UNIT 1: Revision of Basic Concepts

BASIC PRINCIPLES OF ACCOUNTING

All accounts you work with can be classified as one of the following five concepts:

Asset

There are two categories of assets:

Non-current assets

The intention is to keep these assets for a long time, i.e. more than a year. They are divided into two categories:

Tangible/fixed assets

These are physical assets, which can be touched" They are used to run the business, for example: Land and buildings/Premises Vehicles Equipment Machinery.

Financial assets

These represent the investment of cash in a financial institution for more than a year to earn interest, for example: a fixed deposit.

Current assets

The value of these assets constantly changes. They are either cash or can be converted into cash quickly, for example:

  • Inventories

    Trading stock Consumable stores on hand Raw materials stock Finished goods stock Work in process/progress stock

  • Trade & other receivables

    Trade debtors (less Provision for bad debts) Expenses prepaid Income accrued/receivable SARS (income tax) if tax was overpaid {new}

  • Cash and cash equivalents

    Savings account Bank Petty cash Cash float Fixed deposit (if maturing in next 12 months)

Liability

There are two categories of liabilities.

Non-current liabilities

These liabilities will NOT be repaid within the next twelve months, for example: Loans and Mortgage bonds.

Current liabilities

These liabilities will be repaid within the next twelve months, for example:

  • Trade and other payables

    Current portion of loan Trade creditors Expensesaccrued/payable Incomereceived inadvance/deferred Creditors for salaries/wages UIF; Pension fund; Medical aid SARS (PAYE) SARS (income tax) {new} Shareholders for dividends {new}

  • Bank overdraft:

    only if the Bank account has a credit balance.

Expenses

the cost of running the business

This term includes all services and products which have been consumed/used during the accounting period. lt does not matter whether they have been paid for or not. lf the item or service has been used, it is classified as a current expense, e.g. Electricity, Rent, Insurance, Packing material, Salaries, Stationery, etc

It also includes all money lost on assets, i.e. the assets have decreased in value. Examples: Bad debts, Depreciation, Discount allowed, Trading stock deficit.

There are also costs attached to financing activities. We call them financing expenses. Examples: Interest on loan, Interest on overdraft and Interest expense.

Gain/Income

money EARNED by selling goods or providing a service

t t does not matter whether the money has been received or not - it is income when the goods are sold or the service is provided. Examples are: Sales, Current income, Bad debts recovered, Discount received, Commission income, Rent Income, Interest income,Interest on fixed deposit, Interest on current account.

(Owners') Equity

value/worth of the business/company

In Grades 10 and 1 1 this concept represented the capital invested by the owner/s plus the net profit for the year (gains/income minus expenses) minus drawings (anything the owner/s took out of the business for personal use).

It was important to remember that the owner/s and the business had to be treated as separate economic entities. This meant that owner's personal expenses had to be kept separate from the transactions entered into by the business (GAAP Business Entity principle - see page 3).

This is still true in Grade 12 and is applicable in Units 4 to g. However, in Units 2 and 3 we will study a very important form of ownership i.e. a company. The owners are called shareholders and they do not transact personally with the company.

THE BASIC RULE OF ACCOUNTING

ASSETS and EXPENSES have DEBIT balances and LIABILITIES and GAINS/INCOME have CREDIT balances

What does this rule mean?

It means that we write the figure on the:

  • debit side of an asset or expense account to rncrease its value
  • credit side of an asset or expense account to decrease its value
  • debit side of a liability or gain/income account to decrease its value
  • credit side of a liability or gain/income account to increase its value

All this can be reduced to a magic box - the ALEGO box:

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THE ACCOUNTTNG CYCLE

The annual accounting work for all businesses takes place in the following order:

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THE SUBSIDIARY JOURNALS

All businesses record their daily activities, called transactions, in journals. As they have so many, they use a separate, specialised journal for each type of transaction.

THE SUBSIDIARY LEDGERS

All businesses which buy and sell goods on credit keep separate ledgers for debtors and for creditors. These ledgers are updated daily and enable the amounts owing by debtors and to creditors to be easily controlled. [Unit 6]

GAAP

The following GAAP (Generally Accepted Accounting Practice) principles are used when writing up the books of all businesses and affect the amounts shown in the financial statements.

The Historical Cost Principle

When an asset is purchased it must be entered in the books atthe original cost price quoted on the invoice. This invoice is proof of the original 'worth' of the asset and is not subject to sentimental or fraudulent valuation. lt will also be shown at this price in the Statement of Financial Position (used to be called the Balance Sheet). This prevents the manipulation of values from year to year.

The Principle of Prudence

The accountant must ensure that assets are not overstated and liabilities are not understated.

Expenses will always be accounted for if there is a chance that they will occur. For example, if the latest technology has caused some of the inventory to be 'out-ofdate', it will be valued at net realisable value (the price at which it can be sold), even if this is less than the original cost price. The amount written off will be shown as a loss at the end of the accounting period. lt is not left in the Statement of Financial Position at full cost price in the hopes that this will be realised.

However, an accountant will never enter money received from a client as income unless the work has been completed. At the end of the accounting period, the amount received will be classified as income received in advance which is a liability because, if the work is not finished, the business will have to pay the money back to the customer.

The Principle of Materiality

According to this principle when accounting for a transaction the seriousness or impact on the profits must be considered.

It particularly affects the classification of assets and expenses. A fixed asset is something the business will keep and use for a long time, but the cost of some items is not enough to treat them as assets, record them in the Fixed Asset Register and depreciate them year by year. They will be classified as expenses as the impact on the profit is immaterial e.g. files, stationery trays, staplers, etc.

When classifying the cost of flowers sent to an employee in hospital, the question to be asked is - is it material or important enough to warrant a separate account or can it be treated as 'Sundry expenses'? The answer is it can be treated as sundry expenses as the amount is not rnaterial. This is different to 'Interest on bank overdraft' as this is not just'the cost of running the business', but the cost of borrowing money lo finance the business. The impacVresult on the profit is important, so it must have its own account.

The Business Entity Principle

This principle (also called the separate entity rule) states that the owner and the business must be treated as separate people.lf money or other items taken from the business for personal use were treated as business expenses, the profit would be smaller and so would the amount of tax the owner/s pay SARS. This would be unethical and illegal. lt would also not be possible to compare the profit from year to year. (This principle will not be applicable to companies, which means they do not have an account called 'DrawIngs! as they are separate legal entities [Units 2 and 3], but may be applicable in Units 4 to 9.)

The Matching Principle

This principle requires that income, and the expenses incurred to earn that income, should be shown in the same financial period, e.g. both for 12 months.

If the invoice for inventory, sold to a client on 28 February for cash, is not received from the supplier until 15 March, it must still be shown as a February purchase/cost to match the sales income for the month.

Income received for work to be done in the next financial period or expense paid, but not used in this financial period, may not be shown as income or expenses in this year's financial statements. That is why adjustments for accrued and prepaid amounts, and reversals of last year's accruals and prepaid amounts, have to be made before the net profit can be calculated.

The'Going Goncern' Principle

When making decisions on how to value assets in the Statement of Financial Position (new name for Balance sheet), it is assumed that the business will continue operating in the future. lf the business will be closing down in the next few months, a note stating this fact must be added to the financial statements as a different method of valuation would be used.

ETHICS

Ethics could be described as a set of ideals which may take the form of a code of conduct distinguishing between right and wrong. To be ethical means to be honest, fair, transparent (open) and respectful when dealing with all people. They should be treated equally, without racism; sexism, etc. We all consider ourselves to be ethical people with good morals and strong beliefs, but that does not necessarily mean we believe in the same things, act in the same way or consider the same behaviour to be acceptable.

A code of ethics

Most businesses have drawn up their own code of ethics which is a written document given to every staff member. lt ensures that everyone employed by the business understands what is expected of them when doing their work and, dealing with customers and co-workers.

The advantages of running an ethical business

It will improve management and minimise fraud, which will increase profits.

The business will achieve this because it will:

  • treat employees fairly and they, in turn, will be loyal and work hard to make the business sustainable in the future
  • build up a loyal client base by giving the best service to customers so that they trust the business and continue to support it
  • support the community and, in turn, the community will support it and become customers
  • take care of the environment, that is, look after the immediate surrounds and not pollute the atmosphere or water, so that no one suffers in any way because of the existence of the business in the area.

Questions of ethics or'the right way to run a business' are relevant to every management decision and action. The longterm success of the business will depend on the extent to which management decisions reflect its ethical values and principles and the extent to which the staff comply with these values and principles.

Up to now we have only studied small businesses owned and run by a sole trader or by partners. In Units 2 and 3 we will study big business in the form of a listed public company run by a board of directors. These directors bear the ultimate responsibility for the business and so it is imperative that they embrace ethical standards in the way the company is run, and in the way the board itself operates.

It is said that the board of directors, the most senior management, sets the 'tone from the top'. They set the purpose, strategy and vision of the business. When they recruit new staff it is important that the right people with the right experience and value systems are appointed to maintain the business's ethical approach. Ethics is relevant to the way management organises and conducts itself and the way individual managers choose to behave. All must carry out their tasks in a way which reflects ethical values and principles of the business.

Some characteristics of ethical behaviour

    Accountability Senior management must account to the owners and to the staff for ' its actions and decisions. lt also is accountable to the bank or any other institution which has lent the business money.

    Fairness Management's actions must be free from bias and prejudice. Everyone has the right to be treated equally and with dignity. Everyone has freedom of opinion, belief and religion, freedom of speech and the freedom to associate with whomever he wishes.

    Transparency Management must discuss the decisions it makes and the actions it takes openly with employees so that they understand what is expected of them. There must be no hidden agenda. All information provided must be accurate, complete and timeous.

    Sustainability Everyone, owners, staff, public and the environment must benefit from the existence of the business. 1 means it must be conducted in such a way that it will continue to exist for a long time.

    Here are some examples of how the management should carry out its tasks in a way which reflects the ethical values and principles of the business:

    • The management must be transparent and fair in the recruitment of staff.
    • The management itself must reflect the demographics of the community.
    • lt should give serious consideration to the fairness of salary increases and annual bonuses to management, salary and wage earners, and board members.
    • lt must ensure that the business pays the correct amount of VAT, customs duty, and, in the case of companies, income tax to SARS.
    • lt must compete fairly with all other businesses and not collude with certain competitors to fix prices to the detriment of the government or consumers. . All board members must apply ethical principles when handling conflicts of interest e.g. if the board is discussing the acquisition of a small up-and-coming business, the director must immediately make known to the board that his wife is the owner of that business.

INTERNAL CONTROL

The owner/s of the business want to ensure that:

  • all assets, equipment, vehicles and especially stocks and cash, cannot be stolen
  • all income is correct recorded
  • alll expenses are accurate and legitimate

To achieve this, a system of controls will need to be put in place ideally to prevent theft and fraud from occurring, and to detect them quickly if they do happen. This is called internal control because it is monitored by the internal auditor or senior staff.

In addition to using security guards and technological devices such as cameras and plastic discs on merchandise, thought must be given to the duties performed by each staff member to ensure that there is enough control to prevent theft, fraud and collusion. Any member of staff who commits fraud will have to alter the accounting records to cover up what he has done. The aim of the controls is to make this impossible.

A good system of internal control aims to:

  • protect the assets
  • find errors and detect fraud
  • ensure that accounting records are accurate and financial statements are reliable.

It also enables management to identify areas where staff members are not following the policies and controls which have been laid down. lt will show where resources and time are being wasted, and enable the business to improve productivity.

A system of internal control will ensure that:

  • all transactions are properly authorised;
  • all documents are prepared correctly, in duplicate, as proof of transactions and, if necessary, checked by a senior member of staff;
  • the duties are divided among the staff in such a way as to make it impossible for theft or fraud to take place (called separation of duties);
  • the books are written up regularly and accurately;
  • all records are stored in a fireproof safe and all work on computers is backed up regularly and stored off the premises;
  • a particular person is responsible for each class of asset.

Internal control of cash

Cash is received at the till from customers buying goods and from debtors who pay their accounts at the office or through the post. lt is important that strict controls are kept over this money as staff can easily be tempted to steal or'borrow' it

Control procedure for all cash received

  • Each cashier must have her own till drawer so that she can be held responsible for any shortage when cashing up at the end of a shif
  • All cash received must be put in the till so that a cash sale slip or receipt is issued and given to the customer for the amount received.
  • All cheques received must be very carefully examined to ensure that they have not been tampered with
  • The receipts and cash sale slips must be entered in the CRJ in numerical order. lf a receipt is cancelled, it must still be entered and 'cancelled' must be written next to the number. The actual cancelled receipt must be kept.
  • The person writing out the receipts must not be the person who does the posting to the Debtors'Ledger.
  • A senior member of staff must check that the total of the receipts agrees with the CRJ and the total ofthe deposit slip of cash and cheques banked the next day
  • A senior staff member must handle queries by a debtor who thinks that her statement balance is wrong.
  • A Bank Reconciliation [Unit 6] must be done at the end of every month as an external control measure to ensure that the cash received was actually banked.

How to ensure that the person who does the banking does not'borrow'the cash for a few days and bank it later

{known as 'rolling the cash'}

The cash, cheques and credit card vouchers received on one day must be banked the next morning.

The amount banked according to the deposit slip must agree with the tOtal of the receipts entered in the CRJ for the previous day.

How to make sure that a staff member does NOT use a business cheque for personal gain

Every cheque must be signed by two people. Blank cheques should not be signed until all details have been filled in. Cheques should be entered in the CPJ in numerical order so that a staff member cannot hide the fact that a cheque has been issued. Every month the information in the CPJ must be checked against the Bank Statement. This means that fraud will be noticed quickly.

How to ensure that a staff member does NOT use an Electronic Funds Transfer for personal gain

Only a senior member of staff should know the codes and be able to log on to the banking site. When a member of staff wants to make an Electronic Funds Transfer (EfT) he should have to ask this senior staff member to access the bank account for him.

Internal control of debtors

Preventing fraudulent journal entries

Before a staff member can make a journal entry, authorisation must be obtained from the owner, the internal auditor or a senlor staff member. This person will sign the journal voucher (the source document for a journal entry).

This is always necessary as the General Journal is an ideal place to cover up fraud.

Examples of journal entries which need authorisation:

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Internal control of creditors

How to ensure that a staff member does not order stock from a supplier for personal use and charge it to the business

The supplier must be given an order number taken from an order book with printed, consecutive numbers. This order must be signed by the head of department ordering the goods.

All invoices received must be checked against the order forms to make sure that the business did order the goods, and later, against the statement received from the supplier.

The statement received from the creditor must be reconciled with his account in the Creditors' Ledger. The person/s signing the cheque to pay the creditor must check that all the previous checking has been done.

Internal control of stock

How to prevent theft of stock from the storeroom

When goods are delivered to the storeroom they must be physically checked by the person in charge, and the delivery notes must be signed and dated by him to indicate that all items are there. The goods must be placed on the shelves and inventory records updated. lf the stock is very expensive it should be locked up.

