FINANCIAL REPORTING AND ANALYSIS

Module Guide

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MANCOSA
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 This Guide
Financial Reporting and Analysis (NQF level 5)
module guide will be used across the following programmes:

 Bachelor of Commerce in International Business Management

 Bachelor of Business Administration
 Bachelor of Public Administration
 Bachelor of Commerce in Human Resource Management
 Bachelor of Commerce in Supply Chain Management
 Bachelor of Commerce in Information and Technology Management
 Bachelor of Commerce in Marketing Management
 Bachelor of Commerce in Project Management
 Bachelor of Commerce in Financial Management
 Bachelor of Commerce in Tourism and Hospitality Management (New)
 Financial Reporting and Analysis

Preface.................................................................................................................................................................... 1

Unit 1: Understanding Financial Statements ........................................................................................................... 7

Unit 2: Statements of a Sole Proprietorship .......................................................................................................... 26

Unit 3: Financial Statements of a Partnership ....................................................................................................... 49

Unit 4: Financial Statements of a Company .......................................................................................................... 77

Unit 5: Analysis of Financial Statements ............................................................................................................. 112

Bibliography ........................................................................................................................................................ 145

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Financial Reporting and Analysis

List of Content

List of Figures

Figure 1-1 Financial Statements ....................................................................................................................... 9

Figure 1-2 The flow of information through the accounting system .................................................................. 15

Figure 1 Pre-Adjustment Trial Balance ............................................................................................................. 29

Figure 5-1 Financial ratios ............................................................................................................................ 114

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 Financial Reporting and Analysis

Preface
A. Welcome

Dear Student

It is a great pleasure to welcome you to Financial Reporting and Analysis (FRA5). To make sure that you share
our passion about this area of study, we encourage you to read this overview thoroughly. Refer to it as often as
you need to, since it will certainly make studying this module a lot easier. The intention of this module is to develop
both your confidence and proficiency in this module.

The field of Financial Management is extremely dynamic and challenging. The learning content, activities and
self- study questions contained in this guide will therefore provide you with opportunities to explore the latest
developments in this field and help you to discover the field of Financial Management as it is practiced today.

This is a distance-learning module. Since you do not have a tutor standing next to you while you study, you need
to apply self-discipline. You will have the opportunity to collaborate with each other via social media tools. Your
study skills will include self-direction and responsibility. However, you will gain a lot from the experience! These
study skills will contribute to your life skills, which will help you to succeed in all areas of life.

We hope you enjoy the module.

MANCOSA does not own or purport to own, unless explicitly stated otherwise, any intellectual property rights in or
to multimedia used or provided in this module guide. Such multimedia is copyrighted by the respective creators
thereto and used by MANCOSA for educational purposes only. Should you wish to use copyrighted material from
this guide for purposes of your own that extend beyond fair dealing/use, you must obtain permission from the
copyright owner.

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Financial Reporting and Analysis

B. Module Overview
 The module is a 15 credit module at NQF level 5

AIM OF THE MODULE

This module aims to introduce students to financial statements and techniques involved in the preparation, analysis
and interpretation of financial statements

C. Learning Outcomes and Associated Assessment Criteria of the Module

LEARNING OUTCOMES OF THE MODULE ASSOCIATED ASSESSMENT CRITERIA OF THE MODULE

 Explain the role of financial statements in  The six main financial statements are examined to
businesses understand their use and the difference areas of financial
performance they report on

 Understand and apply the regulations of  International financial reporting standards and the
both the Companies Act and companies act are understood to prepare accurate
International Financial Reporting financial statements
Standards in the preparation of financial
statements

 Be familiar with the composition,  Composition, structure and content of financial statements
structure and content of financial are understood to prepare reliable financial information
statements

 Discuss the strengths and weaknesses  Strengths and weaknesses of financial statements are
of basic financial statements discussed to enable a fair and accurate presentations of a
company’s financial information

 Understand the concepts and  Concepts and procedures of preparing financial

procedures underlying the preparation of statements are understood to enable the fair
financial statements representation of financial information

 Prepare financial statements for a sole  Statements for a sole proprietor, partnership and
proprietorship, partnership and company companies are prepared to ensure that stakeholders have
access to information that is reliable

 Analyse and interpret information that  Financial statements and accounting reports are analysed
can be obtained from financial and interpreted to determine the financial stability of an
statements and accounting reports entity

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 Financial Reporting and Analysis

 Prepare projected financial statements  Projected financial statements for a business are prepared
for a business and explain their to assist an entity in their decision making processes
usefulness for decision-making purposes

D. Learning Outcomes of the Units

You will find the Unit Learning Outcomes on the introductory pages of each Unit in the Module Guide. The Unit
Learning Outcomes lists an overview of the areas you must demonstrate knowledge in and the practical skills you
must be able to achieve at the end of each Unit lesson in the Module Guide.

E. How to Use this Module

This Module Guide was compiled to help you work through your units and textbook for this module, by breaking
your studies into manageable parts. The Module Guide gives you extra theory and explanations where necessary,
and so enables you to get the most from your module.

The purpose of the Module Guide is to allow you the opportunity to integrate the theoretical concepts from the
prescribed textbook and recommended readings. We suggest that you briefly skim read through the entire guide
to get an overview of its contents. At the beginning of each Unit, you will find a list of Learning Outcomes and
Associated Assessment Criteria. This outlines the main points that you should understand when you have
completed the Unit/s. Do not attempt to read and study everything at once. Each study session should be 90
minutes without a break

This module should be studied using the prescribed and recommended textbooks/readings and the relevant
sections of this Module Guide. You must read about the topic that you intend to study in the appropriate section
before you start reading the textbook in detail. Ensure that you make your own notes as you work through both the
textbook and this module. In the event that you do not have the prescribed and recommended textbooks/readings,
you must make use of any other source that deals with the sections in this module. If you want to do further reading,
and want to obtain publications that were used as source documents when we wrote this guide, you should look
at the reference list and the bibliography at the end of the Module Guide. In addition, at the end of each Unit there
may be link to the PowerPoint presentation and other useful reading.

F. Study Material
The study material for this module includes tutorial letters, programme handbook, this Module Guide, a list of
prescribed and recommended textbooks/readings which may be supplemented by additional readings.

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Financial Reporting and Analysis

G. Prescribed and Recommended Textbook/Readings

There is at least one prescribed and recommended textbooks/readings allocated for the module.
The prescribed and recommended readings/textbooks presents a tremendous amount of material in a simple,
easy-to-learn format. You should read ahead during your course. Make a point of it to re-read the learning content
in your module textbook. This will increase your retention of important concepts and skills. You may wish to read
more widely than just the Module Guide and the prescribed and recommended textbooks/readings, the
Bibliography and Reference list provides you with additional reading.

The prescribed and recommended textbooks/readings for this module is:

 Bartlett, G., Beech, G., de Hart, F., de Jager, P., de Lange, J., Erasmus, P., Hefer, J., Madiba, T., Middelberg,
S., Plant, G., Streng, J., Thayser, D. and van Rooyen, S. (2014) Financial Management: Turning theory into
practice. 1st Edition. Cape Town: Oxford University Press.
 Conradie, W.M. and Fourie, C.M.W. (2013) Basic Financial Management. 1st Edition. Cape Town: Juta & Co.

H. Special Features
In the Module Guide, you will find the following icons together with a description. These are designed to help you
study. It is imperative that you work through them as they also provide guidelines for examination purposes.

Special Feature Icon Explanation

LEARNING The Learning Outcomes indicate aspects of the particular Unit

OUTCOMES you have to master.

The Associated Assessment Criteria is the evaluation of the

ASSOCIATED students’ understanding which are aligned to the outcomes. The
ASSESSMENT Associated Assessment Criteria sets the standard for the
CRITERIA successful demonstration of the understanding of a concept or
skill.

A Think Point asks you to stop and think about an issue.

THINK POINT Sometimes you are asked to apply a concept to your own
experience or to think of an example.

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 Financial Reporting and Analysis

You may come across Activities that ask you to carry out specific
tasks. In most cases, there are no right or wrong answers to
ACTIVITY
these activities. The purpose of the activities is to give you an
opportunity to apply what you have learned.

