.
The member who still owed his subscription for X8/X9 was
expelled and his membership terminated on 30 May X10.
v) Four senior members resigned from the club on 30 May X10
(after they had paid their subscriptions for the current year in
full).
At 31 May X0 the club had 150 senior and 84 junior members on
its register. Four junior and 6 senior members had paid their
X10/X11 subscriptions in advance.
vi) Entrance fees of R200 for senior members and R150 for junior
members are paid by members in the year they join the club.
Prepare the subscriptions income general ledger account for the year
ended 31 May X11.
QUESTION 16.2 (A)
Given below is an extract of the trial balance of African Farm

Community Club (AFCC) at 31 December X1:
R R
Accumulated fund, 1 January X1 67 500
Olive Schreiner Bursary Fund, 1 January X1 40 000
Savings account: Olive Schreiner 40 000
Ralph Irons Equipment Fund, 1 January X1 18 700
32-day call account: Ralph Irons 18 700
Income 34 000
Expenses 27 000
Fund income (interest): Bursary Fund 8 000
Equipment Fund 6 300
Bursary awards 12 000
Equipment purchased: 31 December X1 15 000
The Olive Schreiner Bursary Fund was established in 1920, after the
famous writer bequeathed R40 000 to the AFCC, with the stipulation
that only the income from the fund was to be used for the award of
bursaries to needy students in the Eastern Cape. The Ralph Irons
Fund was to be used for the purchase of equipment.

1. Prepare the following accounts, as they would appear in the
general ledger for the year ended 31 December X1:
Accumulated fund
Olive Schreiner Bursary Fund
Savings account: Olive Schreiner Fund
Bursary expense
2. Prepare the funds employed section of the statement of financial
position of African Farm Community Club as at 31 December X1.
QUESTION 16.3 (C)
The Living World Foundation is a non-profit organisation which
undertakes national conservation projects to preserve threatened
plant and animal species. For the year ended 30 June X9, the
organisation reported a net surplus of R123 458. You have been
asked to prepare the financial statements for the year ended 30 June
X9.
The following information has been made available to you:
Living World Foundation

Receipts and payments statement for the year ended 30 June X9
Receipts
Donations from members 884 000
Members subscriptions 845 250
Subsidies, bequests and grants 369 430
Dividends received R101 250
Interest received 500 000
TOTAL RECEIPTS 2 699 930
Payments
Forest conservation project 590 000
West Coast Nature Reserve project 300 000
Education and development project 1 26 948
Administration of projects 166 453
Rentals 1 432 000
Sundry expenditure 184 677
TOTAL PAYMENTS 2 466 300
After discussion with the organisation’s board members, you
ascertain the following:
a) The annual subscription is R230. The subscription account for
the year ended 30 June X8 is shown below to assist you with the
calculation of the current year’s subscription income.
At 30 June X9, fees of R75 900 are in arrears. The organisation
signed on 256 new members in the X9 year. New members are
liable for a full year’s fees regardless of when they join.
b) The lump sums received from sources other than members were
earmarked for special development projects. All lump sums

were deposited in the organisation’s current account before
being invested. The amounts received were allocated as follows:
Income received on investment of funds:
Amount Where invested

Forest conservation project R220 000 Current account
West Coast Nature Reserve project R140 000 Current account
Education and development project R140 000 Current account
c) Dividends of R25 000 declared by companies in the listed
investment portfolio have not yet been received. All other
income has been received up to date. The expenditure on
projects is to be amortised over 3 years.
1. Show how member’s subscriptions will be disclosed in the
income and expenditure statement and the statement of
financial position for the current year.
2. Recommend the appropriate treatment for the donations
received from members.

3. Show how the following funds will appear in the general ledger
at 30 June X9.
The West Coast Fund
The Forest Conservation Fund
The Education and Development Fund
(All entries processed during the year must be shown).
4. Comment on which fund had the most attractive return on
investment, using calculations to support your answer.
5. Show how the expenditure on each of the three projects will be
disclosed in the financial statements at 30 June X9.

Incomplete records
17 and other
accounting issues
Judy was having a very busy day and had just rushed off to a
meeting with her accountant, Jacqueline. She had taken all her
accounting records with her to the meeting so that Jacqueline
could draw up the financial statements for the current year. These
documents were stored in five large boxes. Once she had arrived,
Judy began to carry the boxes into the offices. When she returned
to her car for the last box she found that her car was missing …
someone had stolen her car and taken some of her business
accounting records with it!
Judy was very worried and asked Jacqueline, “How are you
going to be able to prepare the financial statements for the past
year now that some of my accounting records are missing?”
She replied, “Well, Judy, you should not worry too much. If we
have some of your accounting records and are able to obtain your
bank statements, we can usually reconstruct what has happened
in your business using these records and our accounting
knowledge of the types of transactions in your business. It's like
putting a large jigsaw puzzle together. We look at what pieces of
the puzzle we have, that is the available documentation, and using
our understanding of how the accounting records fit together, we
can work out what most of the missing pieces in the puzzle are.”
Judy replied, “I am relieved to know that you can produce a trial
balance for the year even with incomplete records. ”
Jacqueline said, “It is definitely more complicated; but on the
other hand it is a challenge and fun, because we get to apply a
wide range of accounting concepts to help us find the missing
information! ”

• Use your knowledge of financial accounting to help you find missing information so
that you can produce financial statements from incomplete records.
17.1 Why do some businesses have

incomplete records?
Businesses are sometimes in the position where they have only some
of the source documentation or only some of the accounting records
for their business. This can be because the records have been
destroyed or stolen, but in most cases this occurs because the owner
of the business has little or no understanding of the accounting
recording process. The owner of a small business (sole
proprietorship, partnership or a small close corporation) is usually
so involved in the business activities that he or she spends little or
no time recording the accounting transactions or making sure that all
the documentation required to record the transactions is kept or filed
using some kind of system.
The result of these poor accounting recording systems is that
financial information about the business is not available when the
owner needs to compile financial statements, complete tax returns,
or review the business performance. The owner may want to apply
for financing and the potential lender wants to review these financial
reports. He may also want to understand how the business is
performing and what the financial worth of the business is. The
financial reports also help the owner to assess the success of the
business decisions he has taken so far and in doing so, identify any
problems or poor decisions. This gives the owner a chance to correct
problems and improve the business’s financial performance.
Business owners that do not keep adequate record can be less
efficient in the management of their business and poor record
keeping can in some cases even have legal repercussions.

Did you know?
According to the new Companies Act 71 of 2008 a company is required to keep its
accounting records and annual financial statements for the previous 7 years
(section 24). The Income Tax Act requires any person who has to submit a tax
return to retain all records for five years after the relevant return has been
received by the Commissioner (section 73A). This includes ledgers, journals, bank
statements, cheques, invoices, and so on.
17.2 A case study with incomplete

records
Let’s consider the case of Dave, who buys second-hand cars and sells
them for a profit. Dave recently took over a business from the
previous owner and operates it as a sole proprietor. The purchase
price equalled the owner’s equity (which as you will recall from the
previous chapters is the assets less liabilities) at 28 February X6 (the
purchase date). Being a mechanic at heart, he avoids the office and
paperwork as far as possible and has never even considered the
necessity of keeping proper accounting records. Fortunately the
previous owner was a bit more businesslike and had prepared
financial statements up to the date Dave bought the business. You
have copies of the statement of comprehensive income and
statement of financial position that the previous owner had prepared
(see below).

February X6
Revenue 1 750 000
Gross pro t 752 000
Other income 27 700
Finance cost (2 800)
Profit for the period 306 090

Assets
Non-current assets
Motor vehicle 80 000
Tools 5 000
Current assets
Inventories 680 000
Trade and other receivables (net of allowance for doubtful debts 371 000
amounting to R32 000)
Other current assets (cleaning materials) 500
Total assets 1 369
500

Owner's equity 1 094
500
Current liabilities
500
During a chat with his friend Mike, Dave realised for the first time
that the law requires him to submit tax returns for his business.
Did you know?

All business entities are required by law to register as taxpayers with the South
African Revenue Service (SARS). They have to submit financial statements to SARS
for every financial year so that the SARS can calculate the taxable profit of the
business and raise an assessment (invoice) for the income tax owed. (Go back to
section 12.7 if you want to revise income tax and how different business entities
are taxed.)
Dave is urgently searching for someone to prepare the financial
statements for last year to submit to SARS. Although he is aware
that he probably has to pay a fine, he is anxious not to incur further
penalties.
Imagine that we run a business that provides financial accounting
services to small businesses. Our business is a close corporation and
is called Financial Services CC. We have agreed to help Dave, and
one morning he arrives at our offices with one very big box full of
papers covered in grease. Dave says, “I don’t know what documents
you need to prepare the financial statements for my business, so I
threw in all the paper I had lying around.”
The box contains the following documents: a few invoices and
receipts (prepared only if requested by a client), the cash register
roll, invoices and statements from suppliers, a few notes Dave made
regarding outstanding payments, cash expenses, and similar items,
five bank statements, inventory figures, and the prior year’s financial
statements (examples are shown below). Dave opened a separate
bank account for his business but sometimes uses it for personal
deposits and expenses.

Below are extracts summarising the contents of the box, all bank
statements for the financial year, and additional information from
our discussion with Dave. Remember that we also have the
statement of financial position and statement of comprehensive
income for the previous year (prepared by the previous owner),
which may be able to help us in reconstructing what happened
during this year.
We will use all of this information to help us reconstruct, or put
together a picture, of the business activities that happened in the
business during the year ended 28 February X7.
Summary of bank statements − 1 March X6 to 28 February X7

Opening balance 230 000
Bank charges (26 351)
Interest received 15 700
Interest paid (573)
Payments to trade payables (1 066 000)
Payments and direct cash deposits from trade receivables 1 894 742
Sales returns (35 000)
Telephone (39 000)
Water and electricity (63 570)
Rental payments (132 000)
Wages (251 098)
Transfer to Dave's personal bank account (451 940)
Proceeds on sale of Dave's daughter's shares 34 500
Proceeds on sale of tools 5 500
Payment from Uncle Sam 10 000
Closing balance 124 910
Dave kept a certain amount of cash on hand in the business. This
cash was not deposited in the bank account and Dave had luckily
kept a notebook in the cashbox in which he kept a record of all the
cash inflows and outflows during the period.
Summary of cashbox inflows and outflows - 1 March X6 to 28

February X7
Payments to trade payables (30 000)
Cash sales and payments from trade receivables 80 000
Dave’s groceries (2 780)
Cleaning materials (41 250)
Loan to Jack (employee) (5 000)
Repayments by Jack 1 000
Summary of other information − 1 March X6 to 28 February X7
Bad debts written off during the year … … … … … … … R55 800

The sum of the list of debtor balances still owed to the business as at R575
28 February X7 … … … … … … … … . 000
The sum of all the outstanding balances on the creditor statements as R456
at 28 February X7 … … … … … … … . . 055
Inventory of cars on 28 February X7 … … … … … … … . R710
650
Inventory of cleaning materials on 28 February X7… … … . R22 000
Original purchase price of Dave's daughter's shares … … . . R21 000
Allowance for doubtful debts on 28 February X7 … … … . . R66 000
Vehicle was purchased on 1 March X5 for R100 000; its estimated useful life at
that date is 5 years, after which it is expected to be worth R0
Tools were purchased on 1 March X5 for R5 940; their estimated useful life at
that date is 6 years and the residual value amounted to R300; the tools were
sold on 1 March X6
Daughter's car worth R10 000 was traded in as part payment for a car costing
R50 000 which Dave took out of the business.
Considering how little of the information relating to the business
activities for the year has been systematically recorded, it is useful to
follow a structured approach, to make sure that the financial
statements we prepare will be correct.
17.3 Approach to an incomplete records

problem
Step 1
We need to understand what information we are going to prepare.
In this example we have been asked to prepare the statement of
comprehensive income and statement of financial position for the
current reporting period.
Step 2
Draw up a list of all typical line items on the financial statements
that may be applicable to Dave’s business.
It is important that we understand Dave’s business so that we are
able to determine which assets, liabilities, incomes and expenses are
likely to be on his financial statements. We need to have a discussion
with Dave about his typical expenses and income, his business
practices (for example, how he pays suppliers), and so on. In this
particular case, the previous year’s financial statements are also a
good reference. We would expect the business to have more or less
the same line items on the financial statements and many of the
financial ratios should be similar to last year. For example, if the
gross profit margin (gross profit/sales) was 50% in the previous
year, we would expect a similar percentage in the current year,
unless the business has a reasonable explanation for any changes.
We should also ask Dave to obtain all the bank statements for the
financial year.
For small enterprises, bank statements often are the most reliable
and readily available source documents.
Cash inflows can represent sales, other income, refunds from
trade payables, loans or capital contributions.
Cash outflows, on the other hand, may be for purchases, other
expenses, refunds to customers, asset purchases, loan repayments or
drawings.
However, it is important to remember that not all expenses and
incomes are cashbased. The statement of financial position,
statement of comprehensive income and the statement of changes in
equity as well as the business tax returns are drawn up on the
accrual concept.
Lastly, we sort all documentation that we have received according
to the nature of the document and summarise the information in
schedules. This has already been done, and appears in section 17.2.
Step 3
Identify and use the relevant information needed to calculate the
amounts reported on the financial statements.
We need to consider what makes up each calculation or item and
need to consider possible sources of information for each calculation.
A useful tool is to draw up the ledger account for each line item and
ask yourself what would normally appear in the account. You will
then be able to use the information available to complete as much of
the ledger account as possible to determine the amounts required for

the financial statements. We will use ledger accounts in a similar
way to that shown in Chapter 14, on cash flows.
Step 4
Check that we used all available supporting documentation to assist
us in drawing up the financial statements.

Let's apply this approach to Dave's business .
Steps 1 and 2
We have been asked to draw up the statement of financial position
and the statement of comprehensive income for the business.
Considering the nature of his business, namely retail, we would
expect the following income, expenses, assets and liabilities:
Income and expenses:

• Sales
• Cost of sales
• Other expenses (depreciation, rent, bank charges, interest
expense, wages)
• Other income (interest income, profit on sale of assets).
Assets and liabilities:

• Land and building
• Inventory: cars, cleaning materials
• Trade receivables
• Cash/Bank
• Loans
• Trade payables
• Owner’s equity
• Taxation payable.
Steps 3 and 4
We need to examine all the information we have available to assist
us in drawing up the financial statements.
17.4.1 Items on the statement of comprehensive

income
Let’s decide which information relates to income and expenses and
compile a profit calculation that will form part of the statement of
comprehensive income.
17.4.1.1 Sales
Sales income recognised in the statement of comprehensive income
includes both cash and credit sales.
Dave did not keep any detailed record of his cash or credit sales,
but we are able to determine the amount of cash received from cash
sales as well as from trade receivables by using the bank statement.
An important source of information for sales is the bank statement.
However, even though the majority of credits on the bank statement
would probably relate to sales, we should remember that not all
credits would necessarily be cash sales deposited into the bank.
What could the credits on the bank statement represent?
• Cash sales
• Payments from trade receivables

• Capital contribution by owner
• Other income, such as interest earned.
We will reconstruct the trade receivable account to find the amount
of sales during the year. Although not all the sales would be on
credit, the trade receivable account will allow us to calculate total
sales. This is a similar procedure to that we used in Chapter 14,
dealing with cash flows.
Trade receivables
Opening balance Bank
Sales (net of trade discounts allowed) Bad debts
Sales returns
Closing balance
Something to do 1
Try to calculate the sales amount using the information given.
Check your answer
Did you also come up with R2 272 542?
Let's work through the calculation together.

We need to obtain the amounts for each of the components in the
ledger account.
1. Opening balance
Luckily, the person Dave bought the business from had drawn
up financial statements and so we have the opening balance for
trade receivables. It still needs to be adjusted for the previous
year’s allowance for doubtful debts (the amount reported in the
financial statements is presented net of the allowance, in other
words, less the allowance; whereas the balance in the trade
receivables account is the gross amount, which is the actual
amount owed to the business by the trade receivables).
R371 000 + R32 000 = R403 000
2. Bank
The cash received from trade receivables includes all the cash
received from trade receivables and cash sales that Dave had
not deposited into the bank.
= R1 894 742 + R80 000
= R1 974 742
3. Sales returns
Customers may return inventory (cars that they had purchased).
Dave provided us with the following information relating to
sales returns.
Dave gave one customer a refund of R35 000 (this customer
had originally purchased for cash) and reduced the amount
owing by Mr Kwasana by R70 000, as he had purchased the car
on credit in the previous financial year.
Sales returns: R35 000 (cash refund) and R70 000 (sales
returns recorded in Trade Receivables account) = R105 000 BUT
Sales returns recorded in Trade Receivables = R70 000.
4. Bad debts
Next, we need to ask Dave whether he has written off any debts
during the year. Dave informed us that Mr Swart declared
bankruptcy in March and that Mr Nongolo’s debt has been
outstanding for longer than a year, and he cannot get hold of
him. The amount being written off was obtained from the
summary shown in section 7.2.
Bad debts = R55 800
5. Closing balance
Remember that the closing balance represents the amount that
the trade receivables still owe Dave at the end of the year. Dave
had managed to find the final statement he had sent to each of
his trade receivables in February X7. The total amount owed by
trade receivables at the end of February X7 amounted to R575
000.
6. Sales
Finally, using the trade receivables account we can calculate the
sales amount for the period. Remember that this is the total sales
figure (cash and credit).
17.4.1.2 Cost of sales

To calculate the cost of sales amount, we can reconstruct the
inventory general ledger account.