The storeman must complete a goods received note and send it with the delivery note to the creditors' department to be checked against the invoice which will be received from the creditor.

The inventory count must be thorough to ensure that the stock is actually there. For example, the staff must be sure that they are not just counting empty boxes.

The merchandise should be electronically tagged. When the customer goes to the till to pay for it, this tag will be removed by a staff member so that the alarm at the door is not activated when the item is taken out of the shop. OR

Security guards should be at the exit to check that the number of items being taken out by a customer agrees with the number listed on the till slip.

How to prevent staff 'taking stock home' at the end of the day

All staff should leave the premises through the same exit, which is controlled by security staff, who check all bags carried by staff.

Random searches of the staff must be made to ensure they do not try to hide the stock on their person.

How to prevent theft of stock by staff being covered up by a journal entry

To ensure that an employee does not make a journal entry to write off trading stock as missing (i.e. a deficit) or as obsolete or stolen, and then take the stock for himself, authorisation for this entry must be obtained from the owner, the internal auditor or a senior staff member. This person would check on the facts and sign the journal voucher agreeing to the write-off.

Internal control of wages

How to ensure that an employee is paid the correct amount

    Wage earners are paid for the hours they work. lf the employee is not at work, he does not get paid, unless he is sick. To ensure that an employee is paid the correct amount the business must implement the following controls:

    • The employee must register the time he arrived at work by clocking in, swiping the employment card through the machine or registering a fingerprint on a 'Sensomatic' machine. The same procedure must be followed when leaving work so that the time spent at work is recorded.
    • lt is necessary that someone in authority watches the clocking-in or card swiping process to ensure that one employee does not register for someone else who is going to be late or absent that day. This will not be necessary if the latest fingerprint method is used.

How to ensure there are no 'ghost workers' on the payroll

To ensure that no wage payments are made to fictitious people, the business must implement the following controls:

  • all wage earners must sign a book as proof they have received their wages
  • supervisor or senior member of staff must be present at this signing procedure to ensure that no employee signs for another
  • this supervisor must ensure that there are no wage envelopes containing cash left over to be taken by the wage clerk who placed fictitious workers on the payroll.

Ways of minimising unethical behaviour and ensuring that internal controls are effective

Here are a few basic ideas for a business to remember and implement in order to reduce fraud and theft.

  • One person should be responsible for one activity e.g. writing up the Cash Receipts Journal, so that blame cannot be shifted onto someone else.
  • One person should not be responsible for the whole process, e.g. from the calculation of wages to the actual payment of the cash.
  • Employees should be rotated occasionally, e.g. one could be responsible for receiving money through the post for six months and then change to writing up the Petty Cash Journal for the next six months.
  • Every employee must take annual leave because, while this person is on holiday someone else will do the work and, if anything unethical has been going on, it will be detected during this time.
  • Either the owner, internal auditor or a senior member of staff, who understands accounting, must check on everyone regularly.
  • The business should employ accounting staff who have a professional degree or diploma, e.g. CA (chartered accountant), CIS (chartered secretary) or CIMA (certified management accountant) as there is then an external organisation that will deal with any unethical behaviour perpetrated by these staff members.

INTERNAL AUDIT

All businesses, be they small or large, must have a system of internal control to minimise errors, fraud and theft. However if the business is large or has a number of branches, it is advisable to appoint an

Internal auditor

He or she must be suitably qualified, have experience of accounting systems and be registered with the Institute of Internal Auditors of South Africa. The advantage of this is that he or she will have access to professional guidance, training and on-going professional development.

The internal auditor is employed by the company or owners and will report directly to the directors or management.

He needs to be sure that the system of controls in place is adequate and is being adhered to by all staff. He does not set up the control system - unless he is employed by a business which does not have one.

His job is to ensure that the controls are relevant and change when circumstances change e.g. the business stops using cheques and changes to internet banking.

Steps to be followed when conducting an internal audit

1. The internal auditor observes how the staff carry out their tasks. He must know what the duties of each slaff member are. He can then assess whether the internal controls are effective e.g. that each task is performed by one person only and checked by another.

2. He analyses the data collected. He constantly compares the results of this year's activities with those of previous years to detect if changes are taking place. He must investigate the cause of any change and make recommendations to management on how to improve the situation.

3. He obtains information he needs from the staff either formally by means of a questionnaire or informally by interviewing each one. The staff who work with the procedures and controls are usually the best people to consult about improvements to be made.

4. He inspects documents and the accounting records. The internal auditor will check that documents have been entered in numerical order in the Journals and that these are constantly updated. He will ensure that, where necessary, reconciliations have been done e.g. bank, creditors and debtors, and that VAT records have been properly filed. He also ensures that all documents are kept for at least 5 years.

5. He will confirm certain transactions by collecting documentary evidence. This must be done for important transactions e.g. purchase of tangible assets. He will ensure the Asset Register agrees with the documentation and that the physical assets are actually where they are supposed to be.

6. He may re-do an activity carried out by a staff member to see if he achieves the same result. Often the best way to check work is to do it as though it had not been done before, e.g. redo a Bank Reconciliation Statement from the Cash Journals and the Bank Statement to ensure no 'rolling the cash' or fraud is taking place.

The internal auditor will constantly report to the owners, or in the case of listed public companies [Units 2 and 3], to the audit committee.

The more effective the internal controls are, and the more efficient the internal auditor is in fulfilling his duties, the less work the external auditor will have to do.

UNIT 2: COMPANIES (1) - Concepts, Ledger and Financial Statements

BAGKGROUND

In Grades 10 and 11, the only forms of ownership studied were sole traders and partnerships. These are small businesses which require no formalities to start. The capital available to run the business is dependent on the amount the owner/s can afford to invest and all profits or losses are appropriated/distributed to them.

There are a few serious disadvantages to these two forms of ownership:

  • if the business cannot pay its debts, the owner/s personally must pay them
  • if an owner dies or retires, the business ends, and
  • the owner/s pay personal income tax on the profits they receive and this may be at a higher rate than company tax.

Starting a company has always been an alternative form of ownership, but it was complicated and expensive and there were many rules and regulations which were costly to adhere to.

The Companies Act no. 71 of 2008, which came into effect in 2011, provides for two kinds of companies:

  • profit-making - which may be private, public, state-owned or personal liability
  • non-profit making.

It is now easy and inexpensive to start a company, which is a separate legal entity responsible for its own debts and taxes. lt can exist forever, provided it is solvent.

MEMORANDUM OF INCORPORATION

Every company has to have a Memorandum of Incorporation (MOl) which is a document setting out the rights, duties and responsibilities of shareholders, directors and others who deal with the company. The incorporators (the people who start the company) may draw up their own Memorandum or use the model in the Companies Act. lts content is flexible and can be changed by the shareholders (owners).

It will state the name of the company, which may not be the same as, or confusingly similar to, that of an existing company or be offensive to any section of the public. The last word of the name must be 'Limited' if it is to be a public company or (Pty) Limited if it is to be private company. This'Limited' refers to a very important advantage of a company from a shareholder's point of view - shareholders have limited liability for the debts of a company. In actual fact, shareholders are not liable for any of the company's debts. All they have to do is pay for their shares.

The Memorandum of Incorporation is sent to the Registrar of Companies. Once it is certain that all provisions of the law have been complied with, the company will receive a Registration Certificate which proves that it now exists as a separate legal entity. This means it can own assets, owe money, sue and be sued, in its own name.

THE CAPITAL OF A COMPANY

The capital of a company is divided into shares. Each share represents an equal portion of the capital and entitles the holder to one vote at a general meeting.

Authorised share capital

This, according to the Memorandum of Incorporation, is the number of shares that the company is allowed to issue (sell).

Issued share capital

This is the number of shares the company has actually issued. lt does not have to issue all its shares at the beginning. In fact, it is good to have some unissued shares which can be issued later to raise funds when the company wants to expand. There are two kinds of shares - ordinary and preference. We will only be concerned with ordinary shares. The first thing the incorporators do is raise the capital needed to run the business by issuing shares. In a public company, i.e. a large enterprise, the public will be invited to buy shares by means of a prospectus. The incorporators of a private company may not do this. They must find enough people willing to buy shares to raise the capital needed on the understanding that, should they want to sell their shares, they would have to find a buyer acceptable to the other shareholders.

The issue price

This is the price at which the shares are issued to the public at a particular time. The unissued shares do not have to be issued at the same price later. For example: On incorporation in 2015, the company issues 100 000 shares to the public at R5 per share. h 2A2O the company issues another 100 000 shares to the public, but this time at R7,50, because the company is profitable and the value of shares has increased.

Listed public companies

(these are the companies we witl be concerned with)

A public company may, if the shareholders and directors wish, apply to be 'listed' on the Johannesburg Securities Exchange (JSE). lt must comply with all the JSE's requirements before it can be listed. lts name will be then put on the long list of companies whose shares can be bought or sold on the JSE by contacting a stockbroker. Not all public companies are listed on the JSE. A shareholder, in a non-listed public company, who wanted to sell his shares, would have to find someone to buy them.

SHAREHOLDERS

These are the people who buy shares in the company. In the beginning they would fill in the form in the prospectus, attach their proof of payment (EFT) or cheque and send it to the company. They become the 'owners' of the company. After this, the purchase and sale of shares takes place through the JSE if the company is listed.

However, OWNERSHIP OF THE COMPANY lS SEPARATE FROM TIS CONTROL.

Shareholders do not have the right to manage the company and they do nothave the right to inspect the accounting records.

Shareholders' rights

Every shareholder has the right to attend the Annual General Meeting (AGM)

When they are at the AGM:

1. they have the right to elect or re-elect the

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From the above diagram you can see the election of directors is an important right as these directors appoint and control the management who run the company on a day-to-day basis.

2. they approve the appointment of the external auditor.

The audit committee will recommend a firm of auditors and the shareholders vote to indicate their approval of the choice.

3. they approve the remuneration of the external auditor.

The company will then pay this amount.

4. they approve the Annua! Financial Statements presented to them.

They have the right to ask questions about the information contained in these statements to ensure that the company is being run for their benefit and that there is no collusion between the directors and the auditor to cover up fraud.

5. they approve the final dividend proposed by the directors.

DIRECTORS

A company is a legal person, but not a physical one. lt therefore has to have people to conduct business on its behalf. These people are the directors. A public company has to have at least three directors, but of course, large listed companies will have many more to cover all the areas of expertise that is needed. Not all directors work for the company on a daily basis. Those who do not, are called 'non-executive directors'.

The board of directors, as it is called, must meet a certain number if times per year. Directors are paid a fee which could be an annual amount or an amount per meeting which they attend, depending on what the Memorandum of Incorporation states. The chairman of this board, who is non-executive director, , plays a very impo(ant part in guiding the path that the company will take.

The chief executive officer, who is also a director of the company, works in a full{ime capacity as he is responsible for the day-to-day management of the business.

The directors determine the moral and ethical values of the business. A good company will comply with allthe laws of the land, fulfil its contractual duties and treat everyone ethical ly.

They are responsible for the company's systems of internal control, which are designed to provide reasonable, but not absolute

  • assurance of the integrity and reliability of the annual financial statements, and
  • safeguards to protect the company's assets and to prevent theft/fraud

The directors are responsible for'governance'. Their primary role is to set or approve the strategic direction and major decisions which management takes. They must monitor the implementation of this direction and these decisions.

The various directors are expected to have wisdom, expertise and experience which should be drawn from different commercial backgrounds i.e. together, they should have a wide range of different experience" However, they are still held accountable for the decisions they make outside of their experience and expertise.

They must all have sufficient financial knowledge to be able to carry out their primary function of monitoring and supervising business activities, even if their main experience, for example, is marketing or lT. They must understand the financial statements, so that they are able to interpret what the information contained in them indicates about the business. lf a director is not sure of the facts, he can ask for advice, but may not blame this advice if it proves to be inadequate.

The directors must use their own independent judgement on all issues and cannot hide behind the fact that a decision was agreed on by all present at a meeting.

Conflict of interest

The Companies Act states that, if a director of a company has a personal financial interest in a matter to be considered at a board meeting, or knows that a person related to him has a personal financial interest in this matter, he or she must

  • disclose the interest before the matter is considered at the meeting
  • if present at the meeting, must leave the meeting immediately after making the disclosure, and
  • may not vote on this matter.

At any other time that a director acquires a personal financial interest in an agreement in which the company already has a material interest or knows that a related person has acquired a personal financial interest in the matter, he must disclose this financial interest to the company.

Evaluation of the pedormance of the directors

All directors, not only the Chief Executive Officer, are accountable for the actions of the company. lt is essential that they perform to the best of their ability and keep up to date with the affairs of the company. New legislation has put more responsibility on their shoulders so it is important that they constantly irnprove their abilities, skills and knowledge of how the company operates.

Performance evaluation can assist the board to recognise where problems exist and help them to solve them. This, of course, will improve the company's results. lf nothing were done, the company may fail, jobs will be lost and nobody will actually understand the reason.

The whole board, as well as the various committees, should participate in this evaluation as it provides a valuable learning experience. lt encourages talking about perceptions, discussIng possible solutions and resolving issues which may have interfered with progress.

There are two ways in which it can be done:

  • interview each director individually to find out what he thinks
  • use peer evaluation which means a director will state his perception of the strengths and weaknesses of each of the other directors. This is more objective and will bring to light any skills gaps on the board or conrmittee. All directors will need to be willing to do it this way and it would need to be handled sensitively.

It should be part of the company's strategy to do this and it should be done regularly.

Directors' remuneration

The directors should be paid a fair remuneration dependent on the performance of their duties. The non-executive directors, those who do not work for the company, usually earn a fee for attending meetings. Those who are employed by the company earn a salary. The Chief Executive Officer (CEO) usually earns a very high salary and is often given shares in the company as part of his remuneration package. Even when the company's results are disappointing, directors'fees, especially the CEO's, are not always reduced.

There is much discussion on how to reward directors in South Africa as their remuneration is so much higher than the ordinary employees of the company. One idea put forward to improve the situation recommends that the ratio between the CEO's salary and that of the lowest paid worker in the company remain constant e.g. 60 . 1. As the ratio in many companies is closer to 200 : 1, it will not be easy to come to a consensus on this issue. The ratio 60 : 1 can work in a developed country, but it is difficult in a country like South Africa where there are many unskilled labourers.

The amount each director earns must be clearly shown in the Notes to the Financial Statements - it may not simply be added to Salaries and Wages.

The remuneration committee

This committee should advise on the remuneration awarded to directors and top management personnel. The members of this comnrittee should be non-executive directors to ensure that the procedure is fair and transparent.

The audit committee

This committee of at least three directors is appointed by the shareholders. One{hird of the members of the audit committee must have academic qualifications or experience in economics, corporate governance, law, finance, accounting, commerce, industry, public affairs or human resource management.