At this point, you should read the references supplied. If you are
READINGS unable to acquire the suggested readings, then you are welcome
to consult any current source that deals with the subject.

PRACTICAL
Practical Application or Examples will be discussed to enhance
APPLICATION
understanding of this module.
OR EXAMPLES

You may come across Knowledge Check Questions at the end of

KNOWLEDGE
each Unit in the form of Knowledge Check Questions (KCQ’s)
CHECK
that will test your knowledge. You should refer to the Module
QUESTIONS
Guide or your textbook(s) for the answers.

You may come across Revision Questions that test your

REVISION understanding of what you have learned so far. These may be
QUESTIONS attempted with the aid of your textbooks, journal articles and
Module Guide.

Case Studies are included in different sections in this Module

CASE STUDY Guide. This activity provides students with the opportunity to
apply theory to practice.

VIDEO You may come across links to Videos Activities as well as

ACTIVITY instructions on activities to attend to after watching the video.

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 Financial Reporting and Analysis

Unit
1: Understanding Financial
Statements

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 Financial Reporting and Analysis

Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

1.1 Introduction  Introduce topic areas for the unit

1.2 Role of Financial Statements  Understand the role played by each of the financial
statements

1.3 Users of Financial Statements  Identify the various users of financial statements and
describe the value of the statements to them

1.4 Generally Accepted Accounting  Explain the key concepts of GAAP

Practice

1.5 Value and Limitations of Financial  Discuss the uses and limitations of financial statements
Statements

1.6 Characteristics of Good Financial  Identify the characteristics of good financial statements
Statements

1.7 Classification of Financial Information  Classify financial information into five types of accounts

 explain the terminology applicable to financial statements

1.8 Summarising Financial Information in  Summarise financial information in the financial statements
the Financial Statements

Prescribed / Recommended Readings

 Bartlett, G., Beech, G., de Hart, F., de Jager, P., de Lange, J., Erasmus, P.,
Hefer, J., Madiba, T., Middelberg, S., Plant, G., Streng, J., Thayser, D. and
van Rooyen, S. (2014) Financial Management: Turning theory into practice.
1st Edition. Cape Town: Oxford University Press.

 Lodewyckx, E., Lötter, W., Rhodes, N. and Seedat, C. (2013) Introduction

to Financial Accounting: Fresh Perspectives. 2nd edition. Cape Town:
Pearson.

 Marx, J., de Swardt, C., Smith, M.B. and Erasmus, P. (2014) Financial
Management in Southern Africa. 4th Edition. Cape Town: Pearson
Education.:

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Financial Reporting and Analysis

1.1 Introduction
A financial statement may be defined as a formal record of the financial activities of a business
(www.studymode.com). Relevant financial information is presented in a structured manner and in a form that is
easy to understand. Stated simply, a financial statement is a declaration of what is believed to be true about a
company, communicated in terms of a monetary unit, such as the Rand.

1.2 Role of Financial Statements

Different financial statements focus on different areas of financial performances. The financial statements consist
of the statement of comprehensive income (also called an income statement), statement of financial position (also
called a balance sheet), statement of changes in equity and a statement of cash flows (also called a cash flow
statement). Marx and Swardt (2014:40) outline the role played by these statements as follows:

FINANCIAL STATEMENT REPORTS ON:

Statement of Financial Position Financial position on a certain date.

Statement of Comprehensive Income Financial performance for a particular period i.e.

whether a profit or loss was recorded.

Statement of Changes in Equity Changes to investments by the owners and retained

earnings.

Statement of Cash Flows Cash flows from operating activities, financing

activities and investing activities.

Figure 1Figure 1-1 Financial Statements

1.3 Users of Financial Statements

Businesses have a number of different stakeholders each with a particular area of interest in the financial
statements of the business. Bartlett et al. (2014:676) elaborate on the specific motives of each stakeholder:

1.3.1Owners/Shareholders
They are interested in the financial performance of the business in order to assess the safety of their investments,
profitability and more importantly the potential for future capital growth. Shareholders pay a great deal of attention
to a company’s dividend policy and operational performance when dividends have not been paid.

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 Financial Reporting and Analysis

1.3.2 Banks and other providers of credit

Credit providers are mainly interested in the ability of a business to meet its capital and interest debt repayments
when they fall due.

1.3.3 South African Revenue Services (Government Tax Collection Agency)

South African Revenue Services (SARS) has to ensure that all taxpayers declare and settle their tax liabilities
correctly. Comparative information enables SARS to determine whether anomalies exist in respect of under-
declared income and assets.

1.3.4 Employees
Employees are usually concerned with job security, fair wages and future advancement prospects. They are
thus concerned with the financial sustainability, profitability and growth of the business.

1.3.5 Management
The information from financial statements helps management to plan and control the activities of the business in
a way that will achieve the objectives that have been set.

1.3.6 External auditors

An external auditor is interested in the extent to which a company’s financial statements fairly present its financial
performance and financial position at any given point in time.

1.3.7 Potential investors

Potential investors analyse financial statements to search for good investment opportunities. They often look for
companies whose shares may be undervalued or underperforming companies that, through restructuring and
management changes, could be made profitable again.

1.4 Generally Accepted Accounting Practice (GAAP)

GAAP refers to the standard framework of guidelines for financial accounting and it includes the standards,
conventions, and rules that accountants follow in recording and summarizing financial information and in the
preparation of financial statements.

Marx and Swardt (2014:41) state that financial statements must be prepared according to GAAP so that
standardisation, uniformity and quality in financial reporting may be achieved. In South Africa, statements of
Generally Accepted Accounting Practice are published by the South African Institute of Chartered Accountants
(SAICA). South African statements of GAAP are entirely consistent with International Financial Reporting
Standards (IFRS). IFRS (see Chapter 4) are designed as a common global language for business affairs so that
company financial statements are understandable and comparable across international boundaries.

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Marx and Swardt (2014:41) provide the following brief overview of the key concepts of GAAP:

1.4.1 Accounting entity

Only transactions that relate to the specific entity must be recorded and transactions that do not concern the entity
must be excluded.
1.4.2 Money measurement
The financial position and financial result can only be described accurately and meaningfully if the assets, liabilities,
equity, income and expenses are expressed in terms of money e.g. in South Africa the Rand is the unit of
measurement for all transactions.

1.4.3 Consistency concept

The consistency concept is based on the principle uniformity that prevails in the accounting treatment of like items
within each accounting period and from one period to the next. Any change in methods or policies must be
disclosed together with the financial statements.

1.4.4 Materiality
Information is regarded as material if its omission or misrepresentation could influence the economic decision of
users taken on the basis of the financial statements. Transactions that are not material in relation to the nature
and scope of an entity’s activities need not be taken into account if the cost and difficulty in recording them are not
justified by the resulting benefit.

1.4.5 Historic cost

Assets are recorded at their original cost to the entity.

1.4.6 Double-entry system

For every debit entry there must be a credit entry for the same amount.

1.4.7 Going-concern concept

In terms of the going concern concept it is presumed that the entity will continue to operate in the future. The
amounts reflected in the statement of financial position thus do not reflect the liquidation value of the assets.

1.4.8 Accounting period

The accounting period, which is usually one year, is the period of time chosen to report on the results of operations
and the financial position.

1.4.9 Matching concept

In terms of the matching concept all income earned and expenses incurred to earn the income are matched with
each other to calculate the profit (or loss) for the period for which they relate.

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1.4.10 Conservatism
Conservatism in accounting requires accountants to be conservative when in doubt. When the principle of
conservatism is applied to making judgements, lower profits and asset valuations are estimated rather than higher
values.

1.4.11 Realisation principle

Income must be recorded as soon as it has been earned and realised. To be realised, income must be measurable
and there must be reasonable certainty that it can be recovered. Likewise, expenses must be recorded as soon
as they have been incurred and realised.

1.4.12 Accrual principle

When calculating the profit for a specific period, the income earned during that period (regardless when it was
received) is brought into account and the value consumed during that period as expenses (regardless of when
payment is made) is brought into account.