Inventory
Opening balance Cost of sales
Purchases (net of trade discount received) Inventory impairment
Drawings
Closing balance
1. Opening balance
The opening inventory figure is obtained from the prior year’s
financial statements: R680 000.
2. Purchases
Next we need to determine the purchases figure. This amount is
made up of credit purchases and cash purchases of cars. As we
did in the cash flow chapter, we will reconstruct the trade
payables account in the general ledger:
Trade payables
Bank Opening balance
Purchases returns Purchases (net of discount received)
Closing balance
We need to obtain each of these amounts:
a) Opening balance
The opening balance is obtained from the prior year’s
financial statements, R275 000.
b) Bank/Payments
Payments made to trade payables during the year are
calculated from the bank statement debits (after carefully

excluding those relating to drawings by Dave, loans to staff
members and other expenses, such as interest paid). We
also have to include all the cash payments to trade payables
that have not been indicated on the bank statement, as they
were paid from the cashbox.
Payments to trade payables = Bank statement debits +
Notes on cash payments
= R1 066 000 + R30 000
= R1 096 000
c) Purchases returns
We need to ensure that we accounted for all cars that were
returned to the suppliers. Possible supporting documents
for that are goods return notes and/or a line item on the
creditor statement. In our example, no such documents are
found and according to Dave he did not return any cars.
d) Closing balance
Creditor statements and invoices are used to compile a list
of trade payables. As Dave did not keep his own detailed
records, we are unable to reconcile the creditor statements
with our records to verify the statement.
Dave has collected all his creditor statements for February X7,
and the total amount owing comes to R456 055. Dave will not be
able to check the creditor statements against his records, as he
did not keep any. He has checked the statements to make sure
that, as far as he can see, the statements are correct.

3. Inventory impairment
Given our knowledge of accounting we realise that inventory
can decrease owing to sales, personal use by owner, damage,
theft, and obsolescence. Dave cannot recall identifying any
incidence of theft. However, he scrapped two rusted Beatles
where the engines were beyond repair and sent the cars to a
scrap metal dealer. We discover that these cars were shown at
R20 000 a car in the prior year’s financial statements. The total
impairment expense for the period amounts to R40 000. The
closing balance is based on the physical inventory on hand
(excluding the scrapped cars), so the inventory write-off has
already been accounted for.
4. Owner's equity
Dave also informed us that he had traded in his daughter’s old
car worth R10 000 for a BMW costing R50 000, which Dave gave
to his daughter. The BMW had been recognised as inventory by
the business. The R50 000 constitutes drawings and is not
considered a sale, while the R10 000 represent a capital
contribution into the business.
5. Closing balance
Closing inventory is based on an inventory count. Luckily, Dave
regularly counts his inventory to determine if he needs to re-
order or if some items are missing. Dave last did an inventory
on 25 February X7. Discussions with Dave and a search of the
available supporting documentation provided us with the

following transactions between the inventory count date and
year-end:
Purchases of cars: 2 cars for R130 000
Sales of cars: 1 car with a cost price of R30 000
Therefore, the closing inventory amounts to:
R710 650 + R130 000 − R30 000 = R810 650
6. Cost of sales
Cost of sales = Opening Inventory + Purchases − Impairment of
inventory − Goods taken for owner’s own use − Closing
inventory

In some instances we may have only enough information to calculate either the
sales or the cost of sales amount. How could we calculate the other amount?
Check your answer
We could use the mark-up percentage (if all goods are sold at the mark-up percentage)
to calculate the other amount.
The formula is:
Sales = Cost of sales + Mark-up
This is not the ideal way to calculate either sales or cost of sales, as it is unlikely that
all the items will be sold at a constant mark-up, and there is the risk that items such as
impairment (included in cost of sales) will not be adjusted for when calculating sales.
17.4.1.3 Other expenses

Next we look at all the operating expenses we would expect in
Dave’s business.
Only expenses incurred by the business in the current year should
be included. Remember to exclude Dave’s personal expenses that he
paid out of the business’s cash. Therefore, Dave’s grocery expenses
are not regarded as an expense, but rather as drawings.
We will question whether any expenses have been prepaid (in
which case the prepaid portion is recognised as an asset and not an
expense) or are still unpaid (in which case we should recognise the
expense and a liability for the outstanding amount). If consumables
purchased (such as cleaning materials) are not used in the current
year, the inventory on hand at year-end is shown as an asset and not
an expense. Applying the same logic, consumables that were on
hand at the beginning of the year and are consumed during the
current year should be shown as an expense.
Referring to the bank statement debits, cash payment notes and
other information provided above, we come up with the following
list of expenses:
Bank charges 26 351

Interest paid 573
Rental payments 132 000
Telephone 39 000
Wages 251 098
Cleaning materials 19 750
532 342
The cleaning material expense is R500 (Opening stock) + R41 250
(Bank/Purchases) − R22 000 (Closing stock) = R19 750.
Apart from these cash expenses, we will need to prepare entries to
recognise non-cash flow expenses such as depreciation, allowance
for doubtful debts and impairment expense.
Depreciation expense (vehicles)

= (Purchase price − residual value)/useful life
= (100 000 − 0) / 5
= 20 000
No depreciation expense needs to be recognised for tools, as they
were sold on the first day of the financial year.
Did you know?

The depreciation amount and the wear and tear allowance for taxation purposes
are not always the same. While depreciation should reflect the pattern in which
the asset's benefits are consumed by the business [IAS 16, para 60], the wear
and tear allowance is determined by SARS and published in the Interpretation
Notes.
Allowance for doubtful debts
= Closing balance (as identified in the summary of other
information) − opening balance

= 66 000 − 32 000
= 34 000
Bad debts
= 55 800
The total bad debts expense is R89 800, which is the total of the
amount written off against trade receivables plus the increase in the
allowance for doubtful debts (R34 000 + R55 800).
17.4.1.4 Other income

Only income earned by the business in the current year should be
included. All income earned other than from car sales falls under
this category. Looking at the bank statement credits, notes on cash
receipts and considering any income identified above, we derive the
following amounts:
Interest received R15 700
Profit on sale of tools R500
Accumulated depreciation is calculated as the depreciation for 1
March X6 to 28 February
X7: (R5 940 − R300) / 6 = R940
The profit on sale amounts to R5 500 + R940 − R5 940 = R500.
Capital contribution
Note that the sale of the shares constitutes personal income of Dave
(as his daughter and not the business owned them) and therefore is
not regarded as an income, but as a capital contribution to the
business.
Taxation
Dave’s Cars is registered as a sole trader, which means that Dave
pays tax on the profit made by Dave’s Cars in this personal capacity.
Dave’s Cars is not registered as a separate taxpayer, which means
that no taxation expense is reflected on the statement of
comprehensive income, nor is a taxation liability reflected in the
Did you know?

A sole proprietor business is not a legal entity. Therefore, the owner is taxed on
the entity's profits in his own capacity. The tax debt is in his name and cannot be
transferred or sold with the business.
Putting all of these amounts together, we obtain the following
statement of comprehensive income:
Statement of comprehensive income of Dave's Cars for the

financial year ending 28 February X7
Revenue (2 272 542 − 105 000) 2 167 542
Cost of sales (1 106 405)
Gross profit 1 061 137
Other income (15 700 + 500) 16 200
Bank charges expense 26 351
Rental expense 132 000
Water and electricity expense 63 570
Wages expense 251 098
Cleaning materials expense 19 750
Depreciation expense 20 000
Bad debts expense 89 800
Finance cost (573)
17.4.2 Items on the statement of financial position

After preparing the statement of comprehensive income, we can turn
our attention to the statement of financial position. Once again, we
consider the typical format and any items specifically relating to
Dave’s Cars.
Assets
Non-current assets XX
Current assets XX
Total assets XXX

Equity XX
Non-current liabilities XX
Current liabilities XX
Total equity and liabilities XXX
17.4.2.1 Assets
We start by considering all assets belonging to the business.
Property
Because rent is paid, we know that the workshop building does not
belong to Dave. Dave’s Cars does not own any property.
Motor vehicles
The carrying value of the motor vehicle is calculated by subtracting
the accumulated depreciation from the cost price. Remember that
the cars that the business intends to sell are considered to be
inventory and are not included as part of the motor vehicles class of
PPE.
R100 000 − (R20 000 × 2) = R60 000
Inventory
Earlier in the example we calculated car inventory as R810 650.
Other current assets

Cleaning materials were also on hand at year-end. Only the portion
used during the current year was recognised as an expense; the
remainder will be shown as an asset of R22 000.
Trade and other receivables

The trade receivable amount on the SFP is shown net of the
allowance. We need to deduct the allowance for doubtful debts from
trade receivables, giving us R575 000 − R66 000 = R509 000.
Loan to employee
If we scan the bank statement debits and all other supporting
documentation to ensure that all cash outflows have been accounted
for, we realise that Dave granted a loan of R5 000 to his employee
Jack, of which only R1 000 has been repaid. Therefore loans to
employees amount to R4 000.
Cash and cash equivalents

This line item is made up of the bank account balance and the
physical cash on hand. The bank balance as at year-end is obtained
from the bank statement: R124 910. Reconstructing the general
ledger account assists us in calculating the cash balance:
Cash
Opening balance Payments
Receipts Closing balance
The opening balance of cash on hand: R233 000 − R230 000 = R3 000
(difference between the cash and cash equivalents figure on prior
year financial statements and the bank statement balance on 1 March
X6)
Cash payments = R79 030 (R30 000 + R2 780 + R41 250 + R5 000)
Cash receipts = R81 000 (R80 000 + R1 000)
Closing balance: 3 000 + 81 000 − 79 030 = 4 970
The total cash and cash equivalents amounts to R124 910 + R4 970 =
R129 880.
17.4.2.2 Liabilities
Trade and other payables

The main liability we would expect is trade payables, which was
calculated as R456 055.
Dave’s Cars is a sole proprietorship and therefore no taxation
liability is incurred in its own right.
To ensure that all income and liabilities have been recorded, we
scan the cash inflows on the bank statement credits and other
supporting documentation. Again, we detect an unrecorded item. It
comes from the Uncle Sam, and further enquiries reveal that the R10
000 is a loan to the business, and is repayable only three years from
now. We immediately realise that a loan usually carries interest and
would expect a related expense. However, in this case the loan has
been granted interest free. (There are some accounting issues that
relate to interest-free loans, but these issues will be dealt with only
later in your accounting career.)
17.4.2.3 Equity
A sole proprietor can have only one line item under equity, namely
owner’s equity. The figure is computed as follows:
Owner's equity
Drawings Opening balance
Closing balance Capital contributions
Pro t for the period
Remember that we can show the undistributed profit in the
Accumulated profit account.
1. Opening balance
According to prior year financial statements this figure is R1 094
500.
2. Profit for the period
This amount is calculated in the statement of comprehensive
income as R435 195.
3. Capital contributions
Contributions are the sum of all amounts paid into and all items
contributed to the business by Dave. He made no direct cash
contributions. However, the proceeds on the sale of his
daughter’s shares were paid into the business bank account: R34
500. Furthermore, he traded in his daughter’s old car. The
market value is R10 000. Therefore, total contributions
4. Drawings
Drawings can be in the form of cash or another asset. In return
for his daughter’s old car, Dave took a new one worth R50 000.
He also paid personal expenses of R2 780 out of the petty cash.
A further R451 940 was transferred into Dave’s personal bank
account.
Total drawings amount to:
R50 000 + R2 780 + R451 940 = R504 720
5. Closing balance
Therefore, the closing balance is:
R1 094 500 + R435 195 + R44 500 − R504 720 = R1 096 475
Now we can draw up the statement of financial position.
Dave's Cars
Assets
Non-current assets
Motor vehicle 60 000
Current assets
Inventories 810 650
Trade and other receivables (509 000 + 4 000) 513 000
Other current assets (cleaning materials) 22 000
Total assets 1 535 530

Equity 1 069 475
Current liabilities
Long-term borrowing 10 000
Total equity and liabilities 1 535 530
PART B: OTHER ACCOUNTING
ISSUES
Judy has been running her leather goods manufacturing company
for just over three years. She now has six branches in South Africa
and has started marketing and selling her leather goods overseas.
It was Saturday night and she was having dinner with a good
friend, David, who had also started a successful company.
Judy and David were discussing the various challenges that had
arisen from operating a company. Judy said to David, “You know,
David, the longer I run a business, the more I realise business is
about more than financial accounting. I find myself needing a
wider understanding of business knowledge to be able to develop
solutions that work.”
David replied, “I know exactly what you mean. The other day I
was checking the inventory stored in the factory storeroom. After I
counted the inventory I realised 200 units of stock were missing.
When I spoke to my accountant about this stock loss, he asked
me what I was doing about internal controls. I have no idea about
internal controls, but it is obviously an area that a business
manager needs to know about. What do you think, Judy?”
Judy replied, “David, I have no experience with internal controls,
but I know how you feel. The other day I sent some goods to an
agent in the United States to sell on my behalf. When I told my
accountant about this, she said that now the company had grown,
we had better check whether there were adequate internal
controls over consignment stock!”
“I don't know if these accountants actually know it all. The
financial statements they draw up at the end of the financial year
don't help me to take the daily decisions needed to run my
business effectively. How does information that relates to the past
year help you make decisions about running your business today?”
said David.
Judy sighed and replied, “I have also found the financial
statements are drawn up too late to help me with my daily
business decisions. The other problem I have is that the business
has grown so quickly that there are now more than 500
transactions to record every day. If I want information about my
business on a daily basis, these transactions need to be recorded
at the time the transaction occurs. I am told this means I need to
computerise my financial records. It seems quite overwhelming,
as I have no understanding of computers.”

By the end of this part of this chapter, you will be able to:
• Identify some of the first steps to take if you want to start a business
• Understand the purpose of a business plan, its components and its uses
• Understand the purpose of internal controls and be able to understand the process
of applying internal control principles to the risks of a business
• Identify the internal control objectives and possible internal control techniques
• Identify the reasons for computerising a company's financial and/or operational
records
• Explain the functions, weaknesses and advantages of the budgeting process and
be able to produce a basic budget
• Identify the differences between management accounting and financial accounting
and know what needs management accounting meets.

As Judy’s business grows and expands, she is likely to need
additional finance She could take on an additional partner, or obtain
a loan from the bank. Whichever option is chosen, it is likely that the
party providing the funding would like to see a detailed business
plan and financial reports. Stricter internal controls and regular
management reports are probably also required, as the external
party is not necessarily personally involved in the day-to-day
running of the business.

Judy’s discussion with David showed us that her knowledge of these
business aspects is limited. Let’s see if we can help Judy understand
the relevant concepts.

What steps would you take if you want to start a business?
Which document summarises these steps and ensures that they support
•
the final goals?

•
What is the purpose of a business plan?

What are the components of a business plan?
•
What are the uses of a business plan?

•
Prepare a business plan.

•
Check your answer
You will not be able to answer all of these questions yet, but you soon will. See section
17.5 below for the answers.
17.5 Business plans

Why did Judy start her business and why is she planning to expand
it? The answer is that she had a business idea and believed and still
believes that it is an opportunity to make a profit from selling a
product. Based on this business vision, Judy started a business to
offer this product for sale.
Is it that simple − do you just start a business?