The directors on this committee may not be involved in the day-to-day management of the business, nor related to anyone who is, or who deals with the company as a supplier or customer.

Some of the functions of the audit committee are to:

  • review the internal control systems
  • monitor and review the effectiveness of the internal audit function
  • keep up to date with changes in accounting standards
  • recommend to shareholders which firm of auditors they should appoint
  • recommend to shareholders the fee which the auditors should be paid
  • monitor the effectiveness of the external auditor's performance and his independence and objectivity.

DISPUTE RESOLUTION

There are so many people who have a financial interest in a compan that there are bound to be disagreements. The Companies Ac provides certain ways to settle these disputes without going to court.

Internal solution

In this case the company facilitates a meeting between the parties who cannot agree in the hope that some common ground will be found. An impartial third party could be asked to 'chair' this meeting as mediator. Having listened to both parties, this mediator can make recommendations on a solution, but these are not binding on the parties. However, if this third person is an arbitrator, he will have certain qualifications and attributes which enable him to arbitrate, and his decision will be binding on both parties.

Solutions in terms of the Companies Act

The company could file a complaint with CIPC (the Companies and Intellectual Properties Commission). It could apply to the Companies Tribunal for arbitration. It could take the dispute to court where a judge will decide on a solution.

BUSINESS RESCUE

A company which is having financial difficulties, or as the Act puts it, 'is financially distressed' may apply for'business rescue' in terms of the Companies Act. There must however be a reasonable chance that the business can actually be rescued.

A professional 'business rescuer'will be appointed to try to rehabilitate the company. This means the company will not have to pay its creditors immediately. The rescuer will take over supervision of the company's finances and manage its business, property and affairs. He will reorganise and restructure the business to make it financially viable again.

For business rescue to be successful, management must realise that there is a problem as soon as possible. The shorter the recovery period, the lower the costs and the lower the risk will be.

If liquidation proceedings have already started against the company, it cannot apply for business rescue.

PREPARATTON OF FINANCIAL STATEMENTS

The directors are responsible for the maintenance of adequate records and for the preparation of annual financial statements. These statements must fairly present the financial position and performance of the company for the period covered.

In South Africa, there are two sets of 'rules'which give guidance on how to prepare financial statements.

International Financial Reporting Standards (IFRS)

These are the standards laid down by an international body of chartered accountants called the InternationalAccounting Standards Board. They must be used by listed public companies. They give accountants and auditors detailed guidance on how to account for certain information when preparing or auditing financial statements. The financial statements must comply with these standards and this fact must be referred to in the auditor's report.

As big business is usually conducted globally, it is an advantage to have financial statements across the world prepared according to the same set of accounting standards. Investors know that they can compare the statements of different companies before deciding which ones to invest in.

South African GAAP

These principles may only be used by small businesses or they may choose to use IFRS for SMEs, i.e. small and medium enterprises.

The attributes of Financial Statements

According to the latest stipulations of the IFRS, financial statements must be

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The users of Financial Statements

The following people/organisations have a financial interest in the statements and the opinion of the auditor:

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THE INDEPENDENT/EXTERNAL AUDITORS

Description & Duties

The Companies Act makes it compulsory for the financial statements of all listed public companies to be audited by properly qualified, registered auditors.

These auditors are independent because they do not work for the company. They are appointed by shareholders at the AGM on recommendation of the Audit Committee. They are paid a fee by the company, based on the hours taken to complete the audit.

An auditor could work alone as a sole proprietor, but usually they work together in partnership as they can then cope with more work, the audit of bigger companies and share the serious responsibilities of being an auditor.

Auditors have to be accounting professionals registered in terms of the Auditing Profession Act. They must also be members of a professional body e.g. South African Institute of Chartered Accountants (SAICA) or the South African Institute of Professional Accountants (SAl PA).

Auditors may not have a financial interest in the company they are auditing, be involved in the management of the business, or be related to anyone who is.

It is their duty, by law, to check the annual financial statements of the company to ensure that they accurately present the state of affairs of the company and that there is no fraud, misstatement or error.

They do this by checking a sample of the work. There are two ways of sampling

  • check all the documents, journals and ledgers for one month of the year e.g. May
  • check the work of one whole week in four different months of the year.

Auditors will always check, in detail, any changes to tangible assets, loans and investments. They will make direct contact with the bank, creditors, loan holders and debtors to verify that the information in the books is accurate.

THE AUDITORS'REPORT

This report must be included with the financial statements and be signed by the auditors. lt states their opinion on the financial statements.

Unqualified Report

If the auditors found nothing wrong with the records of the company or the financial statements they will give it an unqualified report" This indicates to users of financial statements that they are reliable and shareholders will be happy to keep their shares.

An example of an unqualified auditors' report:

To the shareholders

We have audited the annual financialstatements of ABC Company Limited set out on pages 8 to 17, which comprise the Statement of Financial Position at 28 February 2015 and the Statement of Comprehensive Income and Statement of Cash Flows, and the notes for the year ended 28 February 2015.

Directors' responsibility for the Annual Financial Statements

The company's directors are responsible for the preparation and fair presentation of these financial statements in accordance with the International and Financial Reporting Standards and the Companies Act no 71" of 2008.

Auditors' responsibility

Our responsibility is to express an opinion on these financialstatements based on our audit. We conducted our audit in accordance with the International Standards on Auditing. These standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance that the annual financial statements are free from material misstatement.

An audit involves performing the following procedures:

  • obtaining audit evidence about the amounts and disclosures in the annual financial statements
  • considering the internal controls relevant to the annual financial statements to assess the risks of material misstatement whether due to fraud or error
  • evaluating the appropriateness of the accounting policies used and the reasonableness of accounting estimates made by management
  • evaluating the overall financial statement presentation.

Audit opinion

In our opinion, the financial statements fairly present, in all material respects, the financial position of the company at 28 February 2015 and the results of their operatlons and cash flows for the year then ended in accordance with International Financial Reporting Standards, and in the manner required by the Companies Act.

Qualified Report

If the auditors found any suspicious activities or suspect there is fraud, they will qualify the report. This warns all persons and institutions interested in these statements that they found something wrong. No one would want to own shares in this company.

An example of a qualified auditors' report:

We found that the internal control procedures were not adhered to and that documentation did not exist for a significant portion of the transactions tested.

Because of the significance of the matter described in the previous paragraph we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion. Accordingly, we do not express an opinion on the financial statements for 'the year ended 28 February 2015.

OR

In our opinion, the financial statements fairly represent the financial position of the company at 28 February 2015, except for the advertising expense in theI Lrrs LUrrrparry aL Lo L EUr uarJ 4urJ, g^LgpL rul trtg 4uvEr ttJtrrE, E^l,trrJt rrr LrrE Statement of Comprehensive Income which could not be verified, as no documentation existed.

Withholding of opinion

if auditors find a number of activities (severe form of suspicious activities), they can withhold their opinion.

PROFESSIONAL BODIES CONTROLLING AUDITORS South African Institute of Chartered Accountants (SAICA)

To practice as a Chartered Accountant one must be registered with this institute or the South African Institute of ProfessionalAccountants (SAIPA). These bodies lay down the code of professional conduct expected from their members who must agree to comply with the code of ethical practice and integrity.

The functions of SAICA

  • it sets and administers the examination which all accountants have to pass if they want to become chartered accountants or registered auditors
  • it ensures that all members comply with its Code of Ethics
  • it ensures that they comply with IFRS and GAAP by continually updating members on the latest rules
  • it conducts training courses to keep members up to date on the latest developments
  • it investigates complaints against members by shareholders who feel that they have not carried out their duties properly
  • it is responsible for disciplining accountants who have been negligent in the performance of their duties
  • it has the power to deregister a member which means that he cannot act as an auditor or chartered accountant again.

Independent Regulatory Board for Auditors (IRBA)

The objective of this board is to protect the financial interests of the South African public and international investors by ensuring that all registered auditors have the necessary competence on entering the audit profession to serve the public interest and the needs of the economy.

Its duties are to

  • regulate the profession
  • ensure that all registered auditors develop and maintain their professional competence after registration
  • ensure that all registered auditors are subject to appropriate ethical requirements
  • discipline a registered auditor who has not carried out his duties correctly.

INTEGRATED REPORTING AND KING CODE III

The King Code, which is now in its third edition, was first published by a committee headed by Judge Mervyn King in 1994. The committee wanted company reports to acknowledge that a company does not operate in a vacuum, but in an evolving economic, social and environmental context. This is called the'triple context'.

King lll recommends that businesses prepare integrated reports. South Africa was the first country to make this compulsory for all listed public companies. Although there is no law which says it is compulsory, the JSE requires the financial statements to state whether they comply with King lll, and if not, why not. The Companies Act has incorporated certain sections of the King code in its clauses.

It is called integrated reporting because it covers the three different aspects of the company's activities in only one report, not three separate reports. lt brings together information about the company's strategy, its controls, performance and future prospects in such a way that shareholders can understand the economic, social and environmental context in which it operates.

The role of the company in these times is changing from being an organisation which only generates economic benefits for shareholders to one where it sees itself as an integral part of society and therefore needs to act responsibly towards all its stakeholders. This is known as corporate citizenship. As a responsible corporate citizen, the company has to report on the impact of its activities, both positive and negative, on the economy and on the society, as well as the environment. The company must be fair, transparent, responsible and accountable in its dealings with its staff, its competitors, its customers and society as a whole.

Up to now annual reports have only provided information about past years' results. King lll recommends integrated reporting as it enables interested parties, e.g. shareholders, institutional investors such as pension funds, unit trust managers, etc. to understand how the company operates. Not only from a performance point of view, but also how it will manage challenges and opportunities in the future in order to be sustainable. The report will also outline the risks the company faces in the future and how it intends coping with thern. These parties can then make an informed decision whether to keep their shares.

The concept of integrated reporting is very new and will change and improve in the next few years. lt is important as it is the start of new and exciting ways of motivating staff, directors and shareholders to consider the broader picture.


Share Capital

A public company obtains its capital by issuing shares to the public. lt does this by publishing a prospectus, which is an invitation to buy shares. This gives full details of the business to be carried on, who the promoters are, who will run the company initially and as much other detail as possible to enable the person reading it to decide whether to invest in the company or not. In the prospectus is an application form which a person who decides to buy shares, fills in and sends to the company with his proof of EFT (or cheque) for the full amount. Prospective shareholders may also buy shares online via trading platforms e.g. PSG and ABSA.

The issue of shares

The Friendly Company Limited was registered in 2012 with an authorised capital of 1 000 000 shares. On 1 January 2013 the company offered 500 000 shares at an issue price of R2 each to the public by means of a prospectus.

All the money for the shares, R1 000 000, was received by 28 February 2013 and the shares were issued. The company commenced business on 1 March 2013.

The company is now in its second, very successful year. On 1 October 2015 it issued a further 500 000 shares at an issue price of R3 per share.

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EXPLANATION

A This is the first issue of shares when the company started. lt issued 500 000 shares at a price of R2 per share. The contra reference is 'Bank' because shares can only be bought for cash.

B In 2015, the company needed more capital. lt issued another 500 000 shares and at R3 per share. NOTE: The company has now issued all its shares.

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What happens to the net profit?

Retained income - an equity account

A company is a legal person and therefore it owns the profits it makes each year. However, it usually distributes some of the after tax profits to shareholders in the form of dividends, but not all! lt will retain (keep) as much as it needs to strengthen the company for the future. This means the value of the company will increase. {This account can be called Accumulated profits.}.

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B. At the end of 2015, i.e. 28 February, after the net profit has been calculated, the company decides how much to distribute. lt must take last year's retained income into consideration because it can be distributed now. The R100 000 must be transferred to the Appropriation account. The Retained income account is temporarily closed.

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C. After all the distributions have been made, i.e. the tax on the net profit for the year and the total amount of the dividend for the year, the 'left-over' profit is transferred back to the Retained income account.

You will notice that the equity (value) of the company has increased by R256 000. This means the value of each share has increased and perhaps the price on the JSE has too. Unfortunately the JSE price is affected by many, many other factors, for example, the American economy, the perception of the political situation in South Africa, the fact that the CEO has just resigned, unfavourable reports in the press, etc.

Appropriation - the last final account

All profits which are available to be appropriated (shared) are transferred to the credit side of this account at the end of the year.

Treat it as an income account with the credit (right hand) side showing the income available for distribution (net profit 2015 + net profit not distributed in 2014).

The debit (left-hand) side will show how it is distributed.

  • lt has to 'share' some with the taxman,
  • it may share some with the shareholders in the form of dividends and,
  • it will keep some for itself.

This is very important account!

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EXPLANATION

A This is the retained income from the previous year (2014) which was kept by the company and can now be distributed as dividends, if necessary.

B This is the net profit the company made this year.

C This is the tax calculated on the net profit for the year. (30% rate used here)

D The total dividend for the year distributed to shareholders from the R680 000.

E The amount of profit the company is keeping for itself.

Income Tax

If a company makes a profit the company itsett pdls tax on the profit, not the shareholders, because it is a separate legal person.

A company is a provisional taxpayer which means it must pay its tax in advance. Half way through the financial yearthe net profit for the whole year is estimated. Tax is then calculated on this amount according to the percentage quoted by SARS. No entry is made in the books for the tax, but a cheque is sent to SARS for half of the amount calculated.

Then, just before the end of the financial year, it estimates its profit again, calculates tax for the year and sends a cheque for the balance due at this date to SARS.

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EXPLANATION

A The Trial Balance shows the opening balance on the credit side. This means the company underpaid its tax last year and owes SARS R1 000. This amount will be shown in Trade and other payables in the Notes to the Financial Statements on 28 February 2014.

B Early in the new financial year the company pays SARS the amount owing for 2014 and the account closes.

C Half way through the year it pays half of the tax calculated for the year.

D At the end of the year, having recalculated its tax, it pays the rest of the amount it estimates it owes SARS.

E After the net profit for the year has been correctly calculated, the tax on this profit is worked out and entered as a liability.

F Of course, the company has paid most of E already. lt now balances the account to work out how much it still owes SARS OR how much it overpaid.

G In this case, the balance is brought down on the debit side which means SARS owes the company money because it paid more tax than it should have. This amount will be shown in Trade and other receivables in the Notes to Financial Statements on 28 February 2015. SARS will refund this amount when it has assessed the company's income tax return and is satisfied it is correct.

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EXPLANATION

This is an l - or G- account, i.e. distribution of income. Put in the signs.

[Remember to swop sides when you do an A- or an l- (distribution of income/profit) account.l

These are the only two entries in this account.]

Dividends

Instead of retaining all the net profit after tax for itself a company may (but does not have to) distribute some of it to shareholders as their reward for investing in the business.