1.5 Value and Limitations of Financial Statements

1.5.1 Value of financial statements
The financial statements of a company are its primary source of financial information
(www.smallbusiness.chron.com). If one wants to invest in a company and needed to know if the company is
worth the investment, one would study the company’s financial statements.

Financial statements provide information about the financial position, financial performance and changes in
financial position of an enterprise that is useful to a wide range of users in making economic decisions. By
publishing financial statements, companies are able to communicate with interested outside parties about its
accomplishments.

The financial statements reveal a lot to investors regarding the safety and profitability of their investments, the
company’s asset investments, and the company’s outstanding debt and equity components. Debt and equity
investors can thus better understand their relative positions in a company’s capital mix.

1.5.2 Limitations of financial statements

Bartlett et al. (2014:674) identify the following limitations of financial statements:
■ Historical cost: Since financial statements are prepared on the historical cost basis, the net asset value
reflected in the statement of financial position rarely reflects the true economic value of the enterprise.

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Financial Reporting and Analysis

■ Inflation: No adjustments are made to reflect the effect of inflation on the financial results that are reported
in the financial statements. The financial results of the current year cannot be easily compared to its results
to the previous years because currency is not worth the same amount each year.
■ Items that are not accounted for in financial statements: The annual reports of companies are largely
quantitative in nature and do not reflect information that cannot be expressed in monetary value terms. For
example internally generated goodwill, brand values and good corporate wisdom and management are
excluded from financial statements in terms of IFRS.
■ Backward-looking bias: Financial statements do not reflect the future expectations of a business, which
may have an impact on its financial ratios. For example, a company may have won a large profitable
contract or on the other hand may be facing the threat of new major competitors.
■ Accounting policies: Different companies make different choices regarding the application of policies
related to, for example, inventory valuation and depreciation. Furthermore, some values that are reflected
in the financial statements depend on estimates by management, which may differ widely across companies
and distort comparisons.
■ Focus on monetary information: The information contained in financial statements is stated mainly in
monetary terms. The financial reporting does not include, for example, the number of items sold, the total
number of kilometres travelled etc.

1.6 Characteristics of Good Financial Statements

Lodewyckx et al. (2013: 26) identify the following as characteristics that are necessary to ensure that financial
statements of quality are produced:

1.6.1 Understandable
The user should be able to understand the information that the financial statements contain.

Think Point

Suggest ways in which one can make sure that financial statements are
understandable

1.6.2 Relevant
Information is considered to be relevant if it is of assistance to users to make financial decisions. When assessing
the relevance of information, materiality must also be considered. Information is considered material if it is of a
size or nature that will influence the financial decisions of users.

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1.6.3 Prudent
Financial statements often include estimates e.g. the amount of bad debts expected from the balance owing by
debtors. Prudence requires that caution should be exercised when estimates are made. This implies that one
should avoid overstating income and assets and understating expenses and liabilities in the financial statements.

1.6.4 Neutral
Financial statements should be unbiased, based on accounting principles alone and not serving the interests of an
individual. For example, the amount of tax payable is based on the profit (taxable income) of an entity.
Manipulating the profit by showing a lower amount than is the case shows bias towards the entity.

1.6.5 Reliable
Accountants decide which items to include in the financial statements. A recognition test helps with this decision.
They must also decide on the value of the item and this is called measurement. Accountants must use the best
measurement and recognition practices to ensure that the financial statements are reliable.

1.6.6 Complete
Descriptions in words as well as numbers are desirable. Categorising assets and liabilities into non-current and
current helps to form a complete picture of the financial position of an entity.

1.6.7 Comparable
Comparative figures should be included in financial statements i.e. the current year and previous year figures. This
helps the users to compare current performance with the performance of the previous year. Using similar
accounting methods when preparing financial statements also assists users to compare the performance of
different entities of a similar kind.

1.7 Classification of Financial Information

The classification of the vast array of financial information requires a system of accounts. Marx and Swardt (2014:
43) correctly point out that an accountant may use a computerised system or a manual system. Our approach is
to explain manual accounting procedures but the knowledge gained can be applied to any type of automated
accounting system. Any system must provide for five types of accounts, namely:
■ Assets
■ Liabilities
■ Equity
■ Income
■ Expenses

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Financial Reporting and Analysis

Asset, equity and liability accounts are used to determine the financial position of an entity by preparing a statement
of financial position (balance sheet). Income and expense accounts are used to determine the financial
performance (profitability of the entity) by means of a statement of comprehensive income (income statement).

The record in which increases or decreases in any item in the financial statements are noted, is called a ledger
account or simple an account. The entire collection of accounts is called a ledger.

The relationship:
Assets = Equity + Liabilities
is called the accounting equation? Whilst the assets show what the entity owns, the equity and liabilities shows
who supplied the finance and how much each group supplied. Everything that is owned by the entity is funded by
either the owners or creditors. Thus the total claims of the owners plus the claims of the creditors equal the total
assets of the entity. That is why the total assets will always balance the equity and liabilities in the statement of
financial position.

When business events that involve money (called transactions) take place, the flow of accounting information is
summarised in the illustration below:

A business transaction takes place.

A business document is prepared or received.

Information is recorded in journals.

Posting to ledger accounts take place by means of debits and credits.

Financial statements are prepared at the end of the accounting period.

Figure 2Figure 1-2 The flow of information through the accounting system

1.8 Summarising Financial Information In The Financial Statements

The financial information of an enterprise is summarised in financial reports called financial statements. Marx and
Swardt (2014: 43) provide an overview of the typical financial statements viz. statement of comprehensive income,
statement of financial position, statement of changes in equity and cash flow statement.

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 Financial Reporting and Analysis

1.8.1 Statement of Comprehensive Income (Income Statement)

This statement provides a summary of the financial performance (profitability) of an entity for a period of time, by
matching income earned to expenses incurred to obtain that income. Income results from economic benefits
flowing to the entity because of various transactions with third parties, other than the owners of the entity.
Expenses are decreases in economic benefits in the form of outflows or depletion of assets. The following is an
example of a statement of comprehensive income of a sole proprietorship:

Santana Traders
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 28 FEBRUARY 20.14

R
Sales 1 262 000
Cost of sales (700 000)
Gross profit 562 000
Other operating income 62 000
Rent income 60 000
Discount received 2 000
Gross operating income 624 000
Operating expenses (313 850)
Wages 123 000
Bank charges 4 000
Packing materials 37 000
Advertising 18 000
Rates 7 000
Bad debts 2 800
Discount allowed 1 000
Stationery 19 000
Water and electricity 9 000
Insurance 11 500
Telephone 9 900
Depreciation 40 000
Other operating expenses 31 650
Operating profit 310 150
Interest income 0
Interest expense (12 000)
Net profit for the year 298 150

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Financial Reporting and Analysis

Sales reflect the amount that an entity earns through selling products that it has purchased or manufactured.
Cost of sales is the cost of the merchandise sold to customers.

Gross profit is the difference between sales revenue and cost of sales.
Other operating income refers to income, other than sales, generated in the course of ordinary activities of an
entity.

Gross operating income is the sum of the gross profit and other operating income. Operating expenses are the
costs of resources used as part of the operating activities during a financial period and are not directly associated
with specific goods and services. Operating expenses include selling expenses, general and administrative
expenses.

Operating profit is the difference between the gross profit and operating expenses. Interest expense and
interest income must be disclosed separately on the face of the statement of comprehensive income after
operating profit.

Arithmetically, the net profit (or loss) is the difference between income and expenses. Net profit will only result if
the income exceeds expenses.

1.8.2 Statement of Financial Position (Balance Sheet)

The purpose of this statement is to reflect the financial position of an entity on a particular date by reflecting its
assets, equity and liabilities. The following is an example of a statement of financial position of a sole
proprietorship:

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 Financial Reporting and Analysis

Santana Traders
STATEMENT OF FINANCIAL POSITION AS AT 28 FEBRUARY 20.14

ASSETS R

Non-current assets 856 050

Property, plant and equipment 856 050

Current assets 243 700

Inventories 137 000

Trade and other receivables 100 700

Cash and cash equivalents 6 000

Total assets 1 099 750

EQUITY AND LIABILITIES

Equity 934 850

Capital 934 850

Non-current liabilities 72 000

Loan: Len Bank 72 000

Current liabilities 92 900

Trade and other payables 68 900

Current portion of long-term borrowings 24 000

Total equity and liabilities 1 099 750

The following are brief explanations of the items in the statement of financial position:
Assets are the resources that are controlled by an enterprise from which economic benefits will be derived either
now or in the future.