No, as you might have suspected, a lot of thinking, researching and
planning should take place before a business is started. It is a good

idea to write out a plan of what we want to achieve with this
business and how and with which activities we are going to achieve
it. This exercise is important for both you and any external parties
involved. External parties are provided with a clear understanding
of the business and its objectives, while you have a tool that helps to
ensure that the correct decisions and activities are focused on.
A business plan
The business plan is a written road map of where the business is
going, what it has to do to get there, and what it will look like on
arrival. It states the business goals and the plan for reaching these
goals. It is a valuable tool, which has many uses:
Setting goals and objectives. It sets the direction of the business over
the next few years and specifies the actions required to guide the
business through the period. If you know what the end goal is, it
makes it easier to make daily decisions because you know that each
choice you make must help you achieve the end goal. For example,
instead of stating that the aim is to make lots of money, the business
plan would include details such as wanting a return of 15% on the
capital invested and a detailed plan on how this is going to be
achieved, such as sales and expenses forecasts based on research and
realistic estimates. If we write down our goal, it is easy to refer to
when we get very busy and stressed.
Testing the feasibility of an idea. The business plan enables us to
analyse the possibility of the business idea actually succeeding. This
is particularly important as a large percentage of new businesses fail,
which often leaves the owners with huge debts.
Feasibility is the degree to which something can be carried out,

achieved or put into effect.
Establishing and evaluating performance benchmarks. This is a way
to check that the business is on track to meet the goals decided on by
the owner. For example, the 15% return is the benchmark, and the
owner can assess the actual performance to see if the business is on
track to achieve the 15% return. This is important, as keeping track
of your business performance is often difficult while you are
surrounded with the day-to-day problems in the business.
Communicating messages to internal and external parties. This
includes potential investors, the bank or staff members.
Now that we have realised how useful and necessary a business plan
is, we turn our attention to its preparation and structure.
Components of a business plan

The contents of a typical business plan are:
• Executive summary and table of contents

• Personal information of owner (including employment history,
financial affairs and details of personal assets)
• Business description (including type of business, name of

business, owners, structure, proposed activities and, if applicable,
its history)
• Business and personal objectives (goals)

• Market analysis (including competition and potential customers,
as well as regulatory restrictions)
• Market and sales activities and strategies

• Products and services
• Operations (including premises, assets, management, personnel,
accounting, trade receivables, trade payables and suppliers)
• Current sources and application of funding

• Financial data (historic, if applicable, and prospective cash flows,
profit or loss calculations and statement of financial position)
• Appendices and exhibits (including CVs of key management,

audited financial statements, all significant contracts and
agreements and other legal documents).
An executive summary is an overview that provides the reader with

enough of the important information without having to read the full
document. The reader gets a good idea of the main points and
conclusions of the document without being caught up in the detail .
Steps in preparing a business plan
Steps Practical considerations/Application

1. Identify Which type of business do you want to start? Which
your product/service do you intend to sell? What do you want to
objectives achieve? Who is the target audience? Why will your business
(goals) succeed or have an advantage over competitors (for example,
an innovative idea, or access to cheap resources)?
2. Outline Use the objectives (goals) for your business plan and decide
your which areas to emphasise. Make sure that the structure is
business logical and that all aspects of your business are covered.
plan
3. Review Decide which areas will be covered in detail and for which a
your summary is suf cient.
outline
4. Writing Make sure that your business plan answers all relevant
your plan questions.
5. Have your A person familiar with business should check the business
plan plan for objectivity, logic, presentation and effectiveness.
reviewed
6. Update Information written in a business plan needs to be updated
your plan as the environment and objectives change. A businessperson
should be constantly reassessing what he or she wants to
achieve in light of the actual circumstances. As the business
grows, more detail needs to be added to the business plan.
You do not need a commercial degree to draw up a business plan.
You are the best person to draw up your own plan, as you are the
person with the vision. Although you may want to obtain some
financial advice, the business plan should document what you want
your business to achieve and how you plan to get there.
If you are interested in finding out more about small business and
starting a business, you should visit the web site
<www.info.gov.za/issues/govtprog/start.htm>. Another web site
that is useful to small businesses is the Business Partners web site at
<www.businesspartners.com>. A detailed description of a business
plan can be found at
<www.absa.co.za/absacoza/content.jsp?/Home/Business/How-
Do-I/Start-a- Business/Small-Business-Toolbox/The-Business-
Plan>. SA Business Plans offers assistance in drawing up a business
plan (<www.sabusinessplans.co.za>).

The larger the business becomes, the greater the number of
transactions are that occur on a daily basis. It becomes more difficult
for the owner to approve and control every transaction and event.
This means that the owner will need to delegate some decision-
making and rely on key employees. An effective internal control

system replaces the involvement of the owner in the day to day
running and activities of the business.

Internal control systems are also important when an external
party, with no involvement, invests in the business.
Let's start with some definitions explaining the internal control

system.
Internal controls are a set of policies, procedures and practices that
business owners use to achieving the objectives and goals of the
business.
The objectives of any internal control system are the following:
• To make sure that the business runs in an orderly and efficient
way (operational)
• To make sure that management policies are followed
(compliance)
• To prevent, detect and correct fraud and errors in the accounting
records (operational)
• To make sure that business assets are not stolen or used
inefficiently (operational)
• To prepare timely, reliable financial information, which must be
accurate, valid (the transactions actually happened) and complete
(all transactions that happened are recorded) (financial reporting).
In Judy’s case, an example of such a control objective is making sure
that none of her consignment stock is stolen.
Accountants preparing the financial statements concentrate on
achieving the last control objective (“to prepare timely, reliable
financial information”). It can be sub-divided into objectives that
must be met to ensure that financial reports are correctly prepared.
These are the following:
• Authorisation: All recorded transactions are properly authorised

• Validity: All recorded transactions are valid/did indeed incur (not
fictitious)
• Completeness: All transactions that occurred are recorded (no

duplications or omissions)
• Accuracy: All transactions are recorded at the correct amount (this

implies that source documents, the transfer of information and
calculations are accurate)
• Classification: All transactions are correctly classified in

journals/records
• Timeliness: All transactions are recorded as soon as possible and

in the correct accounting period
• Summarising and posting: All journals are correctly added and all
transactions are posted accurately and timely to the correct
general ledger account (classification) and from there to the Profit
or loss account and annual financial statements.

Reconciling the physical consignment inventory with the inventory
records on a monthly basis would be a control technique aimed at
making sure that none of Judy’s consignment inventory has been
stolen.
Implementing a control is not enough on its own. The business
will have to monitor the controls to make sure that they are effective.
Let’s look at further possible situations that could arise in Judy’s
business that would prevent the objectives (goals) of the business
being achieved, and look at which control technique would help to
prevent this.
Situation 1
Judy has a lot of leather goods on hand at any time and inventory
can be bought from suppliers and sold to customers every day. How
does Judy know whether inventory is being stolen from the factory?
17.6.1.1 Supporting documentation

All business transactions should have some supporting
documentation. The documentation should be signed by the person
creating it. It should also be pre-numbered to make sure that all
transactions are recorded in the accounting records. As proof that
the document is accurate and valid, is it useful if another person
checks and signs the documentation.
For example, when Judy sells inventory to customers, the
following documentation should be created: an order, an invoice,

and a delivery note. This allows the business to check that the
transaction actually happened and to trace the transaction (when it
happened and who was involved). For example, a delivery note
travels with the inventory and is signed by the client as proof that
they received the inventory. This is also proof that the business
selling the inventory has reduced its inventory.
17.6.1.2 Physical access controls

Judy could also protect her inventory by controlling the physical
access to it. An example is having only one entrance to the storeroom
where the inventory is kept. This entrance should be locked and at
any time only one person should be in charge of the key. This person
is accountable for all inventory movements during that period.
The factory should also only have one entrance or exit and a
security guard to check who and what enters and leaves the factory.
All inventory leaving the factory premises should be checked against
the relevant documentation, such as a delivery note.
17.6.1.3 Segregation of duties

Another important control is the segregation of duties, this means
that different, independent people should perform the following:
initiating transactions, authorising transactions, recording
transactions, and safeguarding assets.
In Judy’s case this means that the person safeguarding the
inventory should not perform any functions relating to the sales
transaction. Otherwise, the possibility exists that he or she might
steal stock and cover up the theft by recording fictitious transactions.
Note, however, that even with segregation of duties, fraud can
take place. People can collude − this means that two staff members
can work together to defraud the company. For example, if the
person recording the transaction and the person in control of
inventory agree to work together, they can steal inventory and cover
it by recording fictitious transactions. It is therefore important to hire
staff with integrity, and the owner should set an ethical tone for the
business.
17.6.1.4 Stock (inventory) count

Judy should count inventory on a regular basis and, if the business is
using a perpetual inventory system, reconcile the physical quantity
on hand to the quantity reflected in the accounting records or
general ledger (the use of the perpetual inventory system is therefore
a type of control system). Any differences must be explained by the
person in charge of the storeroom. The control is particularly useful

when conducted on a surprise basis, as theft cannot then be covered
up in anticipation of the inventory count.
Situation 2
Judy buys leather from a number of suppliers. These suppliers send
statements at the end of the month in which they summarise her
transactions and state the outstanding balance. How does Judy
know if the amount the suppliers ask for is correct?
17.6.1.5 Reconciliation
Judy can use another control principle called reconciliation.
Reconciliation means that you make sure that a set of information

from one source agrees with the same information that has been
generated by another independent source .
This is a strong control technique. An example of this is a bank
reconciliation, which we covered in Chapter 8. Do you remember
that with a bank reconciliation, we reconcile our Bank account in the
general ledger to the bank statement prepared by the bank? These
two records are prepared by independent persons (the bookkeeper
and the bank), but should contain the same information. In the same
manner, Judy can reconcile the Trade payables (suppliers) account in
the general ledger with the suppliers’ statement to ensure that the
balance owing is correct. This is called a creditor’s reconciliation and
was discussed in detail in Chapter 10.
Something to do 2
Can you explain what risk the internal control of performing a debtor's
reconciliation is addressing?
Check your answer
In a debtor's reconciliation we are reconciling the details in the Trade receivables

subsidiary ledger with the details in the Trade receivables account in the general
ledger. Independent staff members prepare the subsidiary ledger and the Trade
receivables account in the general ledger. This reconciliation helps us to make sure
that the information in the general ledger is accurate. If there had been a mistake in
the account in the general ledger, it would be found when we compared or reconciled
this account with the subsidiary ledger. The individual debtor accounts sent to the
debtors showing them the outstanding balances at the end of each month are
prepared from the subsidiary ledger. This reconciliation helps to make sure that the
ledgers and debtor statements are accurate and complete.
Something to do 3
Can you think of another type of reconciliation we have learnt about during
our accounting studies?
Check your answer
By comparing the inventory value from the general ledger to the actual inventory
counted, we are doing a reconciliation − comparing information that should be the
same and has been prepared by independent people.
Situation 3
How does Judy know that purchases paid for by the business are
purchases made for the business and not personal purchases made
by the staff?
17.6.1.6 Authorisation
Management authorisation of certain transactions can be required to
prevent the misuse of business cash or assets.
For example, all purchase orders and cheques have to be signed
by management or the owner. This means that purchases cannot be
made and/or paid for if they do not agree to the purchase. As a
further control, in most businesses two managers are required to
sign the cheques after looking at the supporting documentation for
that payment.
17.6.2 Risks of the business: choosing and using

internal controls
Now that we know the control techniques, we need to identify
business risks and the situations where controls should be applied.
The risks facing the business are identified by asking, “What could
go wrong?” about every aspect of the business. What we mean by
“going wrong” is anything that will prevent the business achieving
the owner’s goals and objectives.
Here are some of the answers we get when we ask the question,
“What could go wrong?”
• The inventory could be stolen
• The inventory could be too old to sell
• The inventory could be in the storeroom, but we have forgotten to
update our accounting records for new purchases
• The business could be ordering too much inventory in relation to
the sales, so inventory levels are too high
• The business could be ordering too little inventory, and run out of
stock
• The business could order inventory that is of very poor quality,
which means that sales returns will increase
• The business can pay too high a price for inventory that is
available elsewhere at a lower price.
The owner will need to think about what practice, procedure or
policy would prevent or detect and correct the issues identified
above.
For example, what could Judy do to make sure that only good
quality inventory is purchased by her buying department?
The possible internal controls are:
• Examine the products of all suppliers and decide on a list of
approved suppliers whose products are of a good standard.
• Make sure the buying department orders products only from the
approved supplier list.
• Start a quality control division that checks all inventory when the
suppliers deliver the inventory to the factory. All inferior
inventory should be returned immediately to the suppliers.
As with all business decisions, it is important to make sure that the
cost of making a decision is not greater that the benefit gained from
making the decision. The owner should select the most efficient
controls and not simply implement all possible controls. The
question the owner needs to answer is whether the risk of loss costs
more than the cost of the staff member’s time used in carrying out
these controls.
In this situation, implementing a quality control division may be
extremely expensive. Instead, the employees receiving the goods
could inspect them. While the risk of receiving interior quality stock
is higher than if a quality control division exists, it may be reduced
sufficiently to improve the situation. The key question is whether the

actual risk difference between the two approaches is higher or lower
than the extra cost.
Relying on internal controls

As mentioned before, implementing controls does mean that the
risks of the business will be eliminated or reduced. Internal controls
are policies and procedures carried out by staff members, which
means that there can be human errors or fraud. For example, if the
staff member who is doing the reconciliation does not understand
what to do or is careless, the reconciliation may not be correct and
the control will therefore be ineffective.
In small businesses, as there are a small number of employees,
having separate people doing different tasks ( segregation of duties)

is often not possible. In a case like this, the manager may decide to
sign a cheque for a personal expense, without anyone realising.
Did you know?

Internal auditors are used by big businesses to ensure that the business has
appropriate internal controls in place and that they are operating as they are
supposed to be. Internal auditors may be employees of the company but they are
often outsourced from auditing firms.
17.7 Computerisation of the accounting

records of a small business
In Judy’s business, it may be very difficult, if not impossible, to carry
out all controls manually. When a small business starts operating,
the systems used to record transactions are simple because there are
few transactions.. A small business often does not have internal
controls in place because the owner is involved in the daily

operations and decision-making and has a detailed knowledge of
almost every transaction that occurs.
Because of these simple systems and lack of internal controls,
small businesses may start to have problems when the business
expands. The owner finds that there are too many transactions to
track and loses control over the operations. The owner may also find
that simple accounting systems are inadequate to deal with the
increased volume and complexity of transactions. The risk of errors
in the accounting records and the number of losses that have not
been detected or prevented because of a lack of internal controls
increases.
If the business does not change its accounting recording and
reporting systems and implement some internal controls, it may be
making good sales but because of the inefficient systems used by the
business, it may not succeed.
Problems with computerisation of the accounting records

When a business starts to grow rapidly, there is always the
temptation to “fix” the lack of systems and controls by
computerising the accounting records and certain of the business
functions. It is important to remember that computer systems do not
necessarily result in good accounting systems and internal controls.
A computer will be able to process a greater volume of transactions
more quickly than a manual system. However, the information
generated by a computer system depends on the information that is
put into the system (the GIGO principle: garbage in, garbage out). If
staff are not trained to use the computer system, they will make
errors in inputting and processing the information, and the reports
generated by the system will therefore be useless. It is also really
difficult to find errors in a computer system because of the lack of a
paper trail (no written records exist). In addition, because a

computer system is able to process transactions rapidly, a number of
accounts are affected at the same time by a single input; this means
that the error may be made to a number of accounts.
Risks of a computer system

A computer system also introduces a new set of risks to the business.
For example, if the business accepts orders via the Internet, a way
must be found of protecting its accounting records from
unauthorised access by hackers, who can make unauthorised
changes to the accounting records − for example, changing the
outstanding balance on a debtor’s account to zero. Logical access
controls, such as passwords, become vital in a computerised
environment.
17.8 Budgeting
An internal control widely used in businesses is the budgeting
process, which Judy felt a little more comfortable with as she had
used budgeting in her personal life. She had never followed much of
a process but made sure that she had some idea whether she had
enough money each month to cover her monthly costs and to put
away enough cash to be able to meet her longer term goals like
paying off her house and being able to go on holiday.
So what is a budget?
A budget is a formal plan that shows how we are going to use our
resources to achieve our goals. It helps to decide how the resources
of the business are going to be used to achieve the long-term plan
(strategy) of the business. It also has a control function, because
management can compare the actual results to the budgeted results

(what they thought would happen) and determine why there is a
difference. Once they have identified what caused the difference
between the actual and budgeted results (this is called a variance) a
decision can be made to correct the problem (if necessary).
A business can, for example, estimate what its profit for the year
ended 31 December X3 will be. To arrive at this profit forecast, the
owner estimates what the future sales will be, what the selling price
will be, what the costs will be, and how much inflation will increase.
During the period, the business is able to compare the actual sales
and expenses with the budgeted figures and investigate any
differences.
Planning
The budget is a plan of how the company expects to use its
resources. Managers will start by planning future sales based on
what they believe customers will demand and what the company is
able to produce. Once the business has an understanding of the
future demand (sales budget) this information is used in the
production budget so that the business will be able to calculate how
much it will cost the business (production budget) to meet the sales
schedule.
Control
The budget is useful for control purposes. If what actually happens
is different from the planned outcome (budget), it means that
something unexpected happened. Differences are then investigated
for possible problems or weaknesses, such as fraud and error.

Let’s imagine that actual costs incurred by the company for the
year are 20% more than the estimated (budgeted) costs. The reason
for the difference may be as simple as management underestimating
inflation, when estimating future costs; or it may be more complex,
such as unauthorised purchases, an incorrect supplier being used
whose prices are higher than those of the approved supplier, or
inventory being stolen.
Co-ordination
Another function of the budget is to co-ordinate all activities of a
company. When the production process is co-ordinated so that no
unnecessary activities are duplicated, the business can operate more
efficiently and effectively. For example, synergies occur when Judy
centralises the accounting function. Instead of employing an
accountant at each branch, only one accountant is hired, so the
company as a whole saves costs.
Co-ordination is the integration of activities to make sure that

resources are used most efficiently to achieve specified objectives .
Synergy is the working together of two things to produce an effect
greater than the sum of their individual effects .
Motivation
Budgets should act as a motivational tool for employees as budgets
allow them to understand how what they do affects the long-term
vision of the business. Working towards meeting the budgeted
targets should improve business performance, because each
employee now understands what they need to achieve. Employees
are likely to be more motivated to achieve targets if they participated
in setting the targets rather than having the targets forced on them.
Performance evaluation
It is important that the budget is realistic and attainable, as it is also
used as a benchmark in evaluating employee’s performance, and
often their bonus is based on this evaluation. If it is impossible to
achieve the budget’s targets, employees might be demotivated and
give up. An important aspect that should be kept in mind when
using the actual results versus the planned results as performance
measurement is that every person should be evaluated only on the
factors over which he or she has control.
Communication
As with a business plan, the budget is also a communication tool. It
lets employees know what management’s expectations are by
communicating the expected financial objectives for the year to staff.
The budget allows all employees to understand clearly how their
performance will be judged. For example, if total purchases of R100
000 are budgeted for the year, the buying clerk knows that R100 000
is the total amount he or she can spend, and this will be the
benchmark against which actual performance will be evaluated.
The budget helps to indicate areas that require corrective action.
This happens when the actual outcome is significantly different from
the planned outcome.