It can only do this:

    1. IF it has made a profit this year or has retained profits from previous years AND

    2. IF it has sufficient cash in the bank AND

    3. IF the directors decide to declare a dividend and this is agreed to by the shareholders at the AGM.

Dividends may be distributed twice a year. A listed company has to prepare financial statements half-way through the year and, if conditions are favourable and the above three points have been complied with, the company may declare and pay an interim dividend.

After the financial statements have been completed at the end of the year, a final dividend may be declared. This will only be paid in the following financial period.

If the directors decide not to declare a dividend, they must explain their reasons to the shareholders so that they do not sell their shares and cause the share price to fall.

Shareholders may be happy with no dividend if they know that the company needs to do research to improve its products, or invent new products or because it wants to expand its market by opening businesses in other areas. All these should bring greater profits in the future and increase the value of the shares.

INFORMATION

The Friendly Company Limited issued 500 000 shares to the public on 28 February 2013 at an issue price of R2 each.

On 1 October 2014 it issued a further 500 000 shares at R3 each.

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EXPLANATION

A As it has been a very successful, i.e. profitable year so far, the directors declared and PAID an interim dividend of 10 cents per share on 31 August2014. The calculation is 500 000 x 10c = R50 000.

B After the net profit has been calculated for the 2015 financial year the directors declared a final dividend of 10 cents per share. Be careful with the calculation. 1 000 000 shares have now been issued. The calculation is 1 000 000 x 10c = R100 000.

C The total dividend for the year is closed off to the Appropriation account as a dlvidend is a distribution of profits. (Therefore the interim dividend and the final dividend.) N.B. No prqfits : no tlit,itland.

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EXPLANATION

A The balance b/d represents the final dividend declared, but not yet paid for the 2014financial year. This amount would be shown in Trade and other payables in the Notes to the Financial Statements on 28 February 20'14.

B These shareholders were paid on 10 May and the account closes.

C At the end of the 2015 financial year a final dividend is declared, but has not been paid.

The Buy-Backof Shares

After a few years of making good profits a listed public company may find that it is not using all the capital it has at its disposal efficiently and it is making enough profit to finance all its future requirements. It has no long term liabilities.

The problem is that it has to pay dividends on all the shares it issued. This means that the dividend per share may not be competitive with dividends declared by similar companies.

When the financial statements of the company are analysed, [Unit 3] the return on shareholders' equity (which is net profit after tax + average shareholders' equity) is not as good as the return earned on equity of similar companies.

The net asset value of the shares (shareholders' equity + number of issued shares) will also be low (diluted). Usually these excess funds would be used to expand or to buy another company. This may increase profits in the future, but it may also increase risk or involve management in a business for which it does not have the expertise.

In an unlisted pubfic company or a private company, certain shareholders may wish to sell their shares. They cannot sell them on the JSE as the company is not listed. They could offer them to existing shareholders, in which case no entries would be made in the books of the company.

The Companies Act makes it possible for all companies to buy back shares.

There are three requirements to be met before this can happen:

  • 1. the company must be solvent at the time of the sale and remain so for the next financial period
  • 2. the company must be Iiquid, i.e. be able to pay all its current commitments in the next financial period
  • 3. the buy-back must be beneficial to the shareholders.

Example 1: The Family Trading Company Limited (unlisted public company) was formed with an authorised share capital of 1 million shares. On 1 January 2010 it issued 100 000 shares to each of 10 family members at an issue price of R1. On 1 January 2020, after trading very successfully for 10 years, the oldest member of the family wants to retire. lt was agreed by all that the company would buy back her shares as it was in a very good financial position for the future and had excess cash available. A cheque would be issued to her on 1 January 2020.

It is important to remember that the shareholder will be paid back the value of her shares now, not the price at which they were issued.

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The equity (value) of this company on 1 January 2O2O is Rl 500 000.

1 000 000 shares were originally issued at R1 each.

They are now worth R1,50. {l 500 000/l 000 000}

100 000 shares are to be bought back at R1,50 each = R150 000.

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What is the value of one share after the buy-back? Equity is R900 000 + R450 000 = R1 350 000 and 900 000 shares are now in issue

Value of 1 share = R1,50 each { 1 350 000/900 000}

Example 2: The Mega Company Limited is a listed public company with an authorised share capital of 10 000 000 shares. On incorporation it issued all 10 000 000 shares at R2 each. The company is now in a position where it does not expect to take over any other companies and has enough cash available for normal expansion and diversification of its business to remain profitable.

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On 1 January 2015 the company bought back 10% ofthe shares at R4 each.

after buy-back:

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Example 3: The Step by Step Company Limited had issued shares 3 times in the last 10 years. On 1 January 2017 it decided to buy back 750 000 shares at R2 each.

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Quick Revision of Adjustments

In order to comply with the principles of GAAP, the incomes and expenses must be adjusted so that they match the twelve months of the accounting period. Certain assets have to be adjusted to comply with the principle of prudence e.g. bad debts,

How to do adjustments

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Reversal of Adjustments on the first day of the new financial period

After the net profit has been worked out and the books have been closed for the year, the adjustments have served their purpose. On the first day of the new financial period, the adjustments for Income accrued (A-), Expenses accrued (L-), Expenses prepaid (A-), Income received in advance (L-) and Consumable stores on hand (A-) are reversed as the income will soon be earned and the expenses will be paid for or consumed.

These are very easy entries - just do the opposite to the adjustment entry.

Interest Capitalised

In practice, interest on a mortgage bond, and often a loan, is not paid monthly - it is capitalised which means that it is added to the capital amount of the mortgage. The following month the interest is then calculated on the capital amount plus the previous month's interest. The adjustment for interest on mortgage will not be credited to Accrued expenses. lt will be credited to the mortgage or loan itself. The mortgage or loan agreement will state that the borrower has to pay instalments either monthly or quarterly, etc. This instalment is a repayment of the interest and some of the loan.

Changes that need to be made to the Statement of Financiat Position, but not to the books

To make the Statement of Financial Position fairly represent the financial position of the company, there are changes that may have to be made to certain figures in the Trial Balance, but it is not necessary to make any changes in the books.

1. Post-dated cheque given to a creditor This cheque will have been entered in the Cash Payments Journal because the business needs to keep a record of all cheques written out. However the money cannot be paid to the creditor until the date stated on the cheque. The Statement of Financial Position must not tell 'fibs' so the cheque is reversed by adding the amount back on to Creditors control and on to Bank (if it is a debit balance).

2. Repayment of loan/mortgage in the next accounting period You will remember that non-current liability means that the amount owing on a loan or a mortgage will not be paid back in the next 12 months. However, if you are told in an adjustment that a portion/instalment of this liability will be repaid within the next 12 months, you cannot classify the whole amount as non-current.

Subtract the amount to be repaid in the next 12 months from the loan/mortgage balance and show it as a separate Current Liability called'Short-term portion of long term loan/mortgage' (or show it in the Trade and other payables note).

3. Fixed deposit matures within next accounting period When a fixed deposit is classified as a Financial asset under the heading Non-current assets you are saying that this money will not be received in the next 12 months. However, if you are told in the adjustments that all or part of this fixed deposit will mature (be repaid) within the next 12 months, you subtract it from the Fixed deposit and show it in the Notes to the Financial Statements under the heading'Gash and cash equivalents'.

THE FINANCIAL STATEMENTS OF A COMPANY

The financial statements of a listed public company consist of the following:

    1. The statement of comprehensive Income (new name for the Income statement)

    2. The Statement of Financial Position (new namefor the Balance Sheet)

    3. The Notes to the Financial Statements

    4. The Statement of Cash Flows (new namefor the Cash Flow Statement, which will be handled in the next Unit.)

The Statement of Comprehensive Income

This is almost the same as the Statement of comprehensive Income prepared for a sole trader or a partnership except.

  • there are two new operating expenses - audit fees and directors, fees '
  • as the company is a legal person which pays income tax on the profit it makes, the last item will show this tax.
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The Statement of Financial Position

This is the same as it was for sole proprietors and partnerships the only difference is the Equity section.

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The Notes to the Financial Statements

Most of these notes are the same as for other forms of ownership.

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The above Note ls discussed in detail in Unit 4.

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REMEMBER!

Always show changes to the original figures in brackets after the words so that parts marks can be awarded if the the answer is not right.

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This note shows the number of shares that have been issued and at what price. lf the company did not issue more shares during the year the top line and the bottom line will be the same {and you will not be asked to do the note}. lf shares were repurchased during the year, subtract the average issue price of these shares as shown above, from the balance of Note 8.

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CLOSE CORPORATIONS

It used to be expensive and complicated to start a company so in 1984 this form of ownership was introduced as ideal for a small business. However, this changed with the introduction of the new Companies Act of 2008 which became operative in 2011. It is very easy to start a company, especially a small one, and it is no longer possible to start a CC, as it is called. Those already in existence, may continue until the owners want to cease business activities. lt is possible to convert a close corporation into a company in terms of the new act. At the moment this is optional. The curriculum just requires you to know some of the accounting concepts that are unique to a close corporation.

A close corporation was started by a minimum of one person and a maximum of ten, in a simple and inexpensive way. These owners are called members.

The Founding Statement

All the person who started a CC had to do was register a Founding Statement with the Registrar of Close Corporations. This Founding Statement, which could be bought from any good stationery shop or downloaded from the internet, states the following:

  • 1. the name of the close corporation which musf end with CC
  • 2. the postal and physical address of the close corporation
  • 3. the main purpose of starting the business
  • 4. the names and lD numbers of all members - maximum of 10
  • 5. the contribution to be made by each member
  • 6. if there is more than one,member, what percentage of the profits each will get
  • 7. the name and address of the accounting officer

A close corporation has much in common with a company

  • It is a legal person which means the members are not liable for the debts of the CC The exception is if a member has personally stood as surety for a loan taken out by the CC. This means he guaranteed that if the CC fails to repay the loan, he will repay it.
  • It has continuity which means a change in membership will not affect the existence of the business.
  • It is a taxpayer. The CC pays its own tax on profits made. It is a provisional taxpayer, i.e. it pays its tax in advance twice a year. The members do not pay tax on any profits distributed to them, but do pay tax on salaries, interest, etc. received from the CC.
  • The same Generally Accepted Accounting Practices (GAAP) apply to the books and financial statements of a CC.
  • lt does not have to distribute all its after-tax profits. lt can keep some in the business for growth. This can be called Retained income, Accumulated profits, Unappropriated profits or Undrawn income.

In some ways a CC is very different to a Company

  • All members participate in the management of the CC.
  • It does not to have to have its books and financial statements audited by a chartered accountant, but it does have to have them checked by an accounting officer.
  • No formal meetings are necessary.
  • Members can lend money to the CC at any time.
  • Members can, with the written permission of the other members, borrow money from the CC. In fact, the CC can lend a person money to use as a contribution to enable him/her to become a member!

Concepts and Ledger Accounts

Members' Contributions = owners' equity

There is no Capital account in a CC. All contributions from allthe members, even if there are 10 members, are shown in an account called Members'contributions.

Each member had to contribute something to become an owner of the enterprise, but it did not have to be cash. lt could have been an asset e.g. equipment, a vehicle or even trading stock. lf the member did not have any of these he could do some work for the CC and instead of receiving payment for these services, the amount he would have been paid could be used as his contribution.

If this was not possible, the CC lent him the money to contribute. This meant that not every member of the CC needed to be wealthy. People with other attributes to offer e.g. skills, talent, experience, etc. could become members of a CC.

There is only one Members' Contribution account. As the amount of the contribution has nothing to do with the way in which profits are distributed to members, there is no need to keep a separate account for each member. (Different to partnerships).

A member can change his contribution at any time with the consent of the other members.

He can even withdraw part of his contribution, but the CC must be solvent and liquid at the time that this happens.

Distributions to members

Just the same as in a company, the profit after tax belongs to the business as it is a legal person. However, the members may decide to distribute some of the profit to themselves. Instead of calling this a dividend, it is called a Distribution to members.

The accounting is exactly the same. This distribution may take place twice a year:

  • an interim distribution may be paid half way through the year, and
  • a final distribution will be made at end of the year.

The account debited in both cases is Distribution to members. The interim payment will be credited to Bank and the final, which has not been paid, is credited to a liability account called Distribution payable to members.

The actual amount which each member receives depends on the percentage agreed on when he or she became a member.

No distribution to members may take place if the payment of this distribution will mean that the CC cannot pay its other commitments. What this means is - the members cannot pay themselves if the CC is insolvent or illiquid.

Accounting officer's remuneration

A CC does not have to have its books and financial statements audited, but it does have to employ an accounting officer to check that

  • the books and records have been properly kept
  • the financial statements agree with the information in the books
  • all the principles of IFRS for SME's have been complied with.

He does not have to be a qualified chartered accountant, but he must have studied accounting for a number of years and hold a degree or qualification acceptable in terms of the Close Corporations Act of 1984.

A member of the CC can act as accounting officer, but must have the permission of the other members to do so. This fact must also be stated in the financial statements.

If the CC converts to a company in terms of the Companies Act, these requirements will still apply and the business will be classified as a SME (small or medium enterprise).

Just the same as in partnerships, a transaction which affects one of the members must have that member's name mentioned.

Loans from member: Mr A - Non-current liability

When money is borrowed from a member, a separate account must be opened - with the member's name added. This account keeps a record of all repayments and any increases to the loan. The member does not have to lend the CC money. He can suggest that his salary for the year, distribution owing to him or any other amount owing to him, be regarded as a loan and not be paid to him in cash.

The interest on this loan is treated as an expense in the same way as in all businesses or it could be capitalised, i.e. added to the loan.

Loans to member: Ms B - Financial asset

Any money lent to a member must be entered in a separate loan account - with the member's name added. The interest earned by the CC on this loan is a normal income account and may be received in cash, accrued or received in advance. It may be set off against money owing to the member e.g. a salary.

Salaries to member: AAA

This is a normal expense account which may be paid/accrued or prepaid. Instead of paying the member the salary, the amount could be transferred to the Member's Loan account or even used to increase the Member's contribution.

The Financial Statements:

1. The Statement of Comprehensive Income (Income Statement) as it is now called, is the same as that of a company except there will be no directors' fees or audit fees. There will, of course, be Accounting officer's fees.

2. The Statement of Financial Position (Balance Sheet) has the same lay-out as that of a company except-

  • Non-current assets: there may be an additional item called Loan to Ms B
  • Equity and Liabilities will have:
    • Members' Equity (Funds) instead of Shareholders' Equity
    • Members' contributions instead of Share capital
  • Non-current liabilities: may have an item called Loan from Mr B.

3. There will be an additional Note called'Transactions with members'showing how much each member earned as a salary or interest, if the CC borrowed money from him, and how much each member paid for interest, if he borrowed money from the CC.

UNIT 3: - Statement of Cash Flows, Analysis & Interpretation

THE STATEMENT OF CASH FLOWS

Although the main financial aims of any public company are to be profitable and solvent, itis equatly important that it be liquid. This means that it

must have enough available cash to pay its debts and expenses at the right time. lf a company does nof have enough cash available to pay debts and expenses when they have to be paid, it will find it difficult to survive. Similarly if the company has too much cash, it must plan what to do with it e.g. expand or pay off its debt.