Non-current assets are assets such as land, buildings, vehicles and equipment that have a useful life of more
than one year.

Current assets are assets that are cash or can be converted into cash within one year. Inventory refers to the
merchandise that has been purchased but not yet sold. Trade and other receivables include the amounts owing
by customers for merchandise sold to them on credit and any other amounts owing to the entity. Cash represents
cash on hand and cash kept at the bank.

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Financial Reporting and Analysis

Equity may be viewed as the residual claim that the owner(s) has on the assets of the organisation after all the
liabilities have been settled. It normally consists of two parts viz. that which is invested in the entity and that which
is earned by the entity and left in the entity (i.e. retained profits).

Liabilities are claims on the assets of an organisation. Simply put, it refers to what an organisation owes.

Non-current liabilities are debts that are payable after more than one year from the statement of financial position
date.

Current liabilities refer to debts that are payable within one year from the statement of financial position date.
Trade and other payables include amounts owing to suppliers for merchandise purchased on credit and any other
debt payable within one year from the statement of financial position date. Current portion of long-term borrowings
refers to the portion of the long-term debt that is payable with one year from the statement of financial position
date.

1.8.3 Statement of changes in equity

The statement of changes in equity reflects the changes to the equity during the year. The following is a
simplified format of a statement of changes in equity of a sole proprietorship:
Santana Traders
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED
28 FEBRUARY 20.14
Balance on 28 February 20.13 536 700
Additional capital contributed 100 000
Net profit for the year 298 150
Drawings (0)
Balance on 28 February 20.14 934 850

Balance on 28 February 20.13 includes the investment of the owner in the organisation as well as any retained
profit from the previous year(s).

Additional capital contributed reflects an increase in the investment by the owner in the organisation during the
year.

Profit for the year refers to the net profit available to the owner as calculated in the statement of comprehensive
income.

Drawings for the year reflect the portion of the profit earned which has been withdrawn by the owner for personal
use.

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Balance on 28 February 20.14 shows the value of the equity at the end of the accounting period.

1.8.4 Cash Flow Statement (Statement of Cash Flows)

The purpose of the cash flow statement is to provide information to investors, creditors and other users to assess
the ability of an entity to meet its cash requirements. It shows how changes in the accounts in the statement of
financial position and profit affect cash and cash equivalents. It breaks the analysis down into operating, investing
and financing activities. In short, it reflects the sources of cash and how the cash was used during the year. The
following is an example of a simple cash flow statement:
Santana Traders
CASH FLOW STATEMENT FOR THE YEAR ENDED 28 FEBRUARY 20.14
R
Cash flows from operating activities 278 150
Operating profit 310 150
Non cash flow adjustment: Depreciation 40 000
Profit before working capital changes 350 150
Working capital changes: (60 000)
Increase in inventory (50 000)
Increase in accounts receivable (40 000)
Increase in accounts payable 30 000
Cash generated from operations 290 150
Interest paid (12 000)

Cash flows from investing activities (300 000)

Non-current assets purchased 300 000

Cash flows from financing activities 60 000

Cash received from owner 100 000
Repayment of non-current loan (40 000)
Net increase in cash and cash equivalents 38 150
Cash and cash equivalents at beginning of year (32 150)
Cash and cash equivalents at end of year 6 000

Cash flows from operating activities pertain to the cash flows from an entity’s core business activities, such as
manufacturing, distributing, marketing and selling a product or service. These activities should provide the majority
of a company’s cash flow and will largely determine whether an entity is profitable or not.

Depreciation is added back to profit as it is a book entry and cash is not affected.
The increase in inventory is subtracted because cash was paid to increase inventory.
The increase in accounts receivable is subtracted since it reflects sales that have not yet been received.
The increase in accounts payable is added since cash has not been paid for products or services received.
Cash flows from investing activities reflect the cash used to purchase assets that have a long life.

MANCOSA 20
Financial Reporting and Analysis

Cash flows from financing activities include amounts received from the owner to increase capital and amounts
received (or paid) through long-term borrowing.

The net increase in cash can be verified as it is also equal to the difference in the cash balances at the beginning
and end of the accounting period.

1.9 Self-Assessment Activities

1.9.1 Financial statements of an enterprise are required by various individuals and organizations in order to make
decisions. Explain why each of the following user groups may need accounting information from the
financial statements of an enterprise.
■ Suppliers/Creditors
■ Government
■ Owners
■ Lenders
■ Employees
■ Investment analysts
■ Managers

1.9.2 Match the GAAP concept in COLUMN A with the statement in COLUMN B. Write down the letter of the
correct answer.
COLUMN A COLUMN B
1.9.2.1 Historic cost A Interest on overdraft is shown separately in the financial
statements.
1.9.2.2 Accrual principle B The account of a debtor who is experiencing financial
difficulty is written off.
1.9.2.3 Conservatism C An entry is made immediately in the books for an invoice
received for goods purchased.
1.9.2.4 Materiality D The method and rate of depreciation on vehicles is the
same as the previous years.
1.9.2.5 Realisation principle E Rent income for the last month of the financial year was
not yet received but was taken into consideration to
calculate the net profit.
1.9.2.6 Consistency F Land and buildings are reported in the financial
statements at the purchase price of R500 000 even
though they are worth R800 000 today.

21 MANCOSA
 Financial Reporting and Analysis

1.9.3 Your friend has picked up on the following issues in the financial statements of his business, prepared
by his accountant. What advice would you give him with regard to each of the following:
■ The financial statements contain information on the last financial year only.
■ There are no sub-categories for assets and liabilities in the statement of financial position.
■ The land and buildings are reported at the price paid for them twenty years ago.

1.9.4 Define the following terms:

■ Assets
■ Current assets
■ Non-current assets
■ Liabilities
■ Non-current liabilities
■ Current liabilities
■ Equity
■ Income
■ Expenses
■ Profit
■ Cash flow from operating activities
■ Cash flow from investing activities
■ Cash flow from financing activities

1.9.5 Describe the function of each of the following financial statements:

■ Statement of Financial Position
■ Statement of Comprehensive Income
■ Statement of Changes in Equity
■ Statement of Cash Flows

1.9.6 REQUIRED
Use the information given below to prepare the Statement of Financial Position as at 07 January 20.15 after the
transactions for the week ended 07 January 20.15 are taken into account.

MANCOSA 22
Financial Reporting and Analysis

INFORMATION
The balance sheet of a business as at 01 January 20.15 included the following items:

R
Equity 3 045 000
Equipment 3 120 000
Inventories 420 000
Bank overdraft 645 000
Trade and other receivables 495 000
Trade and other payable 345 000

Transactions
During the week ended 07 January 20.12 the following transactions took place:
■ Inventories were sold for R165 000 cash; these inventories had cost R120 000.
■ Sold inventories for R345 000 on credit; these inventories had cost R255 000.
■ Received cash from debtors totalling R270 000.
■ The owners introduced R1 500 000 cash into the business.
■ Ten computers were purchased on credit, R150 000.
■ Bought inventories on credit for R210 000.
■ Paid creditors a total amount of R195 000 in settlement of accounts.

1.10 Solutions

Think Point

THINK POINT 1!
Answers may vary and may include the following:
The statement of financial position or statement of comprehensive income should fit
in a single page so that the financial position or the financial performance can be
observed with a glance.
Individual items in the financial statements may be described in greater detail in
separate notes to the financial statements.
Explain the accounting methods that have been used to value certain items.
Explain any unusual event such as a correction of an error from the previous year

23 MANCOSA
 Financial Reporting and Analysis

1.9.1
■ Suppliers/Creditors: To assess the ability of the business to pay for the goods and services provided.
■ Government: To assess the amount of tax the business should pay.
■ Owners: To assess how effectively the business is managed and to make judgements about likely levels
of risk and return in the future.
■ Lenders: To assess the ability of the business to pay interest and the principal sum lent.
■ Employees: To assess the ability of the business to provide employment and to reward them for their
labour.
■ Investment analysts: To assess the possible risks and returns associated with the business in order to
determine its investment potential, so that they could advise their clients accordingly.
■ Managers: To assist them in making decisions and plans for the business and to help them to exercise
control to ensure that plans succeed.