The following diagram demonstrates the planning and control
process:
A master budget co-ordinates all financial projections in the
organisation's individual budgets into a single organisation-wide set
of budgets for a set time period .
• Budgeting ensures that planning takes place
• The master budget provides a long-term view of the business
• The master budget promotes communication and co-ordination
within the organisation
• Budgeting encourages the business to look at various alternatives
and to motivate the choices
• Budgeting creates cost awareness
• A budget enables more informed and better decision-making
• A budget provides criteria for performance evaluation.
Speed of reporting
Sometimes by the time the actual financial information has been
finalised and compared with the budgeted information, the analysis
may be outdated. Taking corrective action can be significantly
delayed.
Quality of the budgeted information

A budget is a useful tool only if the estimates are based on realistic
assumptions. When preparing budgets, many organisations simply
take the prior year’s actual financial figures as basis and adjust by
some fixed percentage. A budget drafted in such a way is known as
an incremental budget. A better approach is to compile a zero-based

budget. This means that a new budget is drawn up from scratch each
year. Once again, the benefits should be compared with the
additional costs of using this approach. It may be better to prepare a
zero-based budget every third year, while using ordinary
incremental budgets in between.
Staff whose performance is evaluated by comparing actual results
to budgeted results are likely to create a budget with a “lot of fat in
it” (overstated expenses and understated revenue). In that case, it is
important to analyse the budget carefully to make sure that the
assumptions on which the budget is based are correct.
Implications for human relations

If your staff does not believe in the budget plan or see it as a means
of seeing how badly they are doing, they may try to manipulate the
budgeting process. It is important that employees understand the
budget, how it is drawn up, and how it helps the organisation in
achieving its goals. It needs to be clear that achieving budgets is a
tool to assist the business and that factors outside an employee’s
control will be considered when evaluating staff. Top management’s
support of the budget is critical and they need to communicate their
commitment clearly to all employees.

Different businesses will focus on different information when
preparing their budgets. This is because different types of business
have different types of transactions and also different goals, making
different information important.
Budgeting in different organisations

Organisation Main budgeting focus
Manufacturing Sales and manufacturing
Natural resources Sales, resource availability and acquisition
Service Sales activities and staf ng
Non-pro t Raising revenue and controlling costs

We have been learning how to recognise, record and control
financial transactions so that we can produce financial reports such
as the statement of comprehensive income and the statement of
financial position. We learnt in Chapter 2 that financial accounting is

a process where information is taken from source documents,
recorded in the general ledger, and reported on the statement of
comprehensive income and statement of financial position in terms
of Generally Accepted Accounting Practice (GAAP). These financial
reports are used mainly by parties that are external to the business
such as the shareholders of a company (owners), the lenders, SARS
and potential investors. These users of the financial reports base
their economic decisions on the information reflected in the
statement of comprehensive income and the statement of financial
position of the business.
Over the years managers have found that financial statements do
not meet all of their information needs because managers need more
regular and timely information for decision-making.
Management information is information (both financial and non-

financial) that is in a format that meets the needs of people inside
the business − the managers .
Let’s discuss the information needs of management and see whether
financial statements meet these needs.
17.9.1.1 Planning
One of a manager’s main functions is to plan how the business
resources will be used in the future. If a company wants to make
R100 000 profit for the year, management will have to plan what
day-to-day activities will lead to this. For example, the sales
department will have to sell 100 leather bags a day for the company
to generate this profit.
Financial statements report on a period of time that has already
past − and on historic information. When managers are planning the
future activities of the business, they need information that helps
them to make realistic estimates. The information contained in a set
of financial statements has a limited use to management for the
purpose of planning. This is because what happened in the past is
not always an indication of what will happen in the future.
Nevertheless, it can often be used as starting point.
17.9.1.2 Relevant information

Financial statements are required to be relevant to external users −
useful in helping them make their economic decisions. Management
makes different decisions and therefore finds different types of
information relevant to its decisions.
Let’s look at an example to illustrate this idea. The managers of a
company are trying do decide whether they should close one of the
branches. To make this decision they need to evaluate the financial
information.
A statement of comprehensive income for the branch was
prepared for the year ended 31 December X2, and is shown below:
R
Sales 1 250 000
Gross profit 750 000
Rent of shop (550 000)
Wages (200 000)
Electricity (40 000)
Transport (60 000)
Loss for the year (100 000)
Some of the managers feel that, based on the statement of
comprehensive income, the branch should be closed because it is
making a loss. Their marketing department has done some research
and there is little or no possibility that sales will increase. The rental
agreement for the branch commits them to paying the rental for
another two years, irrespective of whether they occupy the premises
or not.
Most managers felt that closing the branch would be good
because the loss would no longer be incurred. However, a few others
felt that they needed more information about the situation before
making a decision. All financial implications of the branch closure
need to be considered. An example of this is estimating the effect of
closing the branch on other parts of the company.
The statement of comprehensive income indicating results if the
branch was closed for X3 and X4, using relevant information, is as
follows:
Year ended 31 December X3
Sales Nil
Rent (550 000)
Year ended 31 December X4

Sales Nil
Rent (550 000)
If the branch was closed, the business would still have to pay the
rental for a further two years and would have an accumulated loss
of R1 100 000 after the two years.
If management decided to leave the branch open for a further two
years, their loss would be only R200 000 (R100 000 × 2) at the end of
X4. This is because the branch would have made some gross profit to
contribute towards meeting the rental expense.
Obviously the better decision is to keep the branch open for the
remaining two years and then to re-evaluate the situation.
Do you see that the information presented in the financial
statements was not very useful in getting to this decision? We had to
combine the accounting information with information from other
sources (the rental agreement) and consider only the information
relevant to the decision.
The rental expense is not relevant to the managers’ decision to
close the shop because this expense does not change no matter what
sunk cost. Sunk cost are costs

decision is taken. This is known as a
already incurred that cannot be recovered. Only income and

expenses that can change depending on the decision taken are
considered relevant.
17.9.1.3 Detailed financial and non-financial

information
One of the decisions management make is how to invest the funds of
the company − in which assets. Let’s say that Judy’s business is
currently selling three different types of bags, models A, B and C.
Management would need to decide which bag gives the company
the best return for the capital invested. However, management
cannot base their decision only on past performance of the bags.
They also need non-financial information about customer
satisfaction and projected fashion trends to forecast future sales
quantities and prices.
Management needs a wide variety of information to make
decisions, some of which is non-monetary and even non-
quantitative. Financial statements do not provide this type of
information.
• Qualitative information is information not expressed in numeric

terms
• Quantitative information is information expressed in numeric

format. It can be divided into financial and non-financial
information
• Financial information is information expressed in a numeric

format that is of a financial nature. It can be divided into
monetary and non-monetary information
• Non-financial information is numeric information that is not of a

financial nature
• Monetary information is financial information expressed in terms
of currency (rands)
• Non-monetary information is financial information that is not

expressed in R-terms, such as financial ratios, percentages,
quantities, and so on.
17.9.1.4 Timeliness
We have learnt that in order to be relevant, information in financial
statements should be timely. This means that the information must
be accessible to the users when they need to make their decisions.
Financial statements are usually prepared once a year, at the end
of the financial period. Managers have to make decisions about the
business during the course of the year. Let’s say that they want to
decide whether they should increase production of the model C bag.
To make this decision, they would need to know the sales, cost of
sales and other expenses attributable to the manufacture and sale of
model C to date.
17.9.1.5 Relevant structure of the information system

This information would be extracted from the same accounting
system that is used to prepare financial statements. Therefore, the
general ledger should be structured with the needs of managers in
mind. Different sales income accounts for each model should be
created, so that management can easily extract the required
information and use it to help produce management reports.
The accounts would either appear in the trial balance summarised
in a single sales control account or as follows:
Sales − Model A R1 000 000

Sales − Model B R1 250 000
Sales − Model C R750 000
Management accounting obtains information from the general
ledger, but can show more detail if management believes this is
relevant. Management accounting also uses information from other
sources, such as non-monetary information, and can look at the
financial information in the general ledger in a different way.
The type of information needed influences the type of managerial
reports that are produced. There are no external regulations about
what a management report should look like. This is different from
financial reporting, which is regulated by GAAP.

• A business which has a set of incomplete financial records can
piece together an accurate picture of its financial transactions
using those records which do exist.
• To start a small business we have to think, research and plan. A
very important part of the planning is the drawing-up of a
business plan.
• The owner and managers of a business should rely on a set of
internal controls − policies, procedures, and practices − to ensure
an orderly and efficient organisation.
• Controls include supporting documentation, access controls, and
segregation of duties, stock counts, reconciliations, and
authorisations.
• There are both advantages and risks in computerising of the
accounting systems in a small business.
• Budgets are useful for planning and controlling.

• Management accounts represent information in a format that
meets the day-to-day needs of the managers.

QUESTIONS
QUESTION 17.1 (B)

Lindiwe is a motor mechanic engaged in repairing minibus taxis.
Duduzile, a first-year BCom student, helped her prepare financial
statements last year, but since she failed her examinations, she was
no longer available to help with Lindiwe’s financial affairs. Lindiwe
does not understand the requirements of double-entry bookkeeping
and accounting and has come to you for help. She presents you with
a few supermarket packets full of bits of oil-smeared paper from
which you are able to ascertain the following:
1. Duduzile had prepared her statement of financial position at 30
September X2 and Lindiwe had assets and liabilities of:
Van − cost R50 000

Accumulated depreciation: vans 12 500
Spare parts inventory 36 000
Accrued expenses:
Water and lights 7 430
Telephone 1 610
Expenses prepaid:
Rent 2 690
Loan from Gilda 27 500
2. Lindiwe banked her takings periodically after payment of the
following amounts in cash:
Apprentice wages R550 per week

Drawings 250 per week
Overalls (expense) 275
3. Lindiwe’s cash in hand at the beginning of the year was R750
and at the end of the year R1 125.
4. Bank account
The summarised bank statements for the year received from
Classical Bank showed the following deposits made and
cheques presented for payment:
The balance at 30 September X2 agreed with the balance in the
cashbook prepared by the student. There were no cheques or
deposits outstanding at that date.
A cheque paid to a supplier of spare parts on 29 September X3
amounting to R37 880 was cleared through the bank only on 4

October X3.
5. Lindiwe knows that her gross profit percentage mark-up on cost
has always been 25%.
6. Lindiwe found that she could not recover R2 280 from a
customer who had left the country.
7. Depreciation is to be provided as follows:
Van: 25% per annum on cost
Lathe: The estimated useful life of the lathe is ten years
with no residual value.
8. The loan from Gilda bears interest at the rate of 10% per annum.
The initial loan was made in April X2, and the additional
amount of R5 000 on 1 October X2. No interest has been paid for
the current financial year.
9. Lindiwe informs you that the balances at the end of the year
were as follows:
Parts inventory R50 000

Amounts due from customers 40 470
Amounts due to suppliers 39 560
Accrued expenses:
Water and light 2 115
Telephone 1 490
Expenses prepaid:
Rent 1 885
10. Lindiwe also informs you that she had failed to keep a record of
the parts and other supplies taken for her own use to maintain
her 1967 Volkswagen Kombi. She is happy for you, as her
accountant, to determine the figure.

Prepare from the information supplied by Lindiwe her statement of
comprehensive income for the year ended 30 September X3 and her
statement of financial position at that date. All calculations must be
made to the nearest rand.
QUESTION 17.2 (A)

Part A
The bank account in the general ledger of Tag Trader on 31 December
X10 reflected a credit balance of R3 600. At the same date, the total
value of outstanding cheques amounted to R1 400 and outstanding
deposits amounted to R2 000. A cheque for R500, previously
received from a debtor, was dishonoured. The actual receipt of the
cheque was correctly recorded, but no entry has yet been made in
respect of its being dishonoured.
Prepare Tag Trader's bank reconciliation statement at 31 December
X10. (5 marks)
Part B
Freddie Ngobeni is the sole owner of Magic Music, a unique music
store located in Steve Biko Road, Durban. The store was established
by Freddie’s father in 1996 and has built up a good reputation and
loyal customer base over the years.
Below is the post-closing trial balance at 31 December X10, the
firm’s financial year end.
DR CR
Capital R415 000
Building R250 000
Furniture at carrying amount 96 000
Computers at carrying amount 18 000
Inventory 30 000
Bank 19 500
R419 500 R419 500
In X8 Freddie refurbished the entire store. He replaced all the
fixtures, fittings and furniture. He also introduced an area where
customers could enjoy coffee while deciding on their choice of
books.
These changes reduced running costs and boosted book sales,
resulting in the business recording a gross profit on cost of sales of
R125 000 in X9.
Freddie has applied a consistent gross profit percentage on cost over
the past three years.
The following additional transactions occurred during X10:

• Sales amounted to R275 000, an increase of 10% from X9.
• Purchases increased from R100 000 in X9 to R139 650 in X10.
• Freddie contributed to the business two new computers that he
had purchased for R22 500. This was the first time that he had had
computers in the business, and by 31 December X10, all the
inventory and accounting records had been computerised.
• Profit for the year amounted to R96 500.
• Freddie’s drawings amounted to R85 000.
1. Calculate Magic Music's gross profit percentage on cost for X10.

2. Calculate Freddie’s capital balance at 1 January X10. (2 marks)
(4 marks)
QUESTION 17.3 (B)

Jenny Marcus owns a retail shop, the financial year-end of which is
30 June. She has a current bank account with local bank, E-com
Bank. A fire occurred at her premises on 29 June X1 and she was able
to salvage information about the current financial year’s business
transactions only from cheque counterfoils and a notebook
containing details of cash payments and amounts due from
customers.
The following information is provided:

The following is a summary of the bank statements for the year
ended 30 June X1, so far as details are available:
Credits
(of which R65 000 was received from debtors; the balance was R106
received from cash sales) 000
Debits
Creditors for purchases of inventory R 75
000
Wages 16
000
Insurance 2 550
Electricity 400
General expenses 2 850
Repairs and maintenance 500
Repairs to son's car 300
Interest on loan 1 500
Cheques dishonoured 3 500
Rent expense 59
500
Jenny Marcus deposited all the money she received during the year
in the bank, with the exception of R350 a month which she took for
personal expenses, and cash payments for general expenses, which
amounted to R425 during the year. The cash float in the cash register
at 30 June X1 was R300.
On 31 December X0 she repaid R10 000 of the loan by a cheque
drawn on her private bank account. Interest on the loan is calculated
at 15% per annum and is payable six monthly in arrears on 1 January
and 1 July of each year.
Depreciation is to be provided as follows:
Delivery vehicle 20% per annum
on cost
Furniture and 5% per annum on
fittings cost
Inventory on hand at 30 June X1 according to a physical count
The business rented premises from Golden Dove Properties at a
monthly rental of R4 250 from the start of the previous year. The
conditions of the lease (rental agreement) were that a particular
month’s rent should be paid in advance on the last day of previous
month and that the rental would increase annually by 10% on 30
September.
Trade payables consisted of:
30 June X1 30 June X0
Wages payable R550 R500
General expenses payable 110 200
Trade payables for inventory purchases 8 250 8 300
Trade receivables consisted of:
30 June X1 30 June X0
Trade receivables R18 600 R12 000
Prepaid insurance and rent 6 075 5 450
Note:
It is the accounting practice of the business to debit the insurance
and rent expense accounts when payments are made.
Any difference between cash received and paid that is not
accounted for is to be treated as drawings.

Prepare a detailed statement of comprehensive income for the year
ended 30 June X1. Ignore VAT.