The accountant must manage the 'cash flow' properly to ensure that every cent is used efficiently to enable the company to grow and provide a good return on investment for its shareholders.

The success of the company is reported at the end of the accounting period to the shareholders by means of financial statements. The law requires that a Statement of Cash Flows, showing the effect of the past year's business on the cash position, be part of these statements.

Some vocabulary you need to know

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Your personal Statement of Cash Flows

Let's work through how you would do a statement of your personal cash flow so that you understand how to do a company's one. We will be using some 'jargon'.

1. First you need to generate (make/earn) money. How do you do this? You work to earn cash (+) and out of this you pay your living expenses. (-) The cash generated from operations (working to earn money) will be the amount left after paying expenses. Out of this cash generated you will also have to pay interest (if you have borrowed money) and you will have to pay tax, Once you have settled these commitments, the cash effects of operating activities ought to be positive, i.e. you should have cash left over.

2. Now you will want to invest money in fixed assets or a fixed deposit. You could buy a house, a car, a new computer, etc. The cost of these will represent cash paid out (-). lf you sell your old house, car, computer, etc. you will receive cash (+). To work out the cash effects of investing activities you take the cost of the assets bought (-), the proceeds of sales of assets (+) and subtract any money placed in a fixed deposit (-)and add any cash received from fixed deposits which have matured (+).

3. You may need to finance these activities, especially if you bought property. This means you will use some of your own money (capital) (-) and the rest you will borrow from the bank (obtain a loan) (+). lf you already have a loan, you may have repaid some of it during the year (-). The results of the changes in capital and loans will be your cash effects of financing activities.

The cash effects of your operating activities [1] (money earned - expenses)

minus/plus cash effects of investing activities [2] (change in non-currenf assefs,)

plus/minus cash effects of financing aclivities [3] (capital and non-current liabilities)

equals the change in your cash balance since the beginning of the year.

A Statement of Cash Flows for a company is prepared using exactly the same logic.

To summarise

The aim of the Statement of Cash Flows is to show

  • where the cash came from
  • where it went to during the year, and
  • whether this caused an increase :) or a decrease :( in the amount of cash left at the end of this year compared to the end of last year.

How to do a Statement of Cash Flows - Step by Step

Start with the notes:

NOTE 1 - Very IMPORTANT

RECONCILIAfTON BETWEEN NET PROFIT BEFORE TAXATION AND CASH GENERATED FROM OPERATIONS

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[1] Net profit before taxation

If you have not been given a Statement of Comprehensive Income, you may need to reconstruct the Appropriation account & to find this figure.

[2] Depreciation

This figure has to be added back as it is not a cash payment. If it is not given in the Statement of Comprehensive Income, you may need to calculate it or work it out by doing the:

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[3] Interest expense

This is the amount shown at the bottom of the Statement of Comprehensive Income. Because interest is such an important cost, and all who read the financial statements need to be aware of it, the actual amount paid has to be shown on the 'face' of the Statement of Cash Flows itself. To subtract it there, it must be added back here. lt includes all interest e.g. on overdraft; on mortgages/loans, on creditors' overdue balances.

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[4] inventory

Work out the difference between this year's figure and last year's figure to determine whether inventory has increased or decreased. lf the company has bought more stock, it will now have less cash :(. lf it has decreased its stockholding this year, it will have more cash :).

[5] Receivables

Never include SARS in this figure because Taxation has its own note. Work out the difference between this year's receivables figure and last year's to determine whether debtors owe the company more this year than last year or less. lf they owe more it means they have not paid 6 and the company has less cash. lf they owe less, they have paid O so the company has more cash.

[6] Payables

Never include SARS or Shareholders for dividends in this figure as they have their own notes. You would include the Expenses accrued figure unless it is for interest. Work out the difference between the two years and determine whether the company has paid them @ OR not O.

NOTE 2

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NOTE 3 DIVIDENDS PAID

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[1] Dividends for year: i.e. interim + final for this year.

You will find them in the Retained income Note if you are given one OR you will have to calculate the interim dividend and add the final dividend given in the Current Liabilities OR you will have to reconstruct the Appropriation account.

[2] You will find the balances in the Statement of Financial Position under 'Shareholders for dividends'. Balance at beginning = last year's final dividend and at end of year = this year's final dividend.

NOTE 4 INCOME TAX PAID

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[1] lf you have not been given a Statement of Comprehensive Income, find the figure by reconstructing the Appropriation account.

[2] Be careful! lf SARS was a creditor in last year's Statement of Financial Position, it means the company must pay the amount this year = less cash (brackets) :(. However, if it was a debtor in last year's Statement of Financial Position, the company paid too much last year and will receive a refund from SARS this year, = positive because no cash is going out, :) so no brackets.

[3] Be carefull lf SARS is a debtor in this year's Statement of Financial Position, it means the company paid too much this year = less cash :( so use (brackets). But, if SARS is a creditor this year, it means that the company has not paid = positive because the company still has the cash :).

NOTE 5 TANGIBLE/FIXED ASSETS PURCHASED

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[1] lf you are given the cost of the asset, this is easy to calculate - just subtract.

[2] lf assets were sold, the company must have bought even more (Equipment).

[3] lf you are only given the carrying value of the asset, do the 5 finger exercise! (see previous page)This time the'x' will be in'2. Additions'.

The Statement of Cash Flow

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Although certain conclusions can be made by studying the financial statements, meaningful information is only obtained by comparing them with the financial statements of previous years and, if possible, with the financial statements of similar businesses.

The Financial Statements are of interest to:

Shareholders

They want to know how much profit the company has earned this year and how it compares to last year and to the profits earned by other companies in the same type of business. They will then understand why the dividend declared is bigger or smaller than the previous year and be able to ask meaningful questions at the AGM. They will also decide whether to keep their shares, sell them or buy more.

Prospective shareholders

Members of the public, who have money to invest, will study the financial statements and read the reports by the directors and the auditors, They can then decide whether to buy shares in the company.

Long-term loanholders, e.g. mortgage bond holders

These institutions (lenders) will study the financial statements to ensure that the company can afford to pay the interest and the actual loan back.

Short-term creditors

They are interested not only in the profitability of the company, but also its liquidity. Will it be able to pay its current commitments on time?

The bank

This institution needs to know that any overdraft facilities it has granted the company is secure.

The trade union and the employees

They have an interest in the profitability of the company so that they know their jobs are secure and that they are being fairly remunerated.

SA Revenue Service

It will check that the information in the financial statements agrees with the declarations bn the company's income tax return, and use this comparison to assess how much tax the company must pay on its profit.

REVISION OF FORMULAE FROM GRADES 1O AND 11

1. Profitability

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2. Liquidity

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It is not a good idea to have a lot of trading stock on hand because:

  • not all stock will be sold. Anyone dealing in clothing, televisions, etc. knows that these go out of fashion, out of date or become obsolete as fashion and technology change, and this can happen very quickly.
  • the greater the quantity of stock on the shelves and in the storeroom, the greater is the risk of theft. This means extra insurance has to be paid.
  • more storage space and more staff to control and handle the extra items may be needed. This causes an increase in costs.
  • it is actually the company's capital that is sitting on the shelves. lt is not earning any profit while there. Instead It is costing money.
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We are assuming that trading stock will be sold for cash and on credit to debtors, AND that these debtors will pay their accounts before the creditors have to be paid. lf there is an economic depression and the company is having difficulty selling its stock, and, if debtors who buy from it do not have the money to pay promptly, this ratio will show how much difficulty the company will be in.

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If the stock turnover rate has decreased since last year the reason could be:

  • prices have increased
  • the stock is not'in fashion' any more
  • there is increased competition from other businesses.
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3. Solvency

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4. Gearing

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The dangers of borrowing too much money are:

  • interest on the loan is payable according to the agreement irrespective of whether the company is profitable or liquid
  • interest rates could increase in the future making it even more difficult for the company to keep to the agreement
  • the loan is usually repaid in monthly or annual instalments. If the company cannot pay an instalment, legal action can be taken against it which would increase its financial difficulties.

THE FORMULAE FOR COMPANIES

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The figure that is really exciting is the 'bottom line' of the Statement of Comprehensive Income, i.e. net profit after tax. This profit belongs to the company, not to the shareholders, because the company is a legal person in its own right.

The company has two options as to what to do with this net profit.

  • It can keep all the profit for itself so that it has enough cash in the bank to expand in the future or buy another business. Both of these may increase profits in the future. This will increase the net asset value of the share and perhaps, the market value quoted on the JSE.
  • lt can pay a dividend to shareholders which will keep shareholders happy and perhaps attract the attention of prospective shareholders, who will buy the shares, and this will increase the market price on the JSE.

Usually the company does a combination of both. Either way the shareholder will be happy as his return in future will be greater.

When calculating the return on equity, the net profit after tax must be used as, from the shareholder's point of view, it is no use getting excited about the net profit itself - tax has to be paid! The answer will be always be stated as cents per share even if it is a big figure e.g. 1 280 cents per share.

It is necessary to compare this return with that earned by the company in previous years and with the return made by competitors to assess whether it has performed well.

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Capital employed is shareholders' equity + long term liabilities, so what you are being asked to do here is to add:

  • net profit = equity's reward before tax
  • interest expense = Iong term liabilities' reward

and calculate what percentage this is of the average shareholders' equity + long term liabilities, i.e. add this year + last year.

Capital is used in the broad sense here. lt means money to be employed (used) to buy assets to run the business. This money could be received from the shareholders or borrowed from financial institutions.

The answer that shareholders want to know is - was it worth it? In other words, did the money the company borrowed earn more than it cost to borrow it?

If the interest rate on the long-term loan is 10% p.a. and the company's return was 147o p.a. before deducting the interest paid on the loan and the tax paid on the profit (i.e. the answer to the above formula), it was a very good idea to borrow the money.

However, if the answer is 10% p.a. or less, then neither the company nor the shareholders gained anything from this loan. The shareholders may now receive a lower dividend.

To emphasise what is being said here - it does not make sense to borrow money at 15% p.a. and earn only 12% p.a. by using the money.

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This answer is always quoted in cents per share and represents the amount of profit each share has generated.

Be careful when working out the number of shares issued. Find the balance of the Share capital account and divide it by the issue price of the shares.

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This is the amount of the net profit that the directors have decided to distribute to the shareholders as a reward for buying shares in the company. lt is always quoted in cents per share. As the company prepares financial statements half way through the year it can distribute an interim dividend if it made a net profit and has enough cash available at this time. The dividend declared at the end of the year is called the final dividend.

As this will be only be paid at the beginning of the following financial year it will be a Current Liability called Shareholders for dividends in Trade and other payables. The interim and final dividends must be added together.

This answer is also stated as cents per share e.g. 10 cents per share. This represents the amount the shareholder actually receives from the company. Whether it is a good return or not will depend on the price he paid for the shares.

You must be cautious when commenting on the dividend. Shareholders would like it to be bigger than last year's, but this should only happen if profits have increased.

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NOTE:All shares were issued at R10 each.

Susie Simple is delighted that the dividend per share has increased this year. As her financial advisor, what would you say to her?

The only way the company could declare a bigger dividend this year was to use some of the retained income from previous years. lt is quite entitled to do this, but it does have an effect on the retained income carried forward to the next year. You will notice it has decreased from R150 000 to R130 000 and this has a negative effect on the net asset value per share.

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Using the above example - the net asset value of the share at the end of 201 4 would be 1 000 000 + 150 000 = 1 150 000/100 000 = 1 150 cents per share. At the end of 2015 the NAV would be 1 300 000/100 000 = 1 '130 cents per share.

This is an extremely important calculation. The answer represents what the share would be worth if all the assets were realised (liquidated, meaning sold) at their carrying values and the current and long-term liabilities paid.

This is the actual value of one share according to the company's financial records. It should always be higher than the price at which the shares were issued to shareholders, even the price of the last share issued.

You will remember from Unit 2 that the company issued shares initially to raise funds to start the company. lf all shares were not issued then, the rest could be issued later. The reason for raising more capital would be to expand the business to improve profits. This means equity should grow by more than the capital raised. The net asset value (NAV) will also increase. This may not happen in the first few years after the issue, but if it does not happen at all, the company has issued too many shares and the money is idle.

This year's net asset value must be compared with the previous year's NAV and the price of the share quoted on the JSE to ensure that the company has been successful and that the public agrees, i.e. more people have bought shares.

Over the years this value must increase by more than the inflation rate and the interest rate earned by depositing money in a bank investment. lf this does not happen, the shareholder must seriously consider selling his shares and investing in another company.

PUBLISHED FINANCIAL STATEMENTS

The Companies Act of 2008 requires that all companies which sell shares to the public publish their financial statements. This means they make their financial statements available on the internet and/or in hard copy format. They also publish an extract of them in the financial press.

The directors are responsible for preparing the statements and they must be audited by an independent auditor.

The published financia! statements consist of

  • Statement of Comprehensive Income
  • Statement of Financial Position
  • Statement of Cash Flows
  • The Directors'Report
  • The Auditors'Report.

If they are called 'Consolidated' Statement of . . . . . . .. it means that this company owns more than 50% of the shares in another company and the results of the two have been combined. The company is then known as a holding company and the one it bought is called a subsidiary company.

There are other statements and reports too, but we are not concerned with them.

Statement of Comprehensive Income

This is a shortened or condensed version, showing only the expenses and income of interest to shareholders. The one which you can be examined on is the detailed statement showing all incomes and expenses of the compttny. It is for internal use only.

How does it differ to the one we do?

  • It shows comparative figures for the previous year so that whoever reads them can see the trend.
  • The figures will be rounded off, usually to the nearest R1 million.
  • The terminology is sometimes different e.g. Sales is called Turnover.
  • If the company is a holding company, there will be a column showing the income and expenses of the Group, i.e. the holding + the subsidiary company figures.

Statement of Financial Position

This will contain many more items than we are used to, and may vary from company to company. All the main items we know will be there.

How does it differ to the Statement we do?

  • The terminology is sometimes different e.g. Land and buildings is called Property, equipment and vehicles or Property, plant and equipment.
  • There is often an item called 'Intangible assets'under non-current assets. This refers to the goodwill that the company paid when it bought the subsidiary company.
  • There will be columns for Group assets and liabilities for this year and last year if the company owns subsidiary companies.
  • The Notes to the Financial Statements which we prepare are only for internal use. The only note which is shown is the Note on Share Capital.

The company often analyses its results and publishes the figures for

  • earnings per share (although it is worked out differently to the one we do)
  • dividend per share
  • gross margin
  • operating expenses as a percentage of sales, etc.

These will all be compared to the previous year.

Statement of Cash Flows

This also has a few more items than the one we do, but basically it is the same.