1.9.2
1.9.2.1 F
1.9.2.2 E
1.9.2.3 B
1.9.2.4 A
1.9.2.5 C
1.9.2.6 D

1.9.3
■ The financial statements contain information on the last financial year only.
The financial statements for an accounting period (e.g. the last financial year) are supposed to report on the
results of operations and financial position that relate that that period. However, the figures of the previous
year should also have been provided to facilitate a comparison of performance.

■ There are no sub-categories for assets and liabilities in the statement of financial position.
Assets and liabilities should be categorised as current and non-current to facilitate interpretation.

■ The land and buildings are reported at the price paid for them twenty years ago.
In terms of the historic cost concept, this is correct otherwise the value can be manipulated in favour of a
particular person (bias).

1.9.4 Refer to paragraphs 1.8.1, 1.8.2 and 1.8.4

1.9.5 Refer to Figure 1-1

MANCOSA 24
Financial Reporting and Analysis

1.9.6
R
Equity 3 045 000 + 165 000 – 120 000 + 345 000 – 255 000 + 1 500 000
= 4 680 000
Equipment 3 120 000 + 150 000 = 3 270 000
Inventories 420 000 - 120 000 – 255 000 + 210 000 = 255 000
Bank overdraft 645 000 - 165 000 – 270 000 – 1 500 000 + 195 000
= 1 095 000 DR (favourable balance)
Accounts receivable 495 000 + 345 000 – 270 000 = 570 000
Accounts payable 345 000 + 150 000 + 210 000 – 195 000 = 510 000

Statement of Financial Position as at 07 January 20.15

ASSETS

Non-current assets

Property, plant and equipment 3 270 000

Current assets 1 920 000

Inventories 255 000

Trade and other receivables 570 000

Cash and cash equivalents 1 095 000

Total assets 5 190 000

EQUITY AND LIABILITIES

Equity 4 680 000

Current liabilities

Trade and other payables 510 000

Total equity and liabilities 5 190 000

25 MANCOSA
 Financial Reporting and Analysis

Unit
2: Statements of a Sole Proprietorship

MANCOSA 26
Financial Reporting and Analysis

Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

2.1 Introduction  Introduce topic areas for the unit

2.2 Pre-Adjustment Trial Balance  Understand the pre-adjustment trial balance

2.3 Year-end adjustments  Identify the year -end adjustments

2.4 Preparing Financial Statements from  Prepare financial statement from pre-adjustment
a Pre-adjustment Trial Balance and adjustment trial balance
additional information

Prescribed / Recommended Readings

Kew, J and Warson, A. (2013) Financial Accounting: An Introduction. 4th

edition. Cape Town: Oxford University Press.

Lodewyckx, E., Lötter, W., Rhodes, N. and Seedat, C. (2013) Introduction to

Financial Accounting: Fresh Perspectives. 2nd edition. Cape Town: Pearson.

27 MANCOSA
 Financial Reporting and Analysis

2.1 Introduction
Before the stage is reached where one is ready to prepare the financial statements of an entity, the following events
would have already taken place
 Transactions occurred during the financial year.
 Transaction data were entered on source documents.
 Transactions were recorded in journals from the source documents.
 Information from the journals was posted to ledger accounts.

A trial balance was prepared to determine whether the double-entry principle has been correctly applied during the
posting process

The financial statements can only be prepared after adjustments are made to the amounts in the trial balance, in
order to comply with the GAAP concepts discussed in topic 1 (paragraph 1.4).

2.2 Pre-Adjustment Trial Balance

A pre-adjustment trial balance is a list of accounts and their balances at a given time. It is usually prepared at the
end of an accounting period. The accounts are listed in the order in which they appear in the general ledger. The
trial balance includes debit balances listed in the left column and credit balances in the right column. The totals of
the two columns must be equal. The main purpose of trial balance is to check that the total of all debit entries is
equal to the total of all credit entries after posting has been completed.
The following is an example of a pre-adjustment trial balance:

Simmonds Traders
PRE-ADJUSTMENT TRIAL BALANCE AS AT 28 FEBRUARY 20.15
Debit (R) Credit (R)
Balance sheet accounts section
Capital 1 264 804
Drawings 116 014
Land and buildings at cost 818 720
Equipment at cost 546 000
Vehicles at cost 350 000
Accumulated depreciation on equipment 176 400
Accumulated depreciation on vehicles 88 200
Fixed deposit: Rio Bank (10% p.a.) 28 000
Trading inventory 84 000
Debtors control 106 400
Provision for bad debts 4 800
Bank 10 000
Petty cash 1 120
Creditors control 131 600

MANCOSA 28
Financial Reporting and Analysis

Loan: Rio Bank (16% p.a.) 64 400

Nominal accounts section
Sales 1 432 480
Cost of sales 795 100
Sales returns 25 200
Advertising 16 800
Consumable stores 22 400
Bad debts 6 160
Discount allowed 9 800
Discount received 5 040
Electricity and water 50 400
Telephone 24 000
Interest on fixed deposit 1 680
Interest on overdraft 840
Insurance 8 400
Salaries 161 040
Bank charges 5 180
Rent income 43 470
Municipal rates 27 300
3 212 874 3 212 874
Figure 3Figure 1 Pre-Adjustment Trial Balance

The accounts in the balance sheet accounts section are used to prepare the statement of financial position. The
accounts in the nominal accounts section are used to prepare the statement of comprehensive income.

The following is an explanation of the accounts in the balance sheet accounts section:
Capital: represents the amount invested by the proprietor plus the profits that has been retained in the business.

Drawings: refers to the cash, inventories etc. that the proprietor may have taken from the business during the
financial year for his/her personal use.

Land and buildings, Equipment and Vehicles at cost: reflect the purchase price of these assets i.e. their
original cost prices.

Accumulated depreciation on equipment and Accumulated depreciation on vehicles: Property, plant and
equipment lose value each year through usage and after a certain number of years they become obsolete. In
accordance with the matching principle, the cost of property, plant and equipment must be written off during the
period it is expected to be economically useful. As a result an expense called depreciation is provided for each
year on assets like equipment, vehicles and machinery. An account called Accumulated depreciation (with the
type of asset attached to it e.g. equipment) is created to reflect the amount of depreciation recorded each year.
This account thus shows the cumulative total of the depreciation recorded on the asset since the date of purchase.

29 MANCOSA
 Financial Reporting and Analysis

Fixed deposit: Rio Bank (10% p.a.): The business invested R28 000 in an investment account at the bank,
earning interest at 10% per annum.

Trading inventory: is the cost price of the merchandise (that was purchased for resale) that has not been sold.

Debtors control: is the amount owing by the customers, to whom merchandise has been sold on credit.

Provision for bad debts: A provision is made for the portion of the amount owing by debtors, that the entity
expects that it will not be able to collect (i.e. bad debts).

Bank: The entity has R10 000 in its bank account.

Petty cash: R1 120 is set aside to make payments for small amounts, in order to save on bank charges.

Creditors control: R131 600 is owing to suppliers for credit purchases (mainly inventories for resale).

Loan: Rio Bank (16% p.a.): R64 400 is owing to Rio Bank and interest at a rate of 16% per annum is payable.

The following is an explanation of the accounts in the nominal accounts section:

Sales: include the cash and credit sales made during the year but excludes the returns of merchandise by
debtors.

Cost of sales: refers to the cost price of the merchandise sold. When an entity uses the perpetual inventory
system, the cost of sales is recorded each time a sales transaction occurs. A cost of sales account thus exists (as
is the case in the trial balance above).