Key concepts
A
accounting
accounting model
accounting policy note
accrual basis of accounting
accrual concept
accrued income
accumulated depreciation account
accumulated funds account
accumulated impairment account
accumulated profit
accrual basis
accrued income
acid test ratio (quick ratio)
adjusting differences
adjusting journal entries
administration of companies
application and allotment account
appropriation of profits
arrear cumulative preference dividends
arrear fixed dividend
“artificial” person
asset
asset class
asset definition and recognition criteria
asset disposal account
asset management
asset utilisation measures
audit
auditors
authorised share capital

B
bad debt expense
balance
bank charges
bank deposit slip
bank overdraft
benefit
bonus issue
bonus shares
books of first entry
borrowers
break-up valuation
budget
business
business entity
business risk
C
capital
capital asset
capital contribution
capital gains tax
capital investment
capital market
capital profit
capital structure
capitalisation (of profits)
carrying value of an asset
cash basis
cash equivalents
cash flows from operating activities
cash flows from operations
cash receipts journal
catch-up method
centralised (records)
certificate of incorporation
certificate to commence business
changes in equity and non-current liabilities
chart of accounts
Class A shares
Class B shares
Class C shares
co-ordination (of activities)
Code of Corporate Practices and Conduct (“King Code”)
collection agent
common base-year financial statements
common law
common size financial statements
Companies Act 71 of 2008
Companies and Intellectual Property
Commission (CIPC)
comparability (of information)
component approach
computerised accounting system
Conceptual Framework
conflict of interest
consignment stock
Constitution of the Republic of South Africa, 1996
consumption
consumption tax
contingent liability
contra-account
core activities
corporate citizen
corporate governance
corporate veil
correcting journal entry
cost
cost allocation method
cost model
cost of sales
cost of sales expense
cost plus method
coupons
creditors’ repayment period
cumulative preference share
cumulative redeemable preference dividend
credit
creditor
creditors list
creditors’ payment period
credit sales invoice
credit terms
creditworthiness
current account
current assets
current cost
current liabilities
current ratio
D
date of declaration
date of incorporation
days inventory on hand
debenture
debit
debit balance
debit card payment
debit order
debt
debt arrangements
debt–equity ratio
debtors’ collection period
decentralised accounting system
decentralised (records)
deferred income
deficit units
delivery note
demand and supply
deposits
depreciable amount
depreciation
depreciation account
differential reporting
diminishing balance method
direct method
directors
directors’ liability
disclosure
disclosure requirements
discounting cash flows to present value
discretionary cash flows
distinguishing designation (of shares)
dividend
dividend in specie
dividend policy
dividend reinvestment plan
dividend tax
dividends account
double entry principle
double entry system
drawer
drawings
duties and responsibilities of auditors
duty of reasonable care
E
e-filing system (SARS)
earnings per share
earnings yield
economic decision-makers
economic decisions
economic development
economic growth
economic resource
economic substance (economic reality) economics
economy
EFT payment
elements of the financial statements employment contract
entity concept
equity investors
equity multiplier ratio
estimated life of an asset
ethical business standards
exchange
executive summary
expenses
exports
Extensive Business Reporting Language (XBRL)

extractive activities
F
face value
fair value
fair value reporting
faithful representation
feasibility
fiduciary duty
FIFO (first in first out) method
finance
financial analysis
financial indicators
financial information
financial institutions
financial period
Financial Reporting Standards Council (FRSC)
financial reports
financial risk
financial structure
financial year
financing activities
financing decision
fixed asset register
fixed asset turnover ratio

FOB (free on board) destination
FOB (free on board) shipping point
forfeited coupons
founding members
founding statement
Framework (Conceptual Framework)
free from bias (information)
free from error (information)
free from prejudice (information)
fundamentals of economics
G
gearing
general ledger
general meeting (of shareholders)
general purpose financial statements
generally accepted accounting practice (GAAP)
going concern
going concern basis
goodwill
gross carrying amount
gross profit
gross profit margin
H
hire purchase agreements
historical cost
historical cost basis
historical cost model
human resources
I
IAS 2, Inventory
IAS 8, Accounting for Changes in Estimates
IAS 16, Property, Plant and Equipment

IAS 36, Impairment of Assets
IAS 40, Investment Properties
IAS Framework
IFRS for SMEs
immaterial (information)
impairment expense
imports
Income Tax Act 58 of 1962
income tax expense
incorporated entity
incorporation of companies
incremental budget
indemnities
independent review
indexed statements
indirect method
inherent goodwill
instalments
insurance
integrated report
integrated reporting
interest
interest rate
interest-bearing borrowings
intermediaries
intermediation
internal control system
internal goodwill
International Accounting Standards Board (IASB)
International Financial Reporting Standards (IFRS)
inventory
inventory account
inventory turnover ratio
investing activities
investment property
investments
invoice
invoice basis
irrelevant (information)
issued share capital
J
jointly and severally liable
juristic person
K
“King Code” (Code of Corporate Practices and Conduct)
King Report
L
lease agreements
legal capacity and powers of an individual
legal person
lender
leverage
liability
liquidation
liquidation account
liquidity
liquidity and solvency test
listed shares
long-term investment
loss on sale account
M
management
management information
manufacturing activities
marginal rates
mark-up on cost
mark-up on sales
market
market-to-book ratio
master budget
matching concept
material error and bias
material information
material omissions
means of payment
Memorandum of Incorporation (MOI)
monetary information
money market
money supply
mortgage bond
moving weighted average
N
natural person
net asset value
net margin on sales
net working capital
neutral (information)
no par value shares
nominal value
non-cash flow expenses
non-current assets
non-current liabilities
non-discretionary cash flows
non-financial information
non-government organisations
non-monetary information
non-profit companies
Notice of Incorporation
O
one period
operating activities
operating cycle
operating profit
order
ordinary operating income
organisation
over-subscription (of shares)
owner-occupied property
P
par value shares
participating preference share
participating share
partnership
partnership agreement
past event
payee
periodic method
perpetual method
perpetual succession
personal financial interest
personal liability company
pierce the corporate veil
post-adjustment trial balance
pre-adjustment trial balance
preferential rights
premium on redemption
prepaid expense
present obligation
present value
price–earnings ratio
private company
private sector
production
profit
profit after tax
profit or loss
profit or loss account
profit attributable to ordinary shareholders

profit companies
profit for the year
profit on sale account
profit ratio
profit-sharing ratio
profitability
prospectus
provisional tax
prudence
public company
public liability company (plc)
public sector
purchased goodwill
purchases account
Q
qualitative information
quantitative information
quick ratio (acid test ratio)
quorate meeting
quorum
R
ratios
recognition criteria
reconciliation
reconciling items
recoverable amount
redeemable cumulative preference share
Registration Certificate
registration of companies
relevant
reliable measurement
reliably measure
replacement cost
reporting date
reserves
residual value
resolution
resources
responsible corporate activities
restricted transferability
retail activities
retained income
retained profit
return on assets
return on equity
return on investment
revaluation model
revaluation of assets
revaluation surplus
revenue
revenue asset
right of pre-emption
rights issue
risk
risk management
roles and responsibilities of management and directors
S
SAICA (South African Institute of Chartered
Accountants)
sales income
sales journal
sales return
savers
scrip dividend
secondary tax on companies (STC)
separate legal entity
separate person
service activities
settlement discount
share applications
share capital
share capital account
share certificate
share issue costs
share issue expenses
share premium
share price
shareholder
shareholder activism
shareholders for dividend account
shares
simple weighted average
sole proprietorship
solvent
source document
sources of finance
South African Revenue Service (SARS)
special resolution
specialised journals
specific identification method
speculating (in shares)
standards of conduct
standards of directors’ conduct
statement of cash flows
statement of changes in equity
statement of changes in shareholders’ equity
statement of profit or loss and other comprehensive income
statement of financial position
statement of income and expenditure
statement of members’ net investment
statement of receipts and payments
state-owned company
stewardship
stop order
straight-line depreciation method
STRATE (Share Transfer Records All Totally Electronic)
strategic plan
strategic planning
subscribers
subscriptions in advance
subscriptions in arrears
subsidiary ledger
sum of digits method
sunk costs
support asset
surplus
sustainability
sustainable business practices
T
T accounts
tangible assets
tax collection system
tax invoice
taxable income
taxation
theoretical closing inventory
time value of money
timeliness
timing (reconciling) differences
total asset turnover
total comprehensive income
trade discount
trade payables
trade payables account
trade receivables
trade receivables account
trading account transactions
trend analysis
trial balance
triple bottom line
triple bottom line reporting
turnover
turnover basis
turnover measures
U
uncertainty
uncertificated securities
under-subscription (of shares)
underwriter
underwriter’s commission
unearned income
unique registration number (of company)
unlimited liability
unredeemed coupons account
useful life of an asset
V
value
value added tax (VAT)
value in use
VAT registration number
VAT return
VAT vendor
verifiability
vision
vision statements
voting rights
W
weighted average
weighted average method
wholesaler
winding up of companies
wound up (company)
working capital
working capital cycle
X
XBRL (Extensive Business Reporting Language)
Z
zero-based budget
zero-rated goods
Index
Page numbers in bold refer to figures and tables.
A
academics and research analysts 568
accountability 465
accounting 9, 11, 12
aggregated and summarised form 615
change of policy 377
cycle 89–94
definition 7
environment 13–17
equation 56, 57–58, 59, 71
income-producing activities 638, 639

information 140
policy 228, 377, 628
for properties as investment 357
purpose of 21–23
record-keeping and concepts 476
sponsorships, grants, donations 639–640

system 8
transactions 28, 28, 98

accounting policies 395
basis of preparation 395
impairment 395
and procedures, different 615
property, plant, equipment 395, 396

accounting policy note 128–9
accounting profit and taxable
income 440–441
dividend tax 443–444
normal tax 440–42

accounting recording system, poor 661
accounting statement and GAAP 520
accounting system 299, 334
accounts, asset, liability, income, expense 476
accrual and cash transactions, difference between 516–517
accrual basis of accounting 32
cash basis 132
concept 40, 47–48, 60, 106, 131–132, 665
financial statements 132
implications 140
profit calculation 132, 133

accrual concept 197, 516
profit before tax, worked example 544–545
accrued income 516
accrued expenses (liability) 179, 538–539
accrued income (asset) 179
Accrued income account 156
accrued interest (liability) 154
Accumulated depreciation 557

account 162, 165, 367, 502
referred to as carrying amount of asset 162
Accumulated Funds
balance 639
accumulated impairment
general ledger account 375
PPE asset account 375
Accumulated profit account 32, 36, 108, 235, 235

of partnership 479
undistributed profit 675–676
see also retained income accuracy of transactions recorded 681
adjusting journal entries 140, 149, 153, 219
accounting process 142–143
accrued expenses 154
recorded in books 154, 154, 155, 156

year-end 147–148
adjustment recorded in books 156
administration of companies 411
agent’s commission (percentage of selling price) 196

allowance for doubtful debts 671
Analysis of Receipts column 94
annual financial statements (AFS) 7, 107, 357
benefits of reporting 461–462
companies 409
general purpose 462
need for differential reporting 462
objective of reporting 461
appendices and exhibits 679
Application and Allotment account 426
appropriation account of partnerships 480–483
in general ledger 482

statement 484, 485
Arabic algebra 8
arithmetic 8
asset and liability accounts 149
asset management 583, 610–611, 614
efficiency ratios 599–608
turnover measures 584
utilisation measures 584
assets 7, 21, 27, 31–32, 33, 34–35, 37, 56, 59, 71, 72, 106, 108, 140, 162, 673–674
accounts (cost of asset) 85, 162
buying and selling 555

control of 360
current or non-current 39
definition 192
disposal 549, 556, 672

disposal types 390
estimated useful life 165
existing partnership 487
general ledger account 385, 385

increase in 29
liquidated (converted into cash) 36
net value 29
past event 110
purchases 665
recognition criteria 115
revaluation 376
safeguarding 682
stated as percentage of total assets 578
turnover ratios 611
audit 464
auditors (independent people) 126, 568
duties and responsibilities 465
authorisation of recorded transactions 681
B
bad (irrecoverable) debts 40, 165–166, 347, 516, 533, 547, 667, 672
expenses 166, 167–168, 548

recording of 166
transactions to record (with VAT) 334
bank 549, 583, 667

account 154, 207, 279, 279, 427, 545
account balance in general ledger 274
account balance on
statement of financial position 281
balance on bank statement 47–48, 50, 274
capital contribution from personal account 274, 274

closing and opening balance 279
as creditor (liability) 275
as debtor (asset) of business 274
deposit slip 66
deposits made into 281, 282
error corrections, debit or credit entry 279
overdraft 35, 459
payments 669
reconciliations of account 634
reconciling the account 274
stop orders or debit orders 284
bank charges and service fees 281
cost for processing cheques 278
cost of issuing cheque book 278
interest paid as debit order 279
paying a stop order or debit order 278
withdrawing cash 278

bank reconciliation, preparing 286
adjusting differences 287
draft statement 287
bank reconciliation process 282, 683
adjusting differences 281, 287–288

expense accounts 281
income (interest income) 281
purpose of 289
reconciling items 281–282
six-step approach 287–289
timing and adjusting differences 281
trade receivables credited 282
updating records 287–288

bank reconciliation statements 274–279, 288, 288, 289–290, 291
bank charges 281
completing of 274
financial position 289
process 280–289
purpose of 289, 289–290

reconciling items 281
stop orders 281
bank statements 276, 280, 302

balance and general ledger differences 275
closing balance 277
credit and debit transactions recorded 276
credits 666
debits 671
interest received 277
opening balance 277
small enterprises 665
source documents for small enterprises 665
summary 663, 663

transactions recorded in general ledger 279
Basic Conditions of Employment Act 75 of 1997 468
bequests by donors 633
bonus shares 432
borrowers 16–17, 17
break-up valuation of assets and liabilities 110
budget
implications of human relations 689
incremental 689
zero-based 689
budgeting 677, 686, 688

advantages 689
control function 686, 687
co-ordination of activities 687
different organisations 689, 690

functions 686–687
master budget 689
planning 586
process 677, 686, 688

quality of information 689
weaknesses of system 689
business 9, 10
classification by activity 18–19
description 679
drawings 38
ethical standards 465
interaction with customers 18
operating 20
organisations 12, 18–20
owners/shareholders 21, 22
returns or value relative to risks 568
setting up 20
tax returns 665
types of 18–19, 19
business plans 677, 678–679
components 679
setting goals and objectives 678–679
steps in preparing 680, 680

testing feasibility of an idea 679
C
capital 8, 32, 38, 108, 409, 639
accounts 94, 479, 489, 502, 502–503

asset 445
contributions 36, 478, 479, 666, 675
investment 21
market 17
profit 445
requirement 20
structure 20, 431, 567
Capital and Current accounts 495
capital contribution 672
capital/drawings 114
capital gains tax 409, 441, 445
capitalisation issue or “bonus” shares 428–429
recording in general ledger 429

share capital plus retained income 428
special resolution for bonus issue 428
capitalisation shares as payment of dividend 432–433
capital maintenance reduction of share capital 446
share buy backs 446–447
capital structure of business 567
carrying amount 161, 357, 365–366, 370, 385, 385, 556

breakdown 391–392
of building sold 390
cost less accumulated depreciation 165, 366–367
reconciliation 392–393
zero 386
cash 7, 674, 674

balance 515
in bank 545, 545, 677

bank charges for withdrawing 278
cost as cost of asset 362
from customers 550
generated by operations 458, 530

inflows and outflows 49, 520
payment 335
payment notes 671
receipt 69, 69
related to income 158
sales 90, 546, 666

slips 90
suppliers and employees 551

suppliers of inventory 550
withdrawal 284
cash/balances with banks 459

cash equivalents 459, 674
greater percentage of total assets 578
cash flows 110, 517
direct method of reporting 520, 523, 524

future 108
gross, of an entity 523
inflows and outflows 665
initial (buying or issuing shares) 523
investing activities 554
net, of an entity 523
subsequent (dividends) 523
cash flows from financing activities 557
decrease in long-term loan 541
interest-bearing loans 541

cash generated from operations 458, 530
direct method 531–532, 537, 537–539, 539
indirect method 531–532, 537–539
paid to suppliers and employees 534, 535, 534

paid to suppliers for inventory 534
received from customers 533, 534
Cash Payments journal 94, 95, 96, 305, 307, 308, 312
Cash Receipts journal (CRJ) 90–91, 91, 94, 96, 338, 338, 343, 346, 347
cash transactions of non-profit organisations 630
catch-up method 398
cheques 68, 302, 684

cancelled 286, 286
or cash deposit on bank statement 277
cost for processing 278
cost of issuing book 278
dishonoured (bounced) 278, 284–5
drawer 68
errors 285
information on 68
payee 68
payment 275, 275

personal 66
stale 282, 285
unpresented 282
see also current account (cheque account)
classification of transactions in journals/records 681
client base 490
close corporation (CC) 476, 661, 663
accounting and disclosure requirements 505
accounting for transactions 505
equity in 474
founding statement 505
general journal 506

information in notes to financial statements 505
investment (capital contribution) 504
members’ interests 474, 504
owners known as members 504
public interest (PI) score 505
record and disclose equity 505
small 661
Statement of financial position 506