The Directors'Report

In this report the directors will review the operations of the company for the financial period. lt gives details of the performance of the company so that the users have a better understanding of its financial position. This report will be reviewed by the auditor. It gives details of the highlights and the problems of the past year and an indication of what the future holds. lt will also outline the company's involvement in social and environmental issues to comply with the requirements of integrated reporting laid down in the King Code of Corporate Governance, i.e. King lll.

The Auditors' Report

This is obviously very important from the shareholders' point of view as they want to be sure that the statements fairly present the affairs of the company and that the auditors found no fraud. They also want to be sure that the financial statements were drawn up according to the International Financial Reporting Standards so that they will be comparable with those of others companies, even international companies.

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UNIT 4: - TANGIBLE ASSETS

This year the emphasis shifts from doing all the entries for the disposal of an asset to understanding and interpreting these entries. You still need to know how to do the entries for asset disposal so that you can work out the profit or loss on the sale of an asset for the Statement of Comprehensive Income and can do the Tangible Assets Note to the Financial Statements.

IMPORTANT CONCEPTS

The age of an asset

'old'assets These assets have been in the firm's possession for more than 12 months and must be depreciated for the full year.

'very old' assets These assets are so old they are worth nothing. They cannot be depreciated after this. Be careful when using the straight line method of depreciation - the asset must be left in the books at R1.

'new' assets These assets have NOT been in the firm's possession for 12 months, i.e. they were bought during the year. They are depreciated for the number of months the business has had them, i.e. from the date bought to the end of the year.

The life span of an asset

This is the length of time the business intends to keep the asset before replacing it, e.g. the policy may be to replace all trucks every 5 years.

This replacement rate affects the deprecation rate. If depreciated on cost, these trucks will be depreciated at 2O% p.a. so that their value after 5 years will be R1 . ff the life span is 4 years, the depreciation rate would be 25% p.a.

The value of an asset

To calculate the 'carrying value' or'book value' of an asset:

    1. find the cost price in the Asset Register or ledger account and

    2. find the total depreciation already written off in the Asset Register or ledger account and subtract the two.

The trade-in an asset

When an asset is traded-in it means that:

    1. the business sells an old asset to a dealer, and at the same time

    2. buys a new asset from the same dealer.

Only the difference between the purchase price of the new asset and trade-in value of the old asset will be paid or owed to the dealer by the buyer.

TWO WAYS OF CALCULATING DEPRECIATION

1. Cost price/straight line method

This is a very easy way of depreciating an asset. All you have to know is how long the business has had the asset.

'old'assets

When the asset account starts with a balance it means that the business has had it for more than 1 year. Depreciation will be calculated for a year unless the assets are -

'very old'assets

When calculating depreciation on cost you must be careful if the balance includes a 'very old' asset. For example: if the rate of depreciation is 25% p.a. on cost, after writing off depreciation for 4 years the value of this asset in the books will be '0', because it is fully depreciated. This would mean the asset no longer exists - and this is not true!

Always read the dates carefully - they are dangerous! If the depreciation rate is 25% p.a. on cost, an asset bought for R20 000 on 1 January 2015 would be'old'in 2016 and'very old'in 2018. Depreciation is R5 000 p.a. for 2015, 2016 and 2017 = R15 000. R20 000 - Rl5 000 = R5 000. In 2018 only R4 999 would be written off. Its carrying value would then be R1. No depreciation would be written off in 2019.

'new'assets

A new asset, i.e. one bought during the year, can only be depreciated for the number of months the business has had it, not necessarily for the whole year.

2. Diminishing balance/carrying value/book value

The words 'balance' and 'value'tell you not to work out depreciation on cost price. The depreciation amount will not be the same each year, it will be smaller, because it is worked out on the value which diminishes each year. This asset will never be completely written off. Before you can calculate depreciation on the diminishing balance, you have to know the total of the depreciation already written off, i.e. the accumulated depreciation.

INTERNAL CONTROL OF TANGIBLE ASSET

The Asset Register

The Companies Act of 2008 requires every company to keep a record of each asset owned showing full details of the asset, i.e.

  • a full description of the asset - make, model number, etc.
  • the cost price including installation and other costs incurred when bought
  • the amount of depreciation written off each year
  • the accumulated depreciation at the end of each year; and
  • the carrying value at the end of each year. This information is kept in an Asset Register which must be updated and checked against the actual physical assets at least once a year.
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Some observations on this information:

  • The life span was expected to be 4 years = 25% p.a. depreciation on cost price. By 28.02.2015 it has been fully depreciated as it is now 4 years old.
  • The book value or carrying value is now R1 = no further depreciation written off.
  • Why has this vehicle not been sold? lt is still reliable, i.e. its repair bill is not high. When it is sold for any amount above R1, a profit will be made.

    When the asset is sold, full details of the sale are entered in this register, i.e.

  • date sold
  • to whom the asset was sold
  • selling price and
  • the profit or loss made on the sale.

    All these details must be declared to SARS for tax purposes.

Purchase/acquisition

ACQUISITION to buy(acquire)

REOUISITION to ask for

No one member of staff should be responsible for all steps in the control of fixed assets, in other words, there should be separation of duties.

The person who requisitions a new asset, e.g. a computer, should not negotiate the purchase of the computer with the supplier.

A senior member of staff should obtain quotes from trustworthy suppliers and make the purchase decision. This will ensure that the business buys the best computer at the best price. lt will also prevent a computer salesman closing the sale by offering the staff member an incentive (bribe) to buy the computer.

If the business is too small to exercise proper control, the owner should be involved in the purchase of the asset.

ETHICAL ISSUES RELATING TO FIXED ASSETS

Sale/scrapping

The decision to sell an asset should only be made by the owners or a senior member of staff. The reason for selling must be investigated to ensure that the asset no longer fulfils the function for which it was bought. The selling price must be carefully considered so that the business does not lose money unnecessarily. No staff member may buy this asset from the business without permission from the owners. It must also be ensured that family and friends of the owners do not have an unfair advantage in buying business assets.

An asset is scrapped if it is obsolete or redundant and of no use to anyone, i.e. it cannot be sold even for a few rand. This process must be controlled to ensure that a staff member cannot arrange for the asset to be scrapped because he wants it, knowing that the business can afford to buy a new model or updated version.

Use of assets for personal benefit

Use of vehicles, laptops, etc. out of business hours by staff members should not happen without permission from the owners or a senior member of staff.

It should not be possible for a staff member to earn money out of hours by using the firm's assets.

Prevention of theft by the public

To prevent theft of tangible assets a business needs to be sure that the premises are properly secured by using impenetrable border fencing, security guards, alarm systems, etc.

To minirhise the financial impact of theft, all assets should be insured.

QUICK REVISION OF ENTRIES FOR ASSET DISPOSAL

When an asset is sold there are 5 entries to be made.

The question will not tell you what to do, so it is useful to remember dCASP

Think of the Asset disposal account as a temporary asset as it will close.

d

depreciation has to be updated if the asset is sold during the year. Calculate the number of months the business has had the asset since the last time it was depreciated, i.e. end of the last year (usual entry). lf it is sold at the beginning of the year, no entry would be needed. lf sold at the end of the year, calculate the depreciation on all the assets first and only work out this amount when doing 'A'.

The double lines here indicate that this entry does not appear in the Asset dlsposa/ account. The small 'd' indicates that the figure may be small, i"e. for less than a year.

C

transfer the Cost price of the asset from the asset account [A-] (equipment or vehicles) to the debit side of the Asset disposal account [A+].

A

transfer the Accumulated depreciation [A-] (total of ALL depreciation from the date bought to the date sold) to the credit side of the Asset disposal account [A-] to reduce its balance to carrying value.

S

enter the Selling price on the credit side of Asset disposal [A-] as:

  • Bank if it was sold for cash OR
  • Debtors' control if it was sold on credit OR
  • Creditors' control if it was traded in.

P/L

CLOSE the Asset Disposal account to either Profit on sale of asset [G+] if the figure needs to be on the '+' side (debit) OR Loss on sale of asset [E+] if the figure needs to be on the '-' side (credit)

MODEL ACCOUNT

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QUICK REVISION OF THE TANGIBLE ASSET NOTE

Although you did this note in Unit 2, it is necessary to revise how to do it when assets are disposed of during the year and the difference it makes when the end of year figures are given rather than the beginning of year figures.

How to do the Tangible Assets Note - Step by Step

INFORMATION

Below is an incomplete Tangible Assets Note for the year ending 30 June 2015.

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The reasons for selling a vehicle or equipment

  • The business has a replacement policy, i.e. vehicles will be traded-in after 5 years, and this time is up.
  • The asset is too costly to keep, e.g. a delivery van needs constant repairs or is using too much petrol.
  • The asset is not being fully utilised, e.g. a computer is not being used at all.

TANGIBLE ASSETS - THE INTERNAL AUDITOR'S DUTIES

Land and buildings

He must ensure that the premises are fully utilised. lf it is not, he should recommend to management that the unused section be sold or rented out to earn income.

Vehicles and Equipment

He must check the Asset Register regularly to ensure that it has been updated, that all details of new assets purchased have been conectly entered according to the invoices.

He must do an actual physical check regularly to ensure that:

  • the assets are being used for the purpose for which they were bought and
  • they are where they are supposed to be - not at a staff member's home.

He must ensure that all assets are properly insured.

He must analyse the cost of using the assets to determine when they should be replaced, i.e. traded-in for a new more efficient model. Any asset not fully utilised should be sold.

TANGIBLE ASSETS - THE EXTERNAL AUDITOR'S DUTIES

Land and buildings

He must check the title deeds to be sure that the business does actually own the property reflected in the Statement of Financial Position. These title deeds should be kept in a safe place e.g. a bank vault as they are the only proof of ownership of property. He should check the condition of the buildings. Have they been maintained? lf not, should they be depreciated? He should check the market value against the cost in the General Ledger. lf lt is lower, he should investigate the reasons. Should the property be devalued? Only a qualified valuator can answer this.

Vehicles and Equipment

He must check any acquisitions against the invoices to ensure that the entries are correct and physically check that the assets in the Asset Register are where they are supposed to be. He must also check that the depreciation entries have been correctly calculated and that a suitable rate has been used.


THE TWO SYSTEMS OF INVENTORY CONTROL

Perpetual means continually/all the time

1. The Perpetual Stock System

To use this system, a business has to have

  • a computerised till and scanner
  • a bar code on each item of stock recording, in code, the cost price, the selling price, details of the product, details of the supplier, etc.

When the customer is at the till, the bar code will be scanned and all the information will be loaded onto the computer. A till slip will be printed out showing the customer what items she bought, which ones are zero-rated for VAT, the total she paid, how she paid i.e. cash or card, the date of sale and as much other information as the business wants to give e.g. guarantees, customer service, etc.

The information on the computer will update the Trading stock account with the cost of sales which is automatically recorded but, of course, not shown on the till slip. The balance on this account will then represent the cost of the stock the business ought to have on the shelves.

The advantages of this system are:

  • It provides management with a means of internal control of stock as it can do a physical count to check whether the stock that ought to be on the shelves according to the Trading stock account is actually there.
  • At the year-end a trading stock deficit can be accurately calculated. lf there is a break-in during the year, the amount of stock stolen can easily be calculated for insurance purposes by comparing a physical count with the balance of the Trading stock account.
  • Less time is taken at the till as the barcode showing the selling price, etc. is read by the scanner. The assistant cannot'ring up' the incorrect price.
  • Management always knows when stock needs to be re-ordered and is less likely to over-order. This is good for liquidity as less stock on hand and less owing to creditors equals more cash in the business.

The disadvantages are

  • the business has to invest in an expensive computer system and
  • the staff need to be trained to use it.

The Periodic Stock System

Periodic means occasionally

A business, which has not invested in a computer system, will not know how much stock should be on the shelves. There will be no bar code on the items sold, which means it is not possible to update the Trading stock (asset) account during the year as the cost price of the goods sold is not known.

It has to use a Purchases (expense) account and separate accounts for Purchases returns (E-), Carriage on purchases and Customs (import) duty (both expenses).

A business using this system only knows how much stock it actually has on hand occasionally. In fact, it will only know this when it physically counts the stock at the end of the financial year. This is also the only time the business can work out the cost of sales.

The advantages of this system are:

  • lt is suitable for a business selling small items on which a barcode cannot be marked e.g. a small hardware store where a customer can buy 4 nails, 5 screws, etc. (Big hardware sfores put 10 nails or screvys, etc. in a packet on to which the barcode rs sfuck A customer cannot buy less than this.)
  • It is a cheap system to use - no computer system is needed.
  • It is quick and easy to use with minimum training of staff, paper work and administration required.

The disadvantages are:

  • Management cannot determine how much theft is taking place. lt has to wait until the Financial Statements have been completed to calculate the gross profit as a percentage of cost of sales. This is then compared to the previous year's percentage. A decline would indicate that theft has occurred.
  • Customers' progress at the till could be slow as the assistant has to physically key in all the prices. Mistakes in 'ringing up'the items can happen easily (or deliberately, if the customer is a friend of the assistant).
  • Management does not know how much stock is on the shelves so it has to physically check whether more stock must be ordered.

Why the Trading stock account cannot be used in the periodic inventory system

An asset is something we own and implles that we know where it is and how much it costs us. In this system the business does not know how much it has until the end of the year when the stock in the shop and the storeroom is physically counted and priced. Only then can it be classified as an asset.

The problem we are faced with in Grade 12 is not the recording of the movement of stock throughout the year, but how to value it at the end of the year.

THREE WAYS OF VALUING INVENTORY

If prices did not increase, there would be no problem. However, in the modern world, prices vary constantly. Shops do not always wait until they have sold all the stock before ordering more. This means that on the shelves at any time could be, for example, identical cans of beans, but with different cost prices. How does the business calculate the total cost of all the cans of beans it has not sold? It has three options:

1. Specific Identification Method

This method has very limited use, but is suitable for a business selling easily identifiable items, especially if they are expensive e.g. motor cars, exclusive jewellery, wedding dresses, lap tops, original paintings, etc.

It must be possible to identify each item of stock available for sale, i.e. know when it was bought and what it cost.

When the item is purchased the cost price is recorded in a register, on a stock sheet or on the computer. All costs of buying the stock must be added to this cost price, e.g. transport costs, customs duty, etc.

When the item is sold the accountant identifies the cost price and immediately records the Cost of sale and removes the item from the register or stock sheet.

Advantages of using the specific identification method

It is very easy to ensure no items are missing as it is possible to check actual inventory against the records frequently.

The business can keep minimum stock available, provided the supplier is close, and this reduces the amount of cash invested in stock.

Disadvantages of using the specific identification method

It cannot be used in a business with a high rate of turnover (sales) as it is very labour intensive to constantly update the records.

How to value ldentification inventory using the Specific Method - Step by Step

CHELSEA GARDEN FURNITURE

This business sells expensive garden table/chair sets made by local craftsmen.