If an entity uses the periodic inventory system, the cost of sales is not recorded when a sales transaction takes
place. In this case, the cost of sales may be calculated as follows:
Opening inventory (Inventory at the end of the previous year) 100 000
Purchases 750 000
Carriage on purchases (delivery costs for merchandise purchased) 29 100
Cost of inventory available for sale 879 100
Closing inventory (Inventory at the end of the current year) (84 000)
Cost of sales 795 100
Any costs that are incurred to purchase the goods (e.g. import duties) must also be included.

Sales returns: Merchandise returned by debtors is recorded in this account. When the financial statements are
prepared the returns are deducted from sales to reflect the net sales for the period.

MANCOSA 30
Financial Reporting and Analysis

Advertising and the other accounts in the debit column of the nominal accounts section: are the other
expenses of the entity. Interest expenses such as interest in overdraft are not considered to be operating expenses
and are thus disclosed separately from them.

Discount received, Interest on fixed deposit and Rent income: (accounts in the credit column of the nominal
accounts section) are the other income accounts of the entity. Interest income accounts such as interest on fixed
deposit are not considered to be operating income and are therefore disclosed separately from them.

2.3 Year-End Adjustments

The transactions that are recorded and posted during the year don’t always relate to the same financial year. In
addition, some transactions relating to a financial year are not recorded because the amounts have not yet been
received or paid. As a result, adjustments need to be made to accounts to reflect the correct amounts in
determining the profit and the financial position of a business. New accounts may be created during this process.
Only after accounts have been adjusted can the financial statements be prepared. Lodewyckx et al. (2013: 51)
identify adjustments that need to be made in respect of the following:

2.3.1 Bad debts

At the end of the financial year, the overdue accounts of debtors are often reviewed and should the proprietor or
manager conclude that the possibility of recovering the debt from the debtor is remote, authorisation is given for
the account to be written off as a bad debt. Effect:
Bad debts (expense) +
Debtors control –

2.3.2 Provision for bad debts

In terms of the amount owing for the credit sales that took place during the financial year, it is usually expected
that a certain portion will not be collected in the next financial year (bad debts). In terms of the accrual principle, a
provision must be made by means of an adjustment entry for these bad debts that may be written off in the next
financial year. The following examples illustrate the creation, increase and decrease in provision for bad debts.
Creation of provision for bad debts
Provision for bad debts adjustment (reflect as an expense)
Provision for bad debts +

Increase in provision for bad debts

Provision for bad debts adjustment (reflect as an expense)
Provision for bad debts +

Decrease in provision for bad debts

Provision for bad debts adjustment (reflect as an income)
Provision for bad debts –

31 MANCOSA
 Financial Reporting and Analysis

2.3.3 Depreciation
As indicated in paragraph 2.2 an expense called depreciation is provided for each year on assets like equipment,
vehicles and machinery. This provision for depreciation is made at the end of the financial year except when the
asset is sold. When an asset is purchased during the financial year, depreciation is provided only for the part of
the year that it was used.

The two most popular methods of calculating depreciation are the fixed instalment method and the diminishing
balance method. When using the fixed instalment method the cost of the asset is written off each year in equal
amounts over its expected economic life. Equal amounts of depreciation each year can be obtained by calculating
a fixed percentage on the cost price e.g. depreciation is calculated at 20% p.a. on cost. When using the
diminishing balance method, a percentage is applied to the carrying value of the asset. Note:
(Carrying value = Cost – Accumulated depreciation).

Effect:
Depreciation (expense)+
Accumulated depreciation +

2.3.4 Accrued income

Accrued income (also called income receivable) refers to income that has been earned during the financial year
but has not yet been received. In terms of the matching concept and accrual principle, any income that has been
earned but not yet received must be brought in to account during the current financial year.

Effect:
Income account +
Accrued income +

Accrued income is included in the statement of financial position as part of “Trade and other receivables” under
current assets.

2.3.5 Accrued expenses

Accrued expense (also called expenses payable) refers to an expense that has been incurred during the financial
year but has not yet been paid. In terms of the matching concept and accrual principle, any expense that has been
incurred but not yet paid must be brought in to account during the current financial year. Effect:
Expense account +
Accrued expenses +
Accrued expenses is included in the statement of financial position as part of “Trade and other payables” under
current liabilities.

MANCOSA 32
Financial Reporting and Analysis

2.3.6 Prepaid expenses

Prepaid expense arises when an expense is paid for in the current financial year but the whole or part of the
expense relates to the next accounting period. In terms of the matching concept, an adjustment needs to be made
so that only the amount relating to the current financial year is transferred to the statement of comprehensive
income. Effect:
Expense account –
Prepaid expenses +
Prepaid expenses is included in the statement of financial position as part of “Trade and other receivables” under
current assets.

2.3.7 Income received in advance

Income received in advance (also called deferred income) arises when income is received in the current financial
year but it relates to the next accounting period. Once again in terms of the matching concept, an adjustment
needs to be made so that only the amount relating to the current financial year is transferred to the statement of
comprehensive income. Effect:
Income account –
Income received in advance +
Income received in advance is included in the statement of financial position as part of “Trade and other payables”
under current liabilities.

2.3.8 Consumable inventory

During the financial year the business may purchase various kinds of consumable items e.g. stationery, packing
materials. At the end of the financial year it is possible that some of these consumable items may be found to be
unused during stocktaking. In terms of the matching concept, the unused consumable items (consumable
inventory) cannot be regarded as an expense for the current financial year. An adjustment thus needs to be made
so that only the amount used during the current financial year is transferred to the statement of comprehensive
income. Effect:
Consumable item account e.g. Stationery (expense) –
Consumable inventory +
Consumable inventory is included in the notes to the financial statements under Inventories.

2.4 Preparing Financial Statements from A Pre-Adjustment Trial Balance and Additional Information
(Including Adjustments)
We are going to examine the effects of year-end adjustments (and additional information provided) on the financial
statements without going through the account system.

It sometimes becomes necessary to draw up financial statements by taking the above year-end adjustments into
account but before these adjustments are posted. If financial statements are required urgently e.g. for decision-

33 MANCOSA
 Financial Reporting and Analysis

making purposes, they may have to be done directly from the balances available and the adjustments that are
necessary.

There are various methods that may be used for taking adjustments into account (without journalising and posting
them) to prepare the financial statements. The method that we recommend is to draw up the financial statements
in a logical manner from the adjustments and information provided. When using this method, the following steps
may be followed:

Prepare the formats of the financial statements viz. statement of comprehensive income, statement of changes in
equity, statement of financial position and notes to the financial statements without entering any amounts.

Now take the figures from the pre-adjustment trial balance and write them down next to the relevant detail in the
financial statements.

Study each adjustment and taking into account the double-entry principle, make the adjustments to the amounts
you have entered (in the previous step).

After adjusting the pre-adjusted amounts, enter the final figures and complete the financial statements with the
necessary calculations.

This is illustrated using the following example:

Required
 Use the information given below for Madida Traders (owner M. Madida) to prepare the:
 Statement of Comprehensive Income for the year ended 28 February 20.15.
 Statement of Changes in Equity for the year ended 28 February 20.15.

Statement of Financial Position as at 28 February 20.15.

Notes to the financial statements for the year ended 28 February 20.15
Note: Madida Traders uses the periodic inventory system.

MANCOSA 34
Financial Reporting and Analysis

Ensure that the financial statements comply with the requirements of statements of Generally Accepted
Accounting Practice (GAAP).

Information
Madida Traders
PRE-ADJUSTMENT TRIAL BALANCE AS AT 28 FEBRUARY 20.15
Debit (R) Credit (R)
Balance Sheet Accounts Section
Capital 596 400
Drawings 130 500
Land and buildings 600 000
Equipment 145 000
Accumulated depreciation on equipment (01 March 20.14) 33 000
Fixed deposit: Ben Bank (8% p.a.) 50 000
Loan: Zen Bank (16% p.a.) 60 000
Debtors control 51 630
Creditors control
Bank 18 720 74 400
Cash float 1 500

Nominal accounts section

Sales 841 600
Opening inventory 105 330
Purchases 408 760
Sales returns 6 000
Purchases returns 4 500
Rent income 80 400
Interest on fixed deposit 2 000
Bank charges 2 700
Water and electricity 18 810
Telephone 5 250
Insurance 5 850
Interest on loan 7 250
Rates and taxes 24 600
Salaries and wages 84 640
Consumable stores 10 960
Advertising 14 800
1 692 300 1 692 300

Adjustments and additional information

1. Inventory on hand on 28 February 20.15 amounted to R91 000. Inventories are measured at cost, on a
FIFO method and at net realisable value, whichever is the lower.
2. Consumable stores according to stocktaking on 28 February 20.15 amounted to R900.