Statement of members’ net investment 505
Close Corporations Act 69 of 1984 504
closing balance 668, 669, 670, 676
closing entries 85–89, 148, 149

information to general ledger 86, 145, 147
partnerships 480
processing of 86
transactions 145
closing inventory, known as stock 107
value calculated 223
closing journal entries 224–225
closing transfers process 140
Codes of Corporate Practices and Conduct, see
King Code of Corporate Practices and Conduct
collusion and fraud 682
commerce 8
commercial transaction 8
commission expense 197
common base-year financial statements
indexed statements 579
trend analysis 579
common law 411, 420, 468
communication
and budget 687
messages to internal and external parties 679
companies 409
criminal wrongdoing or dishonesty 410
date of incorporation 416
entity with rights and duties 409
incorporating 416
juristic person 410
and the law 411–412
legal capacity and powers of individual 417
legal or “artificial” person 409, 410
limited liability 410
names 416
natural person 409, 410, 442
objectives and goals 416–417
profit and non-profit 409, 628
principles and procedures for forming 409
separate from shareholders 410
separate legal entity 416
unique registration number 416
VAT vendor 444
wound up or liquidated 410
Companies Act 2008, 409, 411, 414, 415, 416, 420, 422, 424, 430, 446, 462, 463, 464,
468, 474, 504, 628, 629, 661
Acts of 1926, 1973, 1999 409, 446
administration of 411
alternative provisions to approve decisions 420
shares with distinguishing designation 422
Companies and Intellectual Property Commission (CIPC) 411, 415, 416, 464
Companies Register 416
Registration Certificate 416

company 476
limited liability 475
taxes 440–445
comparability in financial analysis
company to company 570
company to industry 570
previous financial period 569
worked example 570, 571–575

compensating error 85
completeness of transactions 681
comprehensive income 26, 39, 41
computerisation
financial and/or operational records 677
logical access controls 686
problems with accounting records 685–686
risks of system 686
unauthorised access by hackers 686
Conceptual Framework for Financial Reporting 107
conflict of interest 420
consignment stock 195–196
Constitution of the Republic of South Africa, 1996 411
consumption 11
contingent liability 117
contra account 74, 210
contracts of companies 410
contributions 504
control
principle 683
system 400
techniques 684
see also internal control system
core activities 521
corporate citizen 465
corporate governance 465–466
primary characteristics 465
corporate law 474
cost 9, 10, 12, 35
assets and liabilities measured at 122

assets used 27
fair value 362
historical basis 123–124
of inventory (asset) 199
model 122, 391
price 237–239, 362
of sales from sales return 236
cost allocation methods 228–236
purchases returns 236
sales returns 235
sales returns in periodic system 236
sales returns in perpetual system 236
cost of inventory definition 198, 199

cost of sales 550, 668–670
expense 222
formula 601
identify components 600, 600
opening balance 668
purchases 668
Cost of sales account 31, 32, 40, 41, 48, 205, 206, 220, 221–222, 223, 224
coupons 626
accounting for 654
at discount 653
forfeited 654
nominal or sale value, face value 653
or token 653
unredeemed coupon account 654, 654–655

credit 8
agreed terms 303
balance 83
calculate purchases 601

card receipt 302
entry (CR) 71, 72, 83
limit 301
note 303
policy 337
purchases 307
recording of sales 337

sales/credit purchases invoice 70, 70
terms 301
terms of loan 67
transactions 334
creditors 21, 22, 591, 599
communicating perspective 315
payment period ratio 586, 586, 600, 601

reconciliation process 305, 316, 318
repayment period 609, 610
role in partnership 477–478
statements 316, 317

suppliers of short-term funding 568
creditor’s account
corrected, adjusted balance 299
and statement balances 299
Creditors or Trade payables subsidiary ledger 305–306
creditors reconciliation
statement 318, 321–322
subsidiary ledger 299
credit purchases 299, 307
invoice 302
recorded in general ledger 301
recorded under accounting equation 300

transactions 300
credits 71
rating 302
credit sales
in general ledger 335, 335

recording 337–339
source documents 302, 336
credit transactions 341
business and suppliers (creditors) 299
recording 300, 303–313, 314

credit transactions in specialised journals
Cash Payments journal 304, 304, 305

Purchases journal 304, 304
Purchases Returns journal 304
recording 337–339
credit transactions on bank statement
cheque/cash 277
credit card payments 277
deposits 277
electronic fund transfers via Internet banking 277
interest received 277
stop or debit orders 277
creditworthiness 21, 67, 302, 303
cumulative fixed distribution rate, right to 437
current account (cheque account) 66, 481–482, 498, 502

current assets 30, 482, 674
current cost 121
current liability 154, 477–478, 481
customers 109
debtors 334
reliability of suppliers 568
D
debentures
disclosure of in financial statements 460
journal entry to record 460

recording issue of 460
debit card payments
adjusting difference 283
payment slip as source document 283
debit note 303

debits 71
balance 83
entry (DR) 71, 72, 83
debit transactions on bank statement
ATM (automated teller machine) 278
cash withdrawal at ATM or bank teller 278
cheques 277
debit card transactions 278
dishonoured (bounced) cheques 278
electronic fund transfers (EFT) 278

PIN number (personal identity number) 278
R/D, “refer to drawer” 278
service fees and bank charges 278–279
stop or debit orders 278
debt 108, 475
arrangements 459–460
finance 459
management 588, 591, 611–612
payment on due date 335
ratios (financial leverage) 590, 590, 602, 612

debt and gearing 459–460
sources of finance 459
debt−equity ratio 590, 590, 602, 612

debtor(s) 335, 599
balances 334
collection period 585, 585, 586, 600, 609, 610, 610

and creditor relationship 313
collection period (in days) 585, 585

definition of an asset 335
individual 168
list 345
deferred payment 118
delivery costs
of goods sold to clients 199, 200

initial 365
delivery notes 682
demand and supply 12
deposits 17
slips 66, 90
depreciable amount 368, 381

and carrying value 386
depreciation 35, 122, 159–160, 164, 357, 366, 399, 516, 530, 537, 544
account 366, 381, 381
accumulated 164, 165, 366, 535
business expense 162
calculation 384, 397–398
carrying value as cost 161, 370
charge 357
component approach 370–371
diminishing balance method 160, 369–370
expense 48, 164, 381, 671

limited or unlimited useful life 367–368
methods 368–369, 390
non-cash flow item 545
rates 371, 390
recording in books 160, 161

straight-line method 160, 369
de-recognition of inventory 191, 236–237
differential reporting 462
directors 419, 430
conflict of interest 420
duty of reasonable care 420
fiduciary duty 420
general meeting of shareholders 419
indemnities 420
insurance 420
liability 420
personal liability 420
quorate meeting 420
roles and responsibilities 465
special resolution or decision 419–420
standards of conduct 420
discipline, commitment to governance 465
disclosure 9, 11, 12
of inventory in financial statements 237
disposal of property, plant, equipment accumulated depreciation account 389
accumulated impairment account 389
asset account 389
journal entries for sale of building 389

loss on sale account 389
proceeds received by business 389
profit on sale account 389
profit or loss on sale 388–389
recording 389–390
distribution 38
decisions 27–28, 33, 33

fixed 435–436
to shareholders 455, 575

dividend in specie (in kind) concept 433
dividends 38, 422, 633
appropriation of profits 429–430
arrear fixed 437
capital structure 431
companies 409
company liquid and solvent 430
cover 598, 598, 607

interim and final 430
ordinary or Class A 430
policy 419, 431
preference or fixed 430
recording in general ledger 431–432, 432

recording issue of shares as payment 433, 433
reinvestment plan 433
right to 430–431
shareholders for 432

tax 409
yield 597, 597, 606

see also dividend in specie; scrip dividend
dividend tax, withholding tax 443, 443
liability 444
shareholders as South African companies 444
documentation 682
donations 633, 636, 645, 645, 646

from foreign donors 647
General fund 645
as income 639
double entry
principle 58–65, 94
rule 98
system 7–8, 71, 72, 115
doubtful debts
Allowance for 166–168, 169

closed off to Profit or loss account 168
final balance 168

recording 167
drawings 61, 482, 675
account 88, 486

interest on account 486
Du Pont analysis 593
equity multiplier 594, 595
flowchart 594
profit margin 595
return on assets 594

return on equity 594–595
total asset turnover 595
E
earnings and dividend yields 613
earnings per share (EPS) 455, 595, 596–597, 605, 613

earnings yield 596, 596
ratio 605
economic benefits for business 115–116, 199
maximum future benefit 223
economic decision-makers 18, 21
economic decisions 20
information 22
economic development 15
economic growth 15
economics 14
fundamentals 13
economic substance (economic reality) 360
economic system 13–15, 16
economy 9, 11
Electronic Funds Transfer (EFT) 283, 324
ATM banking receipt 283
EFT slips 90, 116
Internet banking 69, 277
payment 69, 69, 275

payment slip as source document 283
electronic transfer instruction 302
employees 21, 22, 109, 568

tax (PAYE) 441
employment contract 420
Employment Equity Act 55 of 1998 468
entity concept 38, 411
equity 7, 27, 33, 34, 36–37, 56, 59, 60, 61, 71, 72, 106, 108, 140, 162
capital 504
changes 522–523
of company 422
defined as residual 418
investors 418
owner’s 675, 675

as residual value 113
stated as percentage of total equity 578
equity accounts 85
capital and drawings 85
income and expenses 85
see also residual amount
error
of omission 85
of original entry 85
of principle 85
estimate
change in 399, 399

costs 365
disclosure requirements 398
ethical business standards 465
exchange 11
executive summary of business plan 679
expenditure on part, additional 382, 382–384
expense account 179, 179–180

expenses 12, 27, 31, 40, 59, 106, 114, 666
cost of sales 35
list 671
prepaid 516
extractive activities 19
F
fairness, dealing with stakeholders 465
fair value 109, 118, 122
calculation 119
feasibility of business plan 679
fees 634
finance 9, 10, 12
sources 20, 459
financial accounting 677, 690
financial advisors 23
financial analysis 21–23, 567
benefits and limitations 567
conducting 599–607
evaluation of business 569–576
external evaluation 614
generalisation and summaries 615
internal evaluation 614
limitations 615
purpose 567–568
results 567
users 568
financial data 679
financial decisions 26–30
financial indicators 595
financial information, qualitative characteristics 106, 124

benefit greater than costs 130
communication 23
comparability of 128
Conceptual Framework 124
enhancing characteristics 128
faithful representation 126–127
materiality 125–126
neutral (free from bias) 126
relevance 125
timeliness 129
understandability 130
verifiability 129–130
financial institutions 17, 21–23
financial leverage 588–589

risk and probability of future returns 589
financial performance 46
financial period 56
financial position of business, current 7
financial prospects of business 7
financial ratios 581–582
financial records of partnership 476
financial reporting 20, 106
benefits 461–462
objective 107–109
financial reports 7, 12, 107, 567, 661
users 690
financial statements 2, 7, 26, 33, 33, 89, 107–108, 626

analysing and interpreting techniques 567
assets and liabilities 115
common base-year 576
common size 576–577
elements 110–112
existing and potential investors, lenders, creditors 108
general purpose of 462
independent review 463
legal requirements, preparation and audit 463, 464

notes to 575, 575–576
preparing after adjustments 140
primary users 106
recording bank balance in 282–283
timely information 692
financial statements for a club cash banked 647
donations from foreign donors 647
grant received 646–647
income earned on fund investment 649

stock count 647
subscriptions from members receipt 646
financial statements for non-profit organisations
financial position 628
income, expenditure, assets, liabilities 628
financial statements for public company
cash flows 448, 453

changes in shareholders’
equity 449, 452

comprehensive income 448, 450
financial position 448, 451
notes to 449, 454
financial structure 108
financial system 16–17
financial year or trading period 358
financing 33
changes in equity and non-current liabilities 522–523
decisions 28–29
inflows and outflows from activities 523
financing activities 522–523, 541–543
cash flows from 557
statement of cash flows 541–542

First-in-First-out (FIFO) 191, 236
and cost allocation method 229
and periodic recording method 230,230–231

and perpetual recording method 230, 230
fixed asset
register 89, 399
turnover 602
turnover rate 587
turnover ratio 587, 611

fixed deposit account (asset) 155–156
fixed distribution
right to a participating 438
right to shares 435
fixed dividend (preference shares) 433
face value 434
recording in general ledger 434–435
food items, zero-rated and exempt supplies 248, 249

forced sale 110
founding members of company 424
fraud 685
free on board (FOB) 194–195
destination 195, 360–361
sell inventory (destination) 195

sell inventory (shipping point) 195, 360–361
funding 27, 28, 36, 474
current sources and application 679
gratuitous (free) 639
non-profit organisations 630
sources 33
fund-raising
Income and Expenditure Statement 638–639, 639

inflows 636
future benefit (liability definition and recognition criteria) 203
future demand (sales budget) 686
future net inflow of economic benefits 379, 379
G
G20 group 107
gearing, see debt and gearing
general fund account 650–651

General Funds account of non-profit organisations 630, 639
general journal 56, 162
closing entries in174–175

entries 117–118, 211, 223
posted to general ledger 143
and VAT 257, 257–258, 258

general ledger 56, 74, 75, 85, 89, 90, 98, 106, 142, 144, 162, 191, 206, 211, 223
accounts 387
bank account 279, 279
posting closing entries to 175–176
recording information in 72–74
transactions 99
and VAT 258, 258–261

generally accepted accounting practice (GAAP) 106, 107, 109, 128, 129, 194, 357,
368, 629, 639, 690, 693
accounting statement 520
companies 409
direct method of reporting cash flows 520, 523, 524

IAS 2, IAS 16 standards 362
IAS 7 523
standard on Property, Plant, Equipment 359–360
general purpose financial reports fair representation 107
general purpose financial statements 462
global fund 650

going concern 106
assumption 109–110
good corporate governance sources 468
good governance primary characteristics 465
goods and services 11, 16, 35
goodwill (premium) 487, 497–498
accounting for 489
choices in recording 491
inherent 490
journal entries 491–492, 492

not reflected as asset 494, 494
private cash settlement 493
purchased 490
recording changes in 491–492
493
reflected as asset 493,
grants 635, 644, 644–645, 645
gross domestic product (GDP) 14
gross profit 41, 224, 225
expected, mark-up 222
margin 612
gross profit percentage 191, 603

calculation 239
H
handling costs 365
hire purchase agreements 460
historical cost 109
amount of cash paid 117–118
basis 615
human errors 685
human relations, implications of budget 689

I
impairment expense 548
expense 548
impairment of property, plant, equipment
debit expense account 375

expense 379, 394
recoverable amount 375
reversal of expenses 375–6
selling the asset 374
using the asset 374
import duties and transport costs 212

periodic system 213, 223
perpetual system 212
on purchases returned 212, 222
wasted costs 212
import tax 199
income 35, 39–40, 60, 106, 113, 114, 639, 666, 672
account in general ledger reduced (debited) 157
accrued 155–156
asset disposal 672
division 20
earned (assets generated) 27, 31
international aid agency 633
received as income or liability 158
received in advance 156–157
taxable 409, 440
tax expense 441, 441, 442

tax return 441–442
under-provided for tax expense 441–442
unearned or deferred 516
Income and Expenditure statement 626
club 648
donations 645
non-profit organisations 630, 634, 645

Income Tax Act 58 of 1962 440, 441, 462, 661
incomplete records
application of approach 665–676

approach to problem 664–665
case study 661–664
incorporation of companies 411, 416
independence 465
individual creditor balances list 299
inflation 436, 615
information
detailed financial and non-financial 692
needs of management 690
recording in general ledger 72–74
relevant structure of system 692
infrastructure 16
initial recognition, calculating cost of 198–204
inputs 15
instalments
costs 365
loan repaid in 67
insurance 400
and directors 420
intangible assets 34–5, 358
integrated reporting 466
Intellectual Property
Commission 464
intention of business 359
interest 17, 18, 302, 477, 633
cover (times earned) 590, 590–591, 603, 612

earned 666
expense after tax 593
expenses 41, 284, 537
income 284
market-related 481
paid 455
rate 119
rate on loan 67
interest-bearing borrowings (debt) 457, 460

intermediaries 17, 68
intermediation 17
internal control system 680–681, 684–685

objectives 677, 681
techniques 677, 681
International Accounting
Standards Board (IASB) 107, 462, 463
IAS 2 (inventories) 107, 123
IAS 6 (property, plant, equipment) 123
IAS 7 (operating, investing, financing) 520
International Financial
Reporting Standards (IFRS) 107, 194, 462
for SMEs 463, 474, 505
internet banking 69
see also Electronic Funds Transfer (EFT)
inventories 456, 575

inventory 30, 32, 39, 40, 59, 72, 112–113, 115, 191–198, 530 538, 538, 545, 599, 674
account 94, 205, 218
adjusting journal entries for 213
amount owed to creditor (liability) 202
asset 82, 192, 193

balance 50
cash payment 207

cost of still on hand 221
credit payment 63–65,207

days on hand 584, 584, 586, 600, 611
decisions 27, 29–30
definition 191
de-recognition of 191, 236–237
examples 191
full cost 202–203
good quality 684
impairment 669
investing 33
levels 611
losses 221–222
perpetual method to record 91, 94
personal use 218
recognised as an asset 194
turnover ratio 585, 585, 600

write-downs 223
see also stock
internal control system
objectives 677
techniques 677
inventory general ledger account 668

inventory recording systems 205–225, 228
perpetual versus periodic 205–206
purchase in perpetual system 207
transactions in general ledger 206
see also periodic system; perpetual system
investment property
IAS 40 “Investment Properties” 400
owner-occupied 400
investing activities
cash flows 540
inflows and outflows 522

net cash flows 522
property, plant, equipment 540

purchase of non-current assets 540
investments 28, 456, 567, 588

of funds 692
long-term 421
shares 194
investors 21–2, 591
invoices 320–321, 682
J
journal
as book of first entry 94
correcting entries 364–365
entries 363–364, 365, 481

worked example 306–307
in accounting cycle 92
adjusting 140, 171–172, 222, 222
post-adjustment trial balance 173–174
posting adjusting entries to general ledger 172–173