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Work through these questions to see if you agree with the answers (in italics).

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2. FIFO - First In First Out Method

This is a straightforward way of valuing stock on hand at the end of the year. For example: 100 cans were bought at R4 each, and then, 150 cans were bought at R6 each. There are only 50 cans left on the shelf at the end.

First in first out means exactly what it says. The 100 cans costing R4 each will be sold first. Then the 100 cans costing R6 will be sold. The 50 cans which have not been sold were bought last i.e. part of the 150 cans bought. The final stock is valued at R300 (50 x RG).

Advantages of using FIFO

  • It is easy to calculate.
  • The value of the closing stock will be close to current price which makes sense in inflationary times when prices are always rising.
  • Unit costs are taken from actual records, no estimates are required.
  • It assumes that the movement of goods in and out of the shop is logical, i.e. the oldest stock is sold first.

How to value inventory using the FIFO Method - Step by Step

NEWCASTLE LIMITED

Newcastle Limited sold 490 scarves for R7B 800. lt uses the perpetual method of stock control; a mark-up of 100% on cost and the FIFO method to value its stock at the end of the period.

Work through these questions to see if you agree with the answers (in italics).

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QUESTION: How did the company manage to achieve its mark-up percentage even though the cost price changed constantly?

The business is using the perpetual method of stock control. This means that the cost price is on the bar code of every item bought.

The selling price based on this cost price + 100% mark-up.

During the year the selling price of the scaryes changed depending on what they cost, but the mark-up was always 100 per cent.

3. Weighted Average Method

Using the cans of beans example again, this time we need to work out the average cost of the cans bought this year.

It is called 'average' because we multiply each cost by the number of units bought and then divide the total cost by the total number of units. It is called 'weighted' average because the larger the purchase - the greater the influence on the answer.

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How to value inventory using the Weighted Average Method - Step by Step

LIVERPOOL LIMITED

This company, an importer of fine china mugs, uses the periodic method of stock control; a mark-up of 100% on cost and the weighted average method to value stock at the end of the period. 490 mugs were sold for R78 800.

Work through these questions to see if you agree with the answers (in italics).

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QUESTION: Liverpool Limited did not achieve its mark-up. Why not?

It did not achieve the 100% mark up because:

  • Stock has been stolen.
  • Specra/ discounts were allowed to customers. OR
  • Liverpool Limited calculated the selling price incorrectly. OR
  • Errors were made during stocktaking.

The main differences between FIFO and the Weighted Average methods

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What does the term 'reconciliation'mean?

It means to work out the differences between TWO 'things'which do not agree. We need to find the reasons why they do not agree. When this process is finished, the two will still not agree, BUT we will know why, i.e. we will have reconciled them.

In practice it is possible for a business to have hundreds of creditors and thousands of debtors. lt will have three ledgers - two subsidiary ledgers, one for debtors and one for creditors and, the most important ledger, the General Ledger.

The General Ledger has no personal accounts, but has a Debtors'control account and a Creditors' control account showing only the totals of all entries which have been posted from the subsidiary journals to the individual debtors' and creditors' accounts"

What is the function of the control accounts?

At the end of the month the balance of the control accounts must agree with the total of the list of balances taken from the subsidiary ledgers. If they do not agree, a mistake has been made and it must be found. They are called Control accounts because they ensure the work in the subsidiary ledgers is correct.

1. CREDITORS' RECONCILIATIONS

Why is it necessary to do the reconciliation procedure?

Before the business pays a creditor it must make sure that the amount owed to him is correct to ensure that it does not overpay him and, when possible, it earns discount by paying the correct amount promptly.

If the cheques sent to creditors are constantly wrong, what does it say about the business?

  • There is a lack of internal control OR
  • The internal auditor is not doing his job OR
  • Fraud is possibly taking place

All of the above - and this is not the impression the business wants to create! lf the creditor is constantly hassled by the business not paying the correct amount on time, he may decide not to grant further credit facilities when the business needs them. The credit worthiness of the business may be questioned and other suppliers may decide not to risk granting it credit.

A. RECONCILIATION OF A CREDITOR'S STATEMENT WITH HIS PERSONAL ACCOUNT (EXTERNAL CONTROL)

We will work with two things:

1. the creditor's statement, received at the end of the month which is a copy of our account in the creditor's books showing all transactions from his (the creditor's) point of view and

2. the creditor's account in the Creditors' Ledger showing the transactions from our (the business's) point of view.

It is a means of external control, as the business books are checked against an external source, i.e. the creditor's statement.

Any errors found in the business books will be corrected immediately. Then a creditor's reconciliation is prepared showing why our balance does not agree with the balance of the creditor's statement. These will be the items on the creditor's statement which the business does not agree with, i.e. errors made by him.

We will send a copy of this reconciliation to the creditor with our cheque so that he understands why the business is not paying the amount owing according to the statement he sent.

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How to reconcile a Greditor's Statement with his Account in our Greditor's Ledger - Step by Step

    1 Compare the opening balance on the Creditor's Statement with the opening balance of the creditor's account in our Creditors' Ledger.

    2 Compare the invoices in the debit column of the Creditor's Statement against the invoices in the credit column of the creditor's account in our ledger.

    3 Corprre the credit notes in the credit column of the Creditor's Statement against the debit notes in the debit column of the creditor's account.

    4 Compare the receipts (and discounts) in the credit column of the Creditor's Statement against the cheques and discounts in the debit column of the creditor's account in our Creditors' Ledger.

    5 Compare any other items found on the Creditor's Statement e.g. journal entry for interest, against the creditor's account in our Creditors' Ledger.

The creditor (Galileo General Dealers)sent us (Godrell Limited)a Statement of Account which is a copy of our account in their Debtors' Ledger.

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Notice that the items which appear in both our ledger and the creditor's statement have been ticked off.

Then, read the additional information to find out who made a mistake.

  • lf we did, correct it in the creditor's personal account and in the control account.
  • lf the creditor did, show it on the creditor's reconciliation statement.

ADDITIONAL INFORMATION

A Galileo General Dealers forgot to deduct the 10% trade discount on invoice 3754.

B Invoice 6120 is addressed to Gribbon Limited - i.e. not us.

C Godrell returned some of the stock bought on 15th April as it was damaged.

D Galileo General Dealers sends statements on the 201h of the month.

CREDITOR'S RECONCILIATON STATEMENT - 30 APRIL 2015

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B. RECONCILIATION OF TOTAL OF THE CREDITORS' LIST WITH THE BALANGE ON THE CREDITORS' CONTROL ACCOUNT (INTERNAL CONTROL)

This is a means of internal control and is done monthly in addition to the above reconciliation.

ERRORS - It is a good idea to remember

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The person in charge of the Creditors' Ledger prepares a list of creditors' balances and totals it. She will check with the accountant that this total agrees with the balance of the Creditors' control account. lf these two agree, cheques or EFT's will be sent to the creditors. lf not, the reason(s) must be found and any errors must be corrected.

How to reconcile a Creditor's List with the Creditors Control Account - Step by Step

COMET STORES

Comet Stores is owned by Edmund Halley. He writes up his own financial records, but the balance of the Creditors' Control account does not agree with the total of the Creditors' List.

REQUIRED

Show on the 'Schedule of errors to be corrected' what entries Edmund needs to make in the Creditors' Control account and the Creditors' List to reconcile the two.

INFORMATION

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2. DEBTORS' RECONCILIATIONS

Why is it necessary to do the reconciliation procedure?

This is a means of internal control which is done monthly before Statements of Account are sent to debtors.

Mistakes must be found before statements are sent to debtors to ensure that:

  • they pay the correct amount timeously to ensure the proper flow of cash
  • they are not upset because the accounts they receive are always wrong and consequently take their business elsewhere.

How to reconcile the Debtor's List with the Debtors Control Account - Step by Step

The balance of the following Debtors' Control account does not agree with the total of the Debtors' List. Take the errors and omissions into account to calculate the correct balance on the Control account and the correct total of the Debtors' List.

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Now read through the errors again concentrating only on the names of people.

Correct the List and calculate the new total.

IT MUST NOW AGREE WITH THE CONTROL ACCOUNT!

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DEBTORS'AGE ANALYSIS

A business analyses the age of every debtor's account every month i.e. it works out (analyses)for how long (age)the debtor has owed the money e.g. 30 days; 60 days.

There are two ways of controlling the amount owing by debtors to keep bad debts to a minimum:

  • When a debtor opens an account she is given a credit limit, which is the amount of credit she will be allowed to buy before paying for anything. For example, if the credit limit is R5 000 and the debtor already owes R4 800, she will not be allowed to buy for R500 until she has brought the balance of her account down to below R4 500.
  • The debtor will also be given 'terms', i.e. a time limit in which she must pay. A business should give debtors 30 days to pay. lf they do not pay in this time, no further credit should be allowed.

A Statement is sent to every debtor at the end of every month (on the 20th or 25th) to show the total amount owing which can be compared to the credit limit. lt will also have an age analysis of the total balance divided into the number of days it has been owing.

DEBTORS' LEDGER OF UNIVERSE TRADERS C CHALLENGER

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First make sure which month we are in. In this case it is June = current. May is then 30 days ago and April is 60 days. Any balance before this is 90 days.

How to analyse how long the debtor has owed the business money for

1. Start with the opening balance. Has it been paid? Yes - on 1 May. BUT, be careful! On 10 May this cheque bounced, so the amounts cancel. Did the debtor pay any other amount? Yes, on 4 June she paid R1 500. How much of the opening balance is stillowing? R1 000. Write this under 90 days.

2. All invoices are for the actual month of the invoice, e.g. subtract R350 from R700.

3. A credit note must be subtracted from the last invoice as goods must be returned within 10 to 14 days.

WORKINGS FOR CHALLENGER'S AGE ANALYSIS:

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It is a means of internal contro! to ensure that the debtor pays within the time stipulated (terms agreed on when she opened her account

The longer the debtor takes to pay, the less likely she is to do so. This mean the business will incur bad debts which decreases profits.

If debtors do not pay promptly the business may have cash flow problems. It would like to use the cash it receives from debtors to replenish its stock and pay its creditors.

How to encourage debtors to pay their accounts

  • give a discount for prompt payment, e.g. 5% discount if paid within 20 days
  • charge interest if not paid within time required e.g. 10% interest will be charged if not paid in 30 days (or 60 days).

What to do if debtors do not pay their accounts

  • contact debtor to find out if there is a problem e.g. error on account
  • make arrangements for her to pay it off over a few months OR
  • threaten her with legal action. Make sure that the amount plus costs can be recovered if you do sue her,

3. BANK RECONCILIATIONS

Why is it necessary to do the reconciliation procedure?

    1. lt is a means of external control. By checking internal documents against the statement received from the bank (external document) we ensure that no errors have been made in our books or in the bank's books and that no fraud has occurred.

    2. lt is necessary to update the Cash Journals with all the items we do not know until the Bank Statement is received e.g. bank charges; R/D cheques; direct deposits; interest, etc. so that our bank balance is accurate.

We will work with 1. the Bank Statement, which is a copy of our account in the bank's books

and 2. the Cash Journals which record all money deposited into and paid out of our bank account in our books.

These two will never agree because there is a time clelay. We make the deposit and cheque entries in our journals first and the bank only knows about them later.

The Procedure

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What is a Bank Reconciliation Statement?

It is a record of all the items that the bank does not yet know about and therefore shows why our balance in the bank's books does not agree with the Bank account balance in our (the business's) General Ledger.

There are only SIX items: LEARN THEM!

An example of a

BANK RECONCILIATION STATEMENT ON 31 JANUARY

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Analysis and interpretation of Bank Statements

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Other terms you need to know

Post-dated This is a cheque dated for some future time. lt is not valid until that date. lf the business receives such a cheque it does not enter it. It will put it in the safe and a note will be made in the diary of the date it can be entered and deposited. lf the business pays someone with a post-dated cheque, it will be entered in the CPJ with its actual date and will be shown as outstanding in the BRS until the creditor can claim the money.

    DO REMEMBER! lf this cheque is dated 14 July and the financial period ends on 30 June, it must be reversed in the financial statements BUT NoT in the books

Stale A cheque is stale when it was written out more than 6 months ago, e.g. it was dated 1 March and the date is now 2 October. The money cannot be claimed by anyone. lt must be cancelled in the CRJ using the same wording as was used in the CPJ six nronths ago.


Value Added Tax (VAT) has to be paid to the South African Revenue Service (SARS) by all factories, wholesalers and retailers selling products and/or services if they are registered as VAT vendors.

VAT is an indirect tax because the final consumer, who buys the product or service from the retailer, does not pay the VAT directly to SARS. The consumer pays the seller the price marked on the goods, which includes VAT, and the seller pays the VAT to SARS. lt is important to note that VAT costs the seller nothing as he uses the money he receives from the consumer.

Many countries use this indirect form of taxation as a source of revenue as it is easy to collect.

QUICK REVISION OF VAT CONCEPTS

Standard rated supplies

These are supplies that are subject to VAT at the prescribed rate, which at present is 14%. fhe rate can be changed by the Minister of Finance. All goods and services are subject to VAT at the standard rate, unless, in terms of the Act, such supply is

Zero-rated supplies

A zero-rated supply is a taxable supply on which VAT is levied at the rate of 0% which means no VAT will be payable to SARS. The law allows VAT to be charged on these items, but the government has decided that, at this moment, no VAT will be charged. lf it changes its mind, it does not have to change the law. All the government has to do is change the percentage.

For example:

  • brown bread
  • milk and milk powders
  • canned pilchards
  • paraffin
  • petrol and diesel (these already have many taxes added on).
  • rice, lentils, maize, dried beans
  • fresh fruit and vegetables
  • eggs
  • international air tickets

Exempt supplies

An exempt supply is not a taxable supply, i.e. the law says no VAT is to be paid.

For example:

  • rates on property (because this is a tax)
  • trade union membership fees
  • transport of people by state roadirail services
  • interest on overdraft
  • school fees
  • life insurance.

VAT vendors

Only a business selling goods or services and registered with SARS for purposes of VAT, is called a VAT vendor. To register as a vendor the business has to have a turnover (sales) of more than R'l 000 000 a year. lf it will sell less than this, but more than R50 000 per year, it can choose to register as a vendor. lf it is not registered as a VAT vendor, it may not add VAT on to its prices. lt will not pay SARS any output VAT and cannot claim any input VAT on the things it buys.

Input VAT

When a business buys goods to resell, or other items to use in the running of the business, it pays the seller the full price, i.e. the selling price + VAT. lt then claims this input VAT it paid to the seller back from SARS. lt is called INPUT VAT because the goods, etc. come INnto the business.

Output VAT

When a business sells goods to a customer, it adds VAT to the price and then pays this output VAT to SARS. lt is called OUTPUT VAT because the goods go OUT of the business.

When is a registered VAT vendor not able to claim VAT back from SARS?