35 MANCOSA
 Financial Reporting and Analysis

3. Advertising included a payment of R1 080 for advertisements to appear in a local newspaper from 01
November 20.14 to 30 April 20.15.
4. Depreciation is provided annually on equipment at 10% p.a. using the diminishing balance method.
5. The loan from Zen bank is an unsecured loan that was granted to Madida Traders on
01 February 20.14. Provide for the outstanding interest on loan. The loan is repayable in 10 equal annual
instalments. The first instalment is payable on 31 March 20.15.
6. The investment at Ben Bank was made on 01 June 20.14. Provide for the outstanding interest on the
fixed deposit. The fixed deposit matures on 01 June 20.15.
7. The tenant has already paid the rent for March 20.15. Note that the monthly rental of R6 000 was
increased by 10% with effect from 01 December 20.14.
8. A debit order for R500 for the insurance of the proprietor’s home was erroneously entered in the insurance
account.
9. A debtor who owed R800 has been declared insolvent. His estate paid a first and final dividend of 70
cents in the Rand. The balance of his account must be written off. No entries have been made for these
transactions.
10. A debtor’s account with a credit balance of R200 must be transferred to her account in the creditors’
ledger.

MANCOSA 36
Financial Reporting and Analysis

Solution
Madida Traders
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED
28 FEBRUARY 20.15
R
Sales (841 600-6 000) 835 600
Cost of sales (418 590)
Opening inventory (105 330) 105 330
Purchases (408 760-4 500) 404 260
Closing inventory (91 000)
Gross profit 417 010
Other operating income 73 800
Rent income (80 400-6 600) 73 800
Gross operating income 490 810
Operating expenses (177 290)
Bank charges (2 700) 2 700
Water and electricity (18 810) 18 810
Telephone (5 250) 5 250
Insurance (5 850-500) 5 350
Rates and taxes (24 600) 24 600
Salaries and wages (84 640) 84 640
Consumable stores (10 960-900) 10 060
Advertising (14 800-360) 14 440
Depreciation 11 200
Bad debts 240
Operating profit 313 520
Interest income (2 000+1 000) 3 000
Interest expense (7 250+2 350) (9 600)
Net profit for the year 306 920

37 MANCOSA
 Financial Reporting and Analysis

REMARKS
The effects of the adjustments and additional information on the financial statements are as follows:
Effect on the Statement of Comprehensive Effect on the Statement of Financial Position,
Income Statement of Changes in Equity and Notes to the
financial statements

1. Closing inventory R91 000 Merchandise R91 000 (Note 4)

2. Consumable stores – R900 Consumable inventory R900 (Note 4)

3. Advertising –R360 (R1 080 X 2/6) Prepaid expenses R360

4. Depreciation R11 200 Depreciation for the year R11 200 (Note 2)

([R145 000 – 33 000] X 10%)

5. Interest expense + R2 350 Accrued expenses R2 350

(60 000 X 16%) = R9 600 – R7 250 R6 000 is the current portion of loan

= R2 350

6. Interest income + R1 000 Accrued income R1 000

(50 000 X 8% X 9/12) Fixed deposit reflected as non-current asset as it

matures in more than 12 months’ time
= R3 000 – 2 000 = 1 000

7. Rent income – R6 600 Income received in advance R6 600

8. Insurance – R500 Drawings +R500

9. Bad debts +R240 Trade debtors –R240 –R560

(R800 X 30%) Bank +R560

10. No change Trade debtors +R200

Trade creditors +R200

Madida Traders
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 28 FEBRUARY 20.15
R
Balance on 28 February 20.14 596 400
Net profit for the year 306 920
Drawings (130 500 + 500) (131 000)
Balance on 28 February 20.15 772 320

MANCOSA 38
Financial Reporting and Analysis

Madida Traders
STATEMENT OF FINANCIAL POSITION AS AT 28 FEBRUARY 20.15
Note R
ASSETS
Non-current assets 750 800

Property, plant and equipment 2 700 800

Financial assets (50 000) 3 50 000
Current assets 165 070
Inventories 4 91 900
Trade and other receivables 52 390
Trade debtors (51 630 – 240 – 560 + 200) 51 030
Prepaid expenses (360) 360
Accrued income (1 000) 1 000

Cash and cash equivalents 20 780

Bank (18 720 + 560) 19 280
Cash float (1 500) 1 500
Total assets 915 870

EQUITY AND LIABILITIES

Equity 772 320
Capital 772 320
Non-current liabilities 54 000
Long-term borrowings 5 54 000
Current liabilities 89 550
Trade and other payables 83 550

Trade creditors (74 400 + 200) 74 600

Income received in advance (6 600) 6 600
Accrued expenses (2 350) 2 350
Current portion of long-term borrowings 5 6 000
Total equity and liabilities 915 870

39 MANCOSA
 Financial Reporting and Analysis

NOTES TO THE FINANCIAL STATEMENTS

1. Accounting policy
The accounting policy of Madida Traders is consistent with that of the previous year, and is as follows:
1.1 Measurement basis
The financial statements are based on the historical cost and comply with Generally Accepted Accounting
Practice.

1.2 Property, plant and equipment

Equipment is written off at 10% per annum on the diminishing balance.

1.3 Inventories
Inventories are measured at the lower of cost, on the FIFO method, and net realisable value, whichever is lower.

2. Property, plant and equipment

Land and
buildings Equipment Total
Carrying value at beginning of year 600 000 112 000 712 000
Cost 600 000 145 000 745 000
Accumulated depreciation (33 000) (33 000)
Depreciation for the year (11 200) (11 200)
Carrying value at end of year 600 000 100 800 700 800
Cost 600 000 145 000 745 000
Accumulated depreciation (44 200) (44 200)

3. Financial assets
Fixed deposit: Ben Bank (8% p.a.) 50 000
50 000

4. Inventories
Inventories consist of:
Merchandise 91 000
Consumable inventory 900
91 900

MANCOSA 40
Financial Reporting and Analysis

5. Long term borrowings

Unsecured
Loan from Zen Bank. Interest rate is 16% p.a. 60 000
Less: Instalment payable within one year, transferred to current liabilities (6 000)
54 000

2.5 Self-Assessment Activities

Use the given information for Ajax Traders to prepare the:

 Statement of Comprehensive Income for the year ended 28 February 20.15.

 Statement of Changes in Equity for the year ended 28 February 20.15.
 Statement of Financial Position as at 28 February 20.15.
 Notes to the financial statements for the year ended 28 February 20.15.
Note: Ajax Traders uses the perpetual inventory system.
Ensure that the financial statements comply with the requirements of statements of Generally
Accepted Accounting Practice (GAAP)

41 MANCOSA
 Financial Reporting and Analysis

Information
Ajax Traders
PRE-ADJUSTMENT TRIAL BALANCE AS AT 28 FEBRUARY 20.15
Debit (R) Credit (R)
Balance Sheet Accounts Section
Capital 395 700
Drawings 87 000
Land and buildings 400 000
Equipment 90 000
Accumulated depreciation on equipment (01 March 20.14) 22 000
Fixed deposit: Ben Bank (12% p.a.) 40 000
Loan: Zen Bank (16% p.a.) 40 000
Trading inventory 70 220
Debtors control 34 420
Provision for bad debts 1 900
Creditors control 49 600
Bank 12 480
Cash float 1 000

Nominal Accounts Section

Sales 563 000
Cost of sales 298 000
Sales returns 4 000
Rent income 52 800
Interest on fixed deposit 3 200
Bank charges 1 800
Water and electricity 12 540
Telephone 3 500
Insurance 3 900
Interest on loan 7 500
Rates and taxes 16 400
Salaries and wages 40 640
Consumable stores 1 600
Advertising 3 200
1 128 200 1 128 200

MANCOSA 42
Financial Reporting and Analysis

Adjustments and additional information

1. According to a physical stocktaking the following inventories were on hand on
28 February 20.15:
Merchandise R69 000
Consumable stores R200.