process 56
reversal of adjusting 179–184
transaction of partnerships 478

JSE 462
Securities Exchange Rules 468
judgement and estimation of financial analysis 615
judgements of financial analysis 615
K
King Code of Corporate Practices and Conduct 420, 465, 466, 468
King I
responsible corporate activities 465
standards of conduct 465
King II Report on Corporate
Governance 465
King III Report 465
King IV Report 465, 466
L
lease agreements 460
ledger accounts (known as T accounts) 56, 72, 72, 665

balancing 79–80, 79, 80
components 667–668
ledgers, worked example 306–307
legal form of transaction 360
legal powers of companies 417
legal requirements 20
setting up new company 416
lenders 21, 22
potential 583
suppliers of long-term funding 568
liabilities 7, 27, 29, 30, 31–2, 34, 35–37, 56, 59, 71, 72, 106, 108, 112–113, 140, 154, 162,
675
accounts 85, 154, 157, 427
accounts stated as total liabilities 578
and creditors of companies 410

current and non-current 39
loan 113
location 20
outstanding 500–501
present obligation and past event 112
trade and other payables 675
as trade payables 30, 112
liability account, shareholders for dividend 435
line items 665
liquidation 110, 500–501, 501

account 502
liquidity 582, 599, 608–609
and solvency test 446
loans 35, 37, 50, 107, 113, 499
account 94
application 67–68
bank overdraft 459
to employees 674
interest-bearing 558
as interest expense 477
interest-free 675
long- or short-term (liabilities) 108, 459
repayments or drawings 665
loss 27, 85–86
M
management 21
planning use of resources 690
responsible 465
roles and responsibilities 465
authorisation of transactions 684
management accounting 677, 690–693
relevant information 690–691
managerial reports 693
managers 22, 588
manufacturing activities 18
market 9, 11–12
analysis 679
ratios 595–598, 604, 613

research 241–242
sales activities and strategies 679
market-to-book ratio 598, 598, 606–607, 613

carry value or book value per share 598
mark-ups 240–241
on cost price 191, 238–239
on selling price 191
stated, and actual gross profit 238
measurement of elements 117–124
initial recognition: cost 117
subsequent measurement 122–123
members of non-profit organisations 630
contributions or donations 630
list or register of details 634
memorandum of association 629
Memorandum of
Incorporation (MOI) 409, 411, 415, 416, 424
binding rules of company 417
companies’ issues 417
misuse of business cash or assets 684
monetary information 692
monetary values 615
money
flow 15, 16
market 17
medium for exchanges 8
received (Dr) in Bank column 94
unit of exchange 15
mortgage bonds 35, 460
motivation and budgets 687
N
net asset value 36–38, 39–40, 41, 46, 59, 60, 61, 113–114, 154, 162
right to share 436
net future economic benefits 224

net margin on sales 612
net realisable value 121, 224
net replacement cost of asset 376–377
net working capital 334
collection policy 351
credit policy 350
current assets 350
non-cash flow income 547–548
item 556, 556

expenses 516, 547–548
non-cash investing and financing 458
non-current assets 29, 599
in generating income 159
proceeds (actual cash received) 548
profit or loss on sale of 548
non-current liabilities 522–523
non-financial information 692
non-government organisations 628
non-monetary information 692
non-profit company, requirements for 629
non-profit organisations (NPOs) 626, 627
accounting for 630, 630–633

accounting records on cash basis 630
accounting rules 628–629
activities 633–634
assets, acquiring and controlling 630
and clubs 626
constitution 629–630
funding 630
general fund 633
General Funds account 630, 639
governing rules 629–630
Income and Expenditure statement 630, 634, 645

investment provisions 630
loss as deficit 630
members 630
memorandum of association 629
profit as surplus 630

regulation 628
requirements 628
sources of income 633
Statement of Income and
Expenditure 630, 633
Statement of Receipts and
Payments 630
total funds and liabilities 633
trust deed 629
Non-profit Organisations (NPO) Act 71 of 1997 628, 629
notice of incorporation by companies 416
O
one period term 358
opening balance 667, 674, 674, 675

of cash on hand 674
opening inventory 600, 601

operating activities 521
cash flows from 521, 521–522, 539, 552

cash from operations 543
dividends paid 539, 539

effect of accrual concept 543
effect of non-cash flow items 544
inflows and outflows 521, 521–522

interest paid 539
journal entry to recognise depreciation 544
profit before tax 543
tax paid 540

operating capacity, maintain and expand 554
operating cash flows, reporting of 523
direct and indirect methods 523, 523

operating costs 48
operating decisions 27, 30–32, 33

operating expenses 670–671
calculation 535, 535

operating profit calculation 454
operations 679
opportunity cost 14
orders 682
other comprehensive income (OCI) 377
outputs 15
overdraft 81
overhead costs 365
owner personal information of 679
using inventory for personal purposes 206
owners’ equity 669, 675, 675

format of partnership 474
P
Pacioli, Luca 8, 71
Summa de Arithmetica 8
participating share 438, 438

partners
admission of new 487, 493
Capital accounts 503, 504

capital contribution 476, 487
current and capital accounts 477
interest on capital accounts 477
jointly and severally liable 475
retirement 495
salaries 477
share of equity 495
partnerships 474
accounting principles 476–478
advantages and disadvantages 475

agreement information 476, 477
debts of 475, 504
dissolution (liquidation) 500–504
lenders or potential partners 476
liquidated 474
recording capital contributions 478–479
record of transactions 476
revaluation of assets 487, 488, 496, 496

statement of financial partnership 495, 495
statement of financial position495
transactions and dissolution 502, 502
unlimited liability 474–475
partnerships, roles in
creditor 477–478
debtor 478
employee 478
owner 477
patents 35
payments 16
to trade payables 302
from trade receivables 666
percentage
basis points 579
change 579
point change 579
performance 7, 567
establishing and evaluating benchmarks 679
evaluation 687
periodic inventory recording method 191, 205, 222, 226–227
calculation of cost of sales 206
periodic inventory system 206
recorded in Purchases returns account 206
periodic recording method 230, 230–231

periodic system 207, 209, 211–213, 213, 218, 267, 267, 301, 301, 328
calculating cost of sales 219, 220, 220
physical stock count 219, 221
theoretical closing inventory 219

perpetual inventory system 682
perpetual recording 91, 94
method 191, 205, 214, 226–227, 230, 230

system 339
perpetual succession 410, 476
perpetual system 205–206, 208–209, 210–215, 218–119 266, 266–267

personal financial interest of directors 420
personal liability company
directors jointly and severally liable 415
incorporated company (“Inc”) 415

personal objectives (goals) 679
physical access controls 682
post-closing trial balance 143

posting from journal to ledger 73–78
pre-adjustment trial balance 141, 170

preference shares, see fixed dividend
preferential right
to be paid out capital before other shareholders 436–437
to receive fixed distribution 436
premium on redemption 438
prepaid assets 181
prepaid expenses 154–155, 179
adjusting entry 179

reversals for 179–180
Prepaid rent account 155
prepayments and accruals 535–536, 536, 537

present value 118
of future payments 121
pric–earnings ratio (P/E ratio) 596, 596, 605, 613

private company (Pty) Ltd 412
comparison with public companies 415
name of 413
restricted transferability 412
restrictions to issue share capital 412
right of pre-emption 412
private property 8
private sector 18
proceeds
disposal of property, plant, equipment 458

sale of investments 458
processing system 56
production 11, 14
budget 686
process co-ordinated 687
products 679
profit 7, 9, 10, 12, 21, 27–28, 31, 32, 33, 47–48, 85–86, 675
accumulated account 149
appropriation of in partnerships 479

before and after interest 589
before tax 537
calculation 41–42, 164, 477
calculation versus cash flow 516
companies 412–416
income earned less expenses incurred 515
influences 546, 546

and loss account 366
percentage 603
reconciliation before tax 525
retained 421
for year 545

for year and tax 440
see also gross profit
profitability 465, 612
gross margin on sales 591, 591

net margin on sales/profit margin 591, 591
operating profit margin 592
ratios 603
profit-orientated organisation 626
profit or loss 146

account 86, 99, 145, 149, 224
calculation in partnership 480, 480

depreciation as part of section 162
statement 39–41
profit-sharing ratio in partnerships 479, 487
Promotion of Access to
Information Act 2 of 2000 468
property 673
property, plant, equipment 357, 455–456, 489

asset definition and recognition criteria 360
carrying value 357, 365–366
classifying assets as inventory 359–360
control of 399–300
correcting journal entries 364–365, 365

cost classification 363
cost model 376
costs capitalised 365

current and non-current assets 394
disclosure requirements 390, 394
estimate, change in 397
estimated useful life 365
GAAP standard 359–360
gross carrying amount 391
increases in value after acquisition 376–377
initial cost 362
initial measurement 362
initial recognition of 360

measuring 391–392
measuring reliability 361
operating profit costs 396

pre-adjustment trial balance 374
probable future economic benefits 361
proceeds of disposal 458

purchase and disposal 357
reconciliation note 393

recording purchase 363–364
revaluation and impairment 357
revaluation model 376–377, 393
transport cost 363
uses of 357–358
see also impairment; subsequent expenditure
provisional payments to SARS 442, 442

public company
commitments 459
comparison with private companies 415
contingent liabilities 459
financial statements 448–459
investments within same sector 414
issuing of share capital 413
listed or unlisted shares 414
name of 415
prospectus 413–414
raising capital from general public 413–414
public interest (PI) score 463

calculation 464
public liability company 414
public sector 18
purchase costs 199, 223
Purchase Returns journal 307
purchases
account 205, 211, 218, 220, 227
amount 550
cash outflows 665
credit 299, 302
of inventory from suppliers 206
orders and cheques 684
power of currency 436
returns 669
returns to suppliers (returns outwards) 206
Purchases journal 95,95, 97–98, 307

Purchases returns account 211, 213, 213, 309
Purchases returns journal 312
Purchases/Trade payables journal 308, 311
Q
qualitative characteristics of financial information 124, 692
comparability of information 128
Conceptual Framework 124
enhancing characteristics 128
faithful representation 126–127
materiality 125–126
neutral (free from bias) 126
relevance 125
timeliness 129
understandability 130
verifiability 129–130
quality control division 684–685
quantitative information 692
R
ratios 608–610
acid test (quick ratio) 583, 583

asset management (efficiency) 599
current 582, 582, 599, 608–609

599, 608–609
quick
summary 607, 608
receipts 90, 116
receivables
account 73, 210

ledger 74
assets and liabilities 115, 192
reconciliation 685
control principle 683
recording a purchase
in periodic system 207,209, 211

in perpetual system 207, 208–209
recording decrease in inventory 214
recording increase in inventory 216, 216–217

recording purchases returns (returns outwards) 209–210
in periodic system 211–212
in perpetual system 210
recording sale of inventory 213
in perpetual and periodic systems 213–215
recording sales returns
in periodic system 218
in perpetual system 214–215
return inwards 214
records, adjusting 143

recoverable amount 122
refunds
from capital contributions 665
to customers 665
from loans 665
from trade payables 665
registration of companies 411
remittance advice 299, 324, 325

rent 18
rental 691
expense 41
replacement cost 121
Replacement of non-current assets 542
reporting frameworks 462–465
independent review 464–465
see also audit
reports compiled by
non-profit organisations 634, 634–635

resale in normal course of business 192
research analysts 614
reserves/retained income 445
revaluation assets 446
revaluation surplus 446
residual amount 36
residual claim 36
residual value 36, 160, 163, 165, 366, 368
resources 11, 18, 28, 108
assets 110
categories 14, 14
retail activities 18
Retained earnings account 87–88, 88

retained income amount 32, 36, 50, 409, 581
amount 50
Retained Profits 459
account 432, 435

accumulated profit 108, 377
return on assets 603, 604

before interest and tax 593
592
before interest but after tax 592,
return on equity (ROE) 593, 593, 604, 613
return on investment 597, 597–598
return on non-current and total assets 612
measured with profit after tax 612
return on total assets 613
before impact of interest and tax 613
return to shareholders 597, 598, 606, 613

revaluation
of assets an unrealised surplus 488
and depreciation 384–366
disclosure of gain 378
disclosure of increase in surplus 378
model 122, 378, 391

reconciliation of surplus 393
surplus 124, 377
Revaluation surplus account 379, 380

revenue 12
asset and tax 445
information 580
reversals
for accrued expenses 182
for accrued interest 184
for income received in advance 184
payments for electricity 182–183

reversing entry 181, 181
reviewing accruals and prepayments 158, 158, 159
rights to receive fixed distribution 435–436
risks 9, 10, 12, 568
business 569
financial 569
internal control principles 677
internal controls, choosing and using 684–685
management 465
probability of future returns 589
running costs 242
S
salaries 18, 477, 481
sales 666
account 75, 94, 224
activities and strategies 679
cost of (expense)82, 668–670, 550

income 32, 40, 40, 71, 72, 82, 247
income account 214, 215, 215, 218
income ledger account 74

of inventory to clients 206
returns from customers (returns inwards) 206
returns in periodic system 236
returns in perpetual system 236
schedule 686
total cost of 238
total value 238
transaction 60
see also cost of sales; Cost of sales account
Sales journal 95, 95, 97, 337, 337

Sales returns 667
journal 338
Sales/Trade receivables journal 343, 346

savers 16–17, 17
scrip dividend 433
capitalisation issue 433
segregation of duties 682
selling price 35, 199
cost plus method 239–241
less disposal costs 223
marked 247
separate legal entity 21, 478
services 679
activities 19
fees/bank charges 278–279, 284
fees income 156–157
provision 20
settlement discounts 191, 201, 338–339
impact on cost of inventory 200
settlement/trade discounts:
invoice 302
settlement value 121
Share Capital 422, 426, 427, 457, 459, 557, 576, 581
account 424
authorised 423, 424
issued by company 409, 417, 423
raising equity 418
recording an issue 424

share certificates 422
companies listed on JSE 418
electronic or computerised documents 418
uncertified securities 418
see also STRATE
shareholders 568, 588
to choose board of directors 419
for dividend liability account 435, 435

financing decision 418
to receive share of profits:
dividend policy 419
rights issue 12, 409, 421, 424
to sell shares in company 421–429
share in net assets of company in liquidation 418–419
share in profits or losses of partnership 477
share issues 428–429
application and allotment account 424
costs and expenses 427, 428

expenses 557
par value shares 424
prospectus 424
rights 428
Share Premium account 427
shares 11–12
allocation procedure 426
buy-backs 409
Classes A and B 422, 425
classification 422
distinguishing designation 422
general journal 425

minimum subscription 426
nominal value 423
no par value 423, 424
over-subscription 425
par value 423
premium 423
of profits 18
preferences or limitations 422

price 421
recording over-subscription in general ledger 425–426

rights to fixed dividends 422
rights of shares with fixed distribution rate 435
right to be redeemed 438
under-subscription 425, 426
voting rights 422, 435
simple weighted average 234
Small and Medium
Enterprises (SMEs) 462, 463, 474, 505, 629
small business 661
small close corporation 661
small enterprises and bank statements 665
social issues 465
Socially Responsible
Investment Index (SRI index), JSE 414
sole proprietorship 410–411, 445, 661, 672, 675
normal tax 442
sole trader 476, 479, 672
source documents 56, 65–70, 89, 92, 98
source of money (Cr) in Sales, Capital, Loan columns 94
South African Revenue
Service (SARS) 21, 22, 109, 440–441, 662–663
business as collection agent 252
e-filing system 441
financial statements 663
General ledger 347

income taxation 568, 662
provisional payments 442, 442

SARS (VAT) Control account 347
as VAT vendor 249–250, 251, 251–252

Special Fund account 639, 641, 641–643
funds section of statement of financial position 643
special funds summary 652, 652–653

specialised journals 56, 90, 93, 99
and accounting cycle 90–95
books of first entry 90
specific identification method 229

speculating in shares 421
sponsorships 635, 643
special purpose 640, 640–643

staff 20
5, 26, 33, 46–49, 48, 89, 99, 131, 515, 515–516, 516–518,
statement of cash flows 2,
527–528, 532–533, 574
direct method 524, 528, 528–529
discretionary and non-discretionary 543
indirect method 525–526, 529, 530

information presented 520, 520–526
preparing 527–558
purpose of 519
reconciliation of profit before taxation 458

separate classification 544
sustainability of business 543
using journal entries to understand 551–552

statement of changes in equity 2, 6, 33, 45–46, 46, 89, 99, 515, 573, 665
of companies 409, 448
share capital and reserves 447
of shareholders 378, 447
4, 26, 33, 34, 34–39, 39, 45, 46, 50, 99, 107, 108,
statement of financial position 2,
109, 115, 131, 140, 149, 149–150, 158, 167, 179, 203, 223, 366, 367, 500, 572,
578, 580–581, 639, 645, 648, 649–651, 662, 663, 665, 676
assets, equity, liability accounts 89
balance sheet of non-profit organisations 630
cash and cash equivalents 525

as current asset 151, 155
current reporting period 664
dividends 435
information 140–141
items on 673
investment account under current assets 643
non-profit organisations 630, 630–631, 635