There are certain circumstances when a registered business cannot claim VAT:

  • it has not kept the invoice received from the supplier showing the amount of VAT included in the price. VAT inspectors visit businesses to check up on the paperwork and documentation.
  • the item bought is not considered necessary for the business's operations. The business will pay VAT on these items, but will not be able to claim the VAT back from SARS, e.g. entertainment expenses (business lunches, golf days); gifts for clients (wine, chocolates, etc.); staff refreshments (tea, coffee, staff parties and lunches) and motor cars and double cab bakkies because they are not delivery vehicles.

QUICK REVISION OF VAT CALCULATIONS

Do remember, when you are given a figure you do not want - divide it by the percentage it represents and multiply it by the percentage you do want. The selling price is R1 653 including VAT. What is the selling price excluding VAT? Always ask yourself - will the answer be bigger or smaller? lf smaller - divide 1 653 by 1,14 (1001114) to immediately get the selling price of R1 450. lf you wanted a bigger answer, you would multiply by 1,14

VAT ENTRIES

In practice a business needs three accounts for VAT:

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Explanation of items

The VAT Control account will usually have a credit balance, i.e. be a liability. The business will owe SARS money because it sells goods to customers at a mark-up which should cover the cost of the stock and the expenses incurred in running the business.

However, there may be months in which the business has bought a large quantity of stock, for example before December, so that it can take advantage of the extra cash customers have to spend on gifts, etc. This may result in the VAT control account having a debit balance, which means that SARS owes it money.

    [A] This is the amount of VAT the business owes SARS for April.

    [B] The balance has to be paid to SARS by the 25th of the month.

    [C] Output VAT collected on cash sales of goods and services.

    [D] Input VAT paid on items bought e.g. as stock, stationery, equipment, etc.

    [E] Output VAT on credit sales to debtors.

    [F] Reversal of the output VAT on sales to debtors because the merchandise was returned or an allowance/discount was claimed because of damage.

    [G] Input VAT included in goods, stationery, packing material, etc. bought on credit. tHl Input VAT reversed because the goods, etc were returned or a claim was made for discount not granted or damage on delivery. When the owner (sole proprietor) takes goods for his or her own use, Output VAT must be charged because Input VAT was claimed from SARS when the goods were purchased. (same as a sole even though it is at cost)

    [J] If a debtor cannot pay the amount he or she owes, the debt is written off. The VAT that has already been paid to SARS will be claimed back. The actual journal entry will look like this.

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LEGAL REQUIREMENTS AND PENALTIES

  • A vendor is required to retain a valid tax invoice as proof of any input tax deductions which are claimed. These tax invoices as well as other records of transactions must be retained for a period of at least 5 years.
  • A business with a turnover of more than R1 million p.a. must register as a VAT vendor. lt will pay VAT every second month^
  • A registered VAT vendor with a turnover of more than R30 million must pay VAT every month.
  • The cheque in payment of VAT must be at the SARS office by the 25th of the month in which it is due.
  • If the VAT is not paid on time, interest of 10% of the VAT amount plus interest of 1,1o/o per month will be charged from the 1st day of the next month. ' Any business which fraudulently does not pay its VAT liability or claims a refund of VAT to which it is not entitled, will be liable, on conviction, for a fine.

In Grade 11 we concentrated on the Ledger accounts of a manufacturing business and the calculation of costs. In Grade 12 we will still do all the calculations, but we will also prepare:

  • a Production Cost Statement with Notes to show how the figures were calculated. It shows exactly the same information as the ledger accounts. It is prepared before the Income Statement as the cost of production of finished goods is used as the cost of sales figure.
  • an Income Statement - which is a short-form with supporting notes for Administration costs and Selling and distribution costs (if asked for).

We will not do the Statement of Financial Position (Balance Sheet).

TWO CATEGORIES OF COSTS

In Basic Concepts [Unit 1] we learnt that the cost of running a business does not refer to what we buy or pay for, but to all the goods and services we use up, in this case, in the manufacture and sale of a product.

1. Variable costs

A variable cost changes according to the number of units manufactured/sold.

There are three variable costs:

Direct materials

These are the 'raw' physical materials we buy in order to make something, e.g. wood used to make furniture. This will include all costs of buying the raw material e.g. the cost of transporting it to the factory and customs duty, if imported. The greater the number of units produced, the greater the total cost of the materials.

Direct Iabour

This refers to the wages paid to the workers who actually make the product. They will be paid on a per unit basis, if they make the whole unit, or on an hourly basis. This means that the more units they produce or hours they work, the more they will be paid. However, if they are on strike they will be paid nothing. This will include all contributions by the business to the pension fund, the medical aid and the unemployment insurance fund.

These two costs are prime costs, i.e. the first to be incurred when making a product.

Selling and distribution cost

The salaries or commission paid to sales personnel would be a large part of this cost. Advertising costs, delivery expenses, depreciation on delivery vehicles, bad debts, rental of shop space, etc. are also included here.

2. Fixed costs

A fixed cost stays the same irrespective of the number of units produced. For example: rent and insurance will not increase if more units are made, nor will they decrease if the workers go on strike.

There are two fixed costs:

Factory Overheads cost

These are all the other expenses/costs involved in running a factory, e.g" indirect materials, indirect labour, factory rent, insurance and all the other costs of running the factory as well as depreciation of machinery, etc.

Administration cost

This refers to the costsiexpense incurred in running the offices where the CEO, the accountant, bookkeepers and secretaries work. Their salaries, including all contributions by the business to the pension fund, the medical aid and the unemployment insurance fund are administration costs. The rental of this office space, insurance, electricity, and all other costs of running the office, as well as depreciation of office equipment, must be included in this cost.

QUICK REVISION OF OTHER CONCEPTS

Indirect materials

Classified as Factory overheads cost, these are the materials used to keep the factory clean and the machines in good running order e.g. mops, rags, oil, etc.

Indirect labour

Classified as Factory overheads cost, these are the people who work in the factory, but do not make the products. They are the cleaner, the storeman, who is in charge of receiving the raw materials from the suppliers and distributing them to the workers, and the foreman/ manager of the factory. Production will continue whether they are there or not.

Finished goods

As the name implies, these products have been completed and are ready for sale. Physically they will be in the selling and distribution area (shop). The total cost of the finished goods sold will become 'Cost of sales' in the Income Statement.

Total cost of production

This is the total of the direct materials cost and

  • the direct labour cost and
  • the factory overheads cost

of the products which were worked on in this accounting period - some of which were not finished.

Work-in-progress/process stock

These are the products which were not finished at the end of the accounting period, and therefore are not yet ready for sale. They will be completed at the beginning of the next accounting period, so they will still be in the factory. An adjustment must be made if there is work-in-progress at the beginning and/or end of the year, before the cost of production of finished goods can be calculated.

THE PRODUCTION COST STATEMENT

The Production Cost Statement, like the other financial statements, is a means to an end. The figures in this statement are used to calculate the cost per unit of every element of a product. This is very important as management can analyse the efficiency of the factory this year by comparing the various costs per unit with those of the previous year. lmportant decisions can then be made about the products to be made in the following year.

How to do the production Cost Statement - Step by Step

Look at the Answer Sheet to see if

    a) all the wording has been written in

    b) only some of the wording is in

    c) it is blank.

You have three options:

    a) Read the question through writing all the figures in brackets next to the wording. Then do the adjustments/additional information straight on to the Answer Sheet.

    b) As you read the question through write in the missing wording and any figures you find next to the wording. Then concentrate on the adjustments.

    c) Adjust the figures on the question paper and then write in the wording and the figures in brackets at the same time.

First do the:

NOTES TO THE PRODUCTION COST STATEMENT

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Then use these totals in the

PRODUCTION COST STATEMENT FOR YEAR ENDED 31 DECEMBER 2Ol5

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This statement and the notes are very straightfonuard especially if you remember the Grade 11 work. In Question 3 you have been given the ledger accounts to remind you of the information each contains, as this is what is converted into the notes and the statement itself.

THE SHORT-FORM INCOME STATEMENT

Income Statement - Step by Step

You are required to do the short-form of the Income Statement with two notes which will be numbers 4. and 5. as they follow on from the notes to the Production Cost Statement.

Do the Notes to classify all the other expenses first.

NOTES TO INCOME STATEMENT

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INCOME STATEMENT FOR YEAR ENDED 31 DECEMBER 2015

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QUICK REVISION OF FORMUTAE

These are the formulae you need to know:

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THE BREAK-EVEN POINT

Every manufacturer needs to work out at what point the business will break even. This means he must know the minimum number of units he needs to produce and sell just to cover variable plus fixed costs, but earning zero profit.

Usually sales = variable costs + fixed costs + profit,

To find the break-even point we want sales = variable costs + fixed costs + 0.

You will need to distinguish between fixed and variable costs. Although some costs are semi-variable e.g. electricity which does not double if production is doubled, but is not zero when the factory is closed, you will usually be told to treat all overheads and administrative expenses as fixed.

How to do the calculate the Break-even Point - Step by Step

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ETHICAL CONSIDERATIONS

Apart from the usual ethical and good governance aspects of running a business, there are a few considerations which are particularly applicable to manufacturing businesses.

The physical environment

The factory must ensure it does not pollute the surrounding ground, the air, the water supply, rivers, etc. in the process of making the products.

The social environment

The factory must be aware of the community which live in the area and do whatever it can to improve their circumstances. lt can, of course, offer employment, but in addition to that it can become involved in community projects e.g. schools, hospitals, orphanages, etc. to ensure good relations with the people of the area.

Supply of raw materials

It is very difficult for management to continually control costs so it may be tempted to buy cheap raw materials from overseas. This is harmful to the economy:

  • South African suppliers lose business and the workers lose jobs.
  • the money to pay for the raw materials leaves the country and weakens the exchange rate.
  • the quality of the product may not be up to standard, and although the finished product may be cheaper, it will not be able to compete with better quality products imported from overseas by competitors.
  • the conditions of employment may not be well regulated in other countries, and the business may, without realising it, be participating in a system of worker abuse.

Employment of workers

All workers must be treated equally if they have the legal right to work in the country. lf they are illegal immigrants they may not be employed. lt is unethical, as well as illegal, to employ them at a much lower wage than South African workers.

Price-fixing

It is illegal to agree with a competitor to charge the same price for a product or service as this is prejudicial to the consumer. Competition between businesses ensures that they produce the best producUservice at the best price. Unfortunately there have been some very high-profile court cases in South Africa in this regard, in recent years. First, was the bread price-fixing case where the producers agreed to charge the same price for bread. More recently, the big construction companies were proved to have agreed to not compete with one another when bidding to build the 2010 World Cup soccer stadiums.


Budgeting is the planning of the financial position of the business for a future period.

It shows

  • whether the business will be able to survive
  • whether it will need to borrow money and
  • whether it will have the potential to expand in the future.

Although you still need to know how to prepare a Projected Income Statement and a Cash Budget, the emphasis this year is on the analysis of the information in them as well as a comparison of actual incomes and expenses with projected figures and actual receipts and payments with budgeted figures. You can also be asked to identify problems and suggest solutions.

THE PROJECTED INCOME STATEMENT

This statement looks the same as the Statement of Comprehensive Income, except that it is for a future period. The figures for sales, cost of sales, and all other income and expenses are projected (predicted) for the next fInancial period. Income is shown in the month it will be earned and expenses in the month they will be incurred, irrespective of when the cash will be received or paid.

The purpose of preparing this statement is to ensure that the business will be profitable each month of the following year" lf expenses will exceed income in certain months, there is still time to make changes.

Although forecasting future sales may seem to be the most important task, every member of staff will be involved as each section of the business will have to work out what it will cost to achieve these sales, and submit a budget to management. A purchases budget is drawn up to work out how much stock needs to be bought to match the sales and in which month. We are usually told that stock is replenished (replaced) monthly. This means that as soon as stock is sold, the same quantity is bought so that the quantity on the shelves remains constant (fixed base stock).

The advertising budget could plan for consistent expenditure throughout the year or could plan for an increase at certain times of the year e.g. November and December. Management has to be sure that it can handle any increase in sales without employing more staff or moving to new premises.

From these budgets the Projected Income Statement is drawn up showing the expected sales, other incomes, all expenses and the resulting net profit the business predicts it will make for each month. Targets can then be set for the staff to motivate them to increase sales while controlling expenses.

Cash transactions are NOT entered in a Projected Income Statement.

THE CASH BUDGET

Based on the figures in the Projected Income Statement, a Cash Budget is prepared for the same period. This will show when the actual cash will be received and paid out (not necessarily in the same month as earned or incurred) and the resulting bank balance at the end of each month. It is just as important to have the right amount of cash at the right time as it is to make a profit. Each month is different. Management must be aware of future commitments so that it knows when large amounts of money will be needed so that money can be borrowed or capital increased. lt must also know when, if ever, it will have excess money on hand to enable it to take advantage of new business opportunities.

Be aware that there are certain items in a Projected Income Statement which will NEVER appear in a Cash Budget e.g. bad debts, depreciation, loss on sale of asset, etc. as these are not cash paymets.

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INTERNAL CONTROL AND INTERNAL AUDIT

Both the Statement of Projected Income Statement and the Cash Budget will act as means of internal control for the next accounting period.

At the end of each month, the actual Statement of Comprehensive Income will be checked against the Statement of Projected Income and the actual cash receipts and payments will be checked against the Cash Budget to ensure that all projected figures have been achieved.

The internal auditor will be responsible for detecting any income, expense, receipt r payment which does not match the projected figure. He will investigate the reason for the difference.

Sometimes it may be necessary to amend the Projected Income Statement and or the Cash Budget for the rest of the year e.g. fuel or electricity have risen more than could have been predicted. Other expenses may need to be cut to accommodate these increases.

DEBTORS' COLLECTION SCHEDULE

How to do a Debtors' Collection Schedule - Step by Step

When goods are sold on credit the profit is accounted for immediately, but the cash only comes in later. How much later will depend on the policy of the firm, i.e. whether it allows 30 days or 60 days for payment. However, not all debtors pay promptly, but the business will, from past experience, know what percentage pay each month.

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NOTES

A. If a 5% discount was allowed to those who pay in the first month, the calculation would be: R50 000 x 0,25 x 0,95 = Rl 1 875, not R12 500.

B. This schedule may show more than an examination question would ask for, but it shows the 'step across x step down' progress of the figures.

C. Bad debts can only be written off after all collections have been received, i.e. August bad debts will be written off in December.

If the Cash Budget were asked for - this is how it would look:

CASH BUDGET FOR JUNE, JULY AND AUGUST

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CREDITORS' PAYMENT SCHEDULE

How to do a Greditors' Payment Schedule - Step by Step

We need to know what the goods cost (cost of sales), how much is bought for cash and the terms of payment for the credit purchases, i.e. when the business will pay for these goods and whether it will get a discount for prornpt payment.

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CREDITORS' PAYMENTS SCHEDULE

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