partnerships 479, 485, 489
reporting date 34
and VAT 263

statement of profit or loss 26
statement of profit or loss and other comprehensive income (SPLOCI) 2, 3, 33, 40,
41–42, 45, 46, 85, 99, 107, 108, 109, 115, 131,
140, 149, 167, 366, 399, 440, 483, 515, 516, 546, 571, 577, 580, 661–662, 663,
665, 673, 691
current reporting period 664
gross profit 238
income and expense accounts 89
items on 666
profit calculation 108
and statement of financial position 177–178

two-statement approach 42–43
and VAT 262

statement of net investment of partners 484, 485
Statement of Receipts and
Payments 626, 634

state-owned company (“SOC”) 416
stationery 151
as asset or as expense 152, 152, 153

on hand 538
recorded in general journal and general ledger 151

stock
consignment 195–196
count 647
inventory count 682
losses and theft 222
old-fashioned term for inventory 194
physical count, periodic system 221–222
STRATE ( Share Transfer Records All Totally Electronic) 418

strategic planning 465
subscribers of company 423, 424
Subscription Fee accounts 626
subscriptions 633, 635, 637–638

accounting for 636
in advance 636
in arrears 636, 636

subsequent expenditure of property, plant, equipment
as asset (capitalised) 373, 373

component approach 373–374
as expense 373, 373
subsidiary ledger 306, 307, 683
balances from individual
accounts lists 310

creditors list 313
individual debtor balances 341
summarising and posting of transactions 681
summary of cashbox inflows and outflows 664

sundry transaction 91
sunk costs 692
suppliers
books 201, 201–202

future growth opportunities 568
suppliers/creditors 588
support asset 362
supporting documentation 665, 681–682
surplus 12
income 633
sustainability of company 465
synergy 687
T
tangible assets 357
tax capital gains 250, 441
collection system 247
income and provisional 250
income expense 441, 441

invoice (source document) 247–248, 248
marginal rates 442
ordinary operating income 441
PAYE 441
returns 441–442, 665
secondary, on companies 250
sole proprietorship 442
turnover 250
under-provided income 441–442
value of exchange, including VAT 247–248

see also under company
taxable income 409, 440
taxation 21, 455, 458, 672

company on invoice basis for VAT 445
partnerships 480
sole proprietor on cash basis 445
turnover basis of company 444
till slip 247, 247

timeliness of transactions recorded 681
time value of money 119
total asset turnover 601, 611

rate 587, 587
total comprehensive income 41
trade
and other payables 675
and other receivables 674
receivables account 73, 210

receivables ledger 74
trade discount 191, 200–201
impact on cost of inventory 200
trade-off 237
trade payables account 207, 210, 210, 304, 305, 306, 307, 517–518, 518, 530, 531,
534, 534–535
in general ledger and list of creditors 299
as liability 300–301
suppliers 683
trade payables balance 545
trade payables/creditors’ reconciliation statement 323–324

trade payables in statement of financial position 203
probable outflow of future benefit and recognition criteria 203
Trade payables ledger 299
adjusted balance 324
creditor’s account and statement 299
trade payables liability 63, 72, 81, 115, 203–204, 538, 538, 550, 551, 668, 669
controlling 313–316
provisions and accrued charges 457, 576
reconciliation statement 324

returns to 302
subsidiary ledger 313
Trade payables reconciliation statement 326
Trade payables subsidiary ledger 309–310, 317, 318–319, 319, 320, 321, 322, 326,
327
account 318
adjusted account balance 322
balance as per statement 322

reconciling items 322–324
trade receivables 32, 34–35, 40, 60, 71, 74, 82, 90, 457, 530, 537, 538, 550, 552, 552,
575, 666
account 168, 338, 341
account as asset 334
account in general ledger 338, 343, 344, 683

advantages of investing in 336
balance 166–167, 168
balance in general ledger 341, 341

journal 337
outstanding 168, 168

payments from 666
314, 334, 344, 345, 683

subsidiary ledger
and VAT 346, 346
trading account 225
trading statement 235

transactions 7, 20, 28, 28, 31, 33, 40, 56, 59, 63, 63–64, 106, 474
change in equity 113–113
completeness 681
increase/decrease in equity 114
initiating, authorising, recording 682
list 56
partnerships 476–477
record 21, 25
recorded by suppliers 314
specific to companies 409
transactions flow, summarising
credit purchase 312

credit sale 348
payment of creditor 312
receipt of payment by debtor 349
return of credit purchase 313
return of credit sale 349
transparency 465
transport
costs 223
costs as selling costs 199
costs of returned goods 212
handling costs 199
import duty 199
trial balance 56, 83–85,84, 89, 99, 140, 143

post-adjustment 144, 152, 226, 226
post-closing 177
pre-adjustment 226, 226
sales control account 692–693, 693
tripple bottom line 414
economic, social, environmental issues 465
trust deed 629
U
under-subscription of shares 425, 426
recording in general ledger 426, 427

underwriter 426
commission 426
underwriting a share issue 426
unearned income (liability) 179
unit cost price calculation 239

unlimited liability 411
unused future benefit amount 162
unusual events and items 615
useful life of asset 159–160, 368
change in an estimate 368
depreciable amount 160
time-based or unit-based 159
unit basis 370

V
validity of recorded transactions 681
value
of equipment received 119
in use of asset 122
value added tax (VAT) 66, 191, 213, 247–248, 363, 365, 441, 445
allowance for doubtful debts 348
bad debts recovered 348
business as vendor 249
bad debts expense 347
calculations 250, 250, 254–255

consumption tax 247
exclusive amount 257

financial analysis of business 568
general journal 257, 257– 258, 258

general ledger 258, 258–261
inclusive amount 311
input and output 251, 265
and inventory 265–266
invoice 302
and periodic system 267,267

and perpetual system 266, 266–267
recording 256–266
records of a business 253, 253–254

registered vendors 311, 345
registration number 249
return 249, 252
trade receivables 346, 346

trial balance 262
vendors 250, 265, 301
value in use (VIU) 374
Venetian method of accounting 8
voting rights 437
W
wages 18
expense 83
Wages account 75
weighted average
cost allocation method 191, 231–232, 233, 233

and periodic recording method 233–235
and perpetual recording method 232, 232–233

price 236
purchase cost 232

weighting the order’s unit purchase 231–232
wholesalers 18
wills 633
winding up of companies 411
working capital
changes 537–539, 553
cycle 586
cycle of trading business 587

financing of 349
level of creditors 351
management 334, 349–351
trade payables 586
see also net working capital
working capital cycle 530
Inventory account 531
Trade payables account 531
Trade receivables account 531
World Wide Fund for Nature 630
balance sheet 630

computer equipment 632
farm implements 632
freehold properties 632
funds 633
Income and expenditure statement 631

investments 633
motor vehicles 632
Y
year-end stock count 206
Table of contents
Cover
Title
Copyright
Abridged table of contents
Contents
Preface
1 Accounting in context
Learning objectives
1.1 Definition of accounting
1.2.1 The first accounting records
1.2.2 Who was responsible for the creation of the
double entry system?
1.4.3 The financial system
1.5.1 Classification of business by activity
1.6.1 Why is it necessary to create a record of
transactions in a business?
1.6.2 Who are the economic decision-makers, and what
decisions do they need to make?
economic decisions?
1.6.4 How is financial information communicated?
What’s next?
2 The purpose of accounting
Learning objectives
2.1 Key financial decisions
2.2 Understanding the statement of financial position
2.3 Understanding profit or loss and comprehensive income
2.3.3 Understanding profit
2.4 An introduction to statement of changes in equity
2.5 Understand the statement of cash flows
What’s next?
Questions
3 The practice of accounting
Learning objectives
3.1 The accounting equation in more detail

3.3.1 Deposit slip
3.3.3 Cheques
3.3.5 Cash receipt
3.4 Journal entry
3.5 Recording information in the general ledger
3.7 Closing entries
3.8.4 Trial balance
3.9 How do specialised journals form part of the accounting
cycle?
3.9.4 Sales journal
What’s next?
Questions
4 The conceptual framework
Learning objectives
4.1 Generally accepted accounting practice
4.2 The objective of financial reporting

4.2.1 Who are the primary users of financial
statements?
4.2.2 Who else would be interested in the financial
statements?
4.2.2.1 Customers
4.2.2.2 South African Revenue Services (SARS)
4.2.2.3 Employees
4.4 Qualitative characteristics of useful financial
information
4.4.1.1 Relevance
4.4.2.2 Timeliness
4.4.2.3 Verifiability
4.4.2.4 Understandability
4.4.3 Will financial information always have all of the
enhancing qualitative characteristics?
4.5 Elements of the financial statements
4.5.1 Assets
4.5.2 Liabilities
4.5.3 Equity
4.7 Derecognition of assets and liabilities
4.8.2.1 Fair value

4.8.2.2 Value in use (assets) and fulfillment values
(liabilities)
4.8.3 Deciding which measurement base to use when
initially recognising an asset
What’s next?
Questions
5 Adjustments
Learning objectives
5.2 Closing entries
5.3.5 Depreciation
5.3.6 Bad debts
5.4 Let’s pull it all together
accrued interest
What’s next?
Questions
6 Inventory
Learning objectives
6.1.1 Definition of inventory
6.2 Calculating the cost at initial recognition
6.2.1 Definition of “cost of inventory”
6.3 Recording inventory in the general ledger
periodic
6.3.2 Recording inventory transactions in the general
ledger
6.4 Cost allocation methods − subsequent measurement of
inventory
6.4.4 Cost allocation methods − purchase returns
6.6 Disclosure of inventory in the financial statements
6.7 Selling price and cost price in more detail
6.7.1 Understanding the difference between the stated
mark-up and the actual gross profit
What’s next?
Questions

Learning objectives
7.1 What is VAT?
7.1.1 Tax invoice
7.2 When does a business register as a VAT vendor?
7.5 Is VAT another tax that my business must pay?
7.6 How does VAT affect the records of a business?
7.7 Recording VAT
ended 31 January X1
7.7.5 Statement of financial position as at 31 January X1
What’s next?
Useful web sites
Questions
8 Bank reconciliation statements
Learning objectives
8.1.1 What is the bank statement, and what does it look
like?
8.1.2 An example of how transactions are recorded in
the general ledger and on the bank statement
8.2 Understanding the bank reconciliation process

8.2.2 Identifying reconciling and adjusting items, and
understanding why these differences occur
8.3 What is the purpose of doing a bank reconciliation?
8.4 Another example
What’s next?
Questions
9 Introducing credit: Trade payables
Learning objectives
9.1.2 Recording credit purchases in the general ledger
9.2 Why would a business purchase on credit?
9.4 How do we record credit transactions?
individual creditors?
journals
9.4.3 Creditors or trade payables subsidiary ledger
9.4.4 A worked example: Journals, ledger and
subsidiary ledger
9.6.1 The creditors’ reconciliation process
9.6.2 How do we prepare a creditors’ reconciliation
statement?

What’s next?
Questions
10 The other side of credit: Trade receivables and working
capital management
Learning objectives
individual debtors?
journals
10.5.2 Why is working capital management important?
10.5.3 The financing of working capital
10.5.4 Managing the various components of net
working capital
What’s next?
Questions
11 Property, plant and equipment
Learning objectives
11.1 What does the term “property, plant and equipment”
mean?
11.1.2 Classifying assets as inventory or property, plant
and equipment
11.2 Initial recognition of property, plant and equipment
11.2.1 When is property, plant and equipment
recognised?
11.2.2 At what amount do we initially recognise
property, plant and equipment?
11.2.3 Record the purchase of property, plant and
equipment?
11.3 Decrease in the carrying value of property, plant and
equipment owing to use of the asset
11.3.1 Depreciation
11.4 Treatment of subsequent expenditure on property,
plant and equipment
11.4.2 Recognising subsequent expenditure as an asset
(capitalised)
11.5 How to measure property, plant and equipment
11.5.2 Increases in value of property, plant and
equipment after acquisition
11.6.1 Combining the concepts of revaluation,
impairment, subsequent expenditure and depreciation
11.7 Disposing of an item of property, plant and equipment
11.7.1 Profit or loss on sale
equipment
11.8 Disclosure requirements for property, plant and
equipment
11.8.2 How property, plant and equipment is measured
11.8.4 Reconciliation of the carrying value at the
beginning of the year to the carrying value at the end
of the year
11.8.5 Additional information for the revaluation
model
11.9.1 Depreciation calculation for a change in estimate
11.9.2 Disclosure requirements for a change in estimate
11.10 Control of property, plant and equipment
What’s next?
Questions
12 Companies
Learning objectives
shareholders
12.4 Different types of profit companies

12.5 Legal requirements for the formation of a company
12.6.3 Shares and share certificates
12.7 Dividends
12.7.4 Recording a Class A dividend in the general
ledger
dividend
12.8 Shares with a fixed dividend (preference shares)
12.8.1 Recording the issue of shares with a fixed
distribution
12.8.2 Recording a fixed dividend in the general ledger
12.8.3 What type of rights could shares with a fixed
12.9 Company taxes
12.9.1 Normal tax
12.9.2 Dividend tax
12.9.3 VAT

12.10 Reserves
12.11.1 Reduction of share capital − share buy-
backs
12.13 Financial statements for a public company
12.14.1 Debentures
12.15 Requirements for annual financial statements
(AFS)
12.15.1 Objective of financial reporting
12.15.2 Benefits of good financial reporting
12.15.5 Legal requirements for preparation and
audit of financial statements
What’s next?
Questions
13 Partnerships, and a brief note on close corporations (CCs)
Learning objectives
13.1 Partnerships
13.1.1 Some important terms in respect of partnerships

13.1.5 Differences that occur when recording
information for a partnership
13.2.1 Accounting for transactions in a close
corporation
What’s next?
Questions
14 Statement of cash flows
Learning objectives
14.1 An introduction to the statement of cash flows
14.1.1 Profit calculation versus cash flow
transactions
14.2 What is a statement of cash flows?
14.3 When should a statement of cash flows be prepared?
14.4 The purpose of the statement of cash flows
14.5 What information does a statement of cash flows
present?
14.6 How is the information presented in the statement of
cash flows?
14.6.4 Direct and indirect methods of reporting cash
flows
14.7 What does the statement of cash flows look like?
14.8 Preparing the statement of cash flows
14.8.1 How do we go about identifying cash flows that

14.8.3 Cash from operations on the direct and indirect
method
14.8.4 Cash flows from operating activities, investing
activities and financing activities
14.8.6 Cash from investing activities in more detail
14.8.7 Cash from financing activities in more detail
What’s next?
Useful web links
Diagram summarising the statement of cash flows
Questions
Learning objectives
15.1 What is financial analysis?
15.2 The purpose of financial analysis
15.3 Who uses financial analysis?
15.4.2 Some of the risks affecting business operations
15.5 Using financial analysis to evaluate the business
15.6.2 Liquidity
15.6.5 Profitability

15.7.1 Liquidity
15.7.2 Asset management (efficiency) ratios
15.7.3 Debt ratios (financial leverage)
15.7.4 Profitability ratios
15.8 The benefits of financial analysis
15.9 Limitations of financial analysis
What’s next?
Questions
16 Non-profit organisations and club accounting
Learning objectives
16.1 What are non-profit organisations?
16.2 How are non-profit organisations regulated?
16.3 What accounting rules govern non-profit
organisations?
16.4 What rules govern the formation of non-profit
organisations?
16.5 Accounting for non-profit organisations
16.5.1 What financial activities should be performed in
the business?
16.5.2 What reports do non-profit organisations
compile?

16.5.7 Accounting for sponsorships, grants and
donations
16.6 Preparing the financial statements for a club
What’s next?
Questions
17 Incomplete records and other accounting issues
17.1 Why do some businesses have incomplete
records?
17.2 A case study with incomplete records
17.3 Approach to an incomplete records problem
17.4.1 Items on the statement of comprehensive
income
17.4.2 Items on the statement of financial position
17.5 Business plans
17.6.2 Risks of the business: choosing and using
internal controls
17.7 Computerisation of the accounting records of a
small business
17.8 Budgeting
Questions
Key concepts
Index
Landmarks
Cover
Contents
Page List
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2 The purpose of accounting

3 The practice of accounting

4 The conceptual framework

7 Value added tax (VAT)

8 Bank reconciliation statements

9 Introducing credit: Trade payables

10 The other side of credit: Trade receivables and working capital

11 Property, plant and equipment

13 Partnerships, and a brief note on close corporations (CCs)

16 Non-profit organisations and club accounting

17 Incomplete records and other accounting issues

PART A: INCOMPLETE RECORDS

PART B: OTHER ACCOUNTING ISSUES

the University of Cape Town, where she co-ordinates the first-year

accounting course. She also lectures at the University of Cape

Town’s Graduate School of Business, where she specialises in

finance for non-financial managers and small business development.

She is a member of the South African Global Entrepreneurship

Monitor team and in this capacity is actively involved in small

business research. She is also the co-author of Tracking

Entrepreneurship in South Africa: A GEM Perspective.

Alex Watson, the original content editor, is a professor in the College

chairperson of the Accounting Practices Committee of SAICA and a

former member of the Accounting Practices Board. She is an

independent director of Coronation Funds Managers Ltd.

Carla Fourie is a senior lecturer in the College of Accounting at the

University of Cape Town.

editions of Financial Accounting: An Introduction for their

contribution: Carmen Mettler, Tracey Walker, Stefan Bezuidenhout,