2. Rates and taxes included a payment of R4 080 for the period 01 January 20.15 to
30 June 20.15.

3. Depreciation is provided annually on equipment at 10% p.a. using the diminishing balance method. Note:
Equipment costing R30 000 was purchased on credit on

01 February 20.15. The purchase has not been recorded.

4. Rent for February 20.15 is still outstanding.

5. A portion of the interest on loan has been paid in advance. The unsecured loan was obtained on 28
February 20.14. Equal annual repayments of R10 000 will commence on 01 March 20.15.

6. On 28 February 20.15, a cheque of R500 was received from O. Henry whose account was previously
written off as irrecoverable. No entry has been made for this.

7. A debtor, A. Donald who owed R800, is declared insolvent. His estate paid Ajax Traders a first and final
dividend of 60 cents in the Rand. This has been recorded. The balance of his account must now be
written off.

8. The provision for bad debts must be adjusted to 5% of trade debtors.

9. The fixed deposit at Ben Bank was made on 01 March 20.14 and matures on 30 June 20.15. Provide for
the outstanding interest on fixed deposit.

10. Service fees according to the bank statement for February 20.15 have not yet been recorded, R160.

11. The telephone account for February 20.15 has not yet been paid, R320

43 MANCOSA
 Financial Reporting and Analysis

2.6 SUGGESTED SOLUTIONS

Ajax Traders
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED
28 FEBRUARY 20.15
R
Sales (563 000 – 4 000) 559 000
Cost of sales (298 000) (298 000)
Gross profit 261 000
Other operating income 58 295
Rent income (52 800 + 4 800) 57 600
Bad debts recovered 500
Provision for bad debts adjustment (1 900 – 1 705) 195
Gross operating income 319 295
Operating expenses (89 730)
Bank charges (1 800 + 160) 1 960
Water and electricity (12 540) 12 540
Telephone (3 500 + 320) 3 820
Insurance (3 900) 3 900
Rates and taxes (16 400 – 2 720) 13 680
Salaries and wages (40 640) 40 640
Consumable stores (1 600 – 200) 1 400
Advertising (3 200) 3 200
Trading inventory deficit (70 220 – 69 000) 1 220
Depreciation 7 050
Bad debts 320
Operating profit 229 565
Interest income : on fixed deposit (3 200 + 1 600) 4 800
Interest expense : on loan (7 500 – 1 100) (6 400)
Net profit for the year 227 965

MANCOSA 44
Financial Reporting and Analysis

REMARKS
The effects of the adjustments and additional information on the financial statements are as follows:
Effect on Statement of Comprehensive Effect on Statement of Financial Position,
Income Statement of Changes in Equity and Notes to
the financial statements
1. Trading inventory deficit Merchandise (Note 4) R69 000
(R70 220–R69 000) = R1 220
(Loss incurred through shortfall in inventory.)
Consumable stores – R200
Consumable inventory (Note 4) R200
2. Rates and taxes – R2 720 (4 080 X 4/6) Prepaid expenses R2 720
3. Depreciation R7 050 (R6 800 + R250) Depreciation for the year R7 050 (note 2)
Old: (90 000-22 000) X 10% = R6 800 Purchase of equipment:
New: 30 000 X 10% X 1/12 = R250 * “Additions at cost” R30 000
* Trade creditors +R30 000
4. Rent income +R4 800 (R52 800/11) Accrued income R4 800
5. Interest expense – R1 100 Prepaid expenses R1 100
(R7 500 – R6 400) R10 000 to be shown as current portion of loan
R40 000 X 16% = R6 400 (interest for the year) (payment due in less than 12 months)
6. Bad debts recovered R500 Bank + R500
7. Bad debts +R320 (R800 X 40%) Trade debtors – R320
8. Provision for bad debts – R195 Provision for bad debts:
(R1 900 – R195) = R1 705
Provision for bad debts has decreased. (R34 420 – R320) X 5% = R1 705
9. Interest income +R1 600 Accrued income R1 600
(R4 800 – R3 200) Fixed deposit matures in less than 1 year and is
R40 000 X 12% = R4 800 (interest for year) thus part of Cash & cash equivalents
10. Bank charges + R160 Bank – R160
11. Telephone + R320 Accrued expenses R320

45 MANCOSA
 Financial Reporting and Analysis

Ajax Traders
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 28 FEBRUARY 20.15
R
Balance on 28 February 20.14 395 700
Net profit for the year 227 965
Drawings (87 000)
Balance on 28 February 20.15 536 665

Ajax Traders

STATEMENT OF FINANCIAL POSITION AS AT 28 FEBRUARY 20.15

Note R
ASSETS
Non-current assets 490 950
Property, plant and equipment 2 490 9500
Current assets 165 635
Inventories 3 69 200
Trade and other receivables 42 615
Trade debtors (34 420 – 320) 34 100
Provision for bad debts (1 900 – 195) (1 705)
Prepaid expenses (2 720 + 1 100) 3 820
Accrued income (4 800 + 1 600) 6 400
Cash and cash equivalents 53 820
Fixed deposit: Ben Bank (12% p.a.) 40 000
Bank (12 480 + 500 – 160) 12 820
Cash float (1 000) 1 000
Total assets 656 585

MANCOSA 46
Financial Reporting and Analysis

EQUITY AND LIABILITIES

Equity 536 665
Capital 536 665
Non-current liabilities 30 000
Long term borrowings 4 30 000
Current liabilities 89 920
Trade and other payables 79 920
Trade creditors (49 600 + 30 000) 79 600
Accrued expenses (320) 320
Current portion of long term borrowings 4 10 000
Total equity and liabilities 656 585

NOTES TO THE FINANCIAL STATEMENTS

1. Accounting policy
The accounting policy of Ajax Traders is consistent with that of the previous year, and is as follows:
1.1 Measurement basis
The financial statements are based on the historical cost and comply with Generally Accepted Accounting
Practice.
1.2 Property, plant and equipment
Equipment is written off at 10% per annum on the diminishing balance.
1.3 Inventories
Inventories are measured at the lower of cost, on the FIFO method, and net realisable value, whichever is lower.

2. Property, plant and equipment

Land and
buildings Equipment Total
Carrying value at beginning of year 400 000 68 000 468 000

Cost 400 000 90 000 490 000

Accumulated depreciation (22 000) (22 000)
Additions at cost 30 000 30 000
Depreciation for the year (7 050) (7 050)
Carrying value at end of year 400 000 90 950 490 950
Cost 400 000 120 000 520 000
Accumulated depreciation (29 050) (29 050)

47 MANCOSA
 Financial Reporting and Analysis

3. Inventories

Inventories consist of:

Merchandise (70 220 – 1220) 69 000
Consumable inventory 200
69 200

4. Long term borrowings

Unsecured
Loan from Zen Bank payable in equal instalments commencing 01 March 20.15. Interest rate is
16% p.a. 40 000
Less: Instalment payable within one year, transferred to current liabilities (10 000)
30 000

MANCOSA 48
 Financial Reporting and Analysis

Unit
3: Financial Statements
of a Partnership

49 MANCOSA
 Financial Reporting and Analysis

Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

3.1 Introduction  Introduce topic areas for the unit

3.2 Equity accounts in a partnership  Identify the equity accounts pertaining to a partnership

3.3 Sharing profits in a partnership  Perform the necessary calculation related to the
appropriation of the profit between partners

3.4 Preparation of the financial  Prepare the financial statements of a partnership

statements of partnership

Prescribed / Recommended Readings

 Kew, J and Warson, A. (2013) Financial Accounting: An introduction. 4th

edition. Cape Town: Oxford University Press.

 Lodewyckx, E., Lötter, W., Rhodes, N. and Seedat, C. (2013) Introduction

to Financial Accounting: Fresh Perspectives. 2nd edition. Cape Town:
Pearson.

MANCOSA 50
Financial Reporting and Analysis

3.1 Introduction
A partnership is an agreement between two or more persons who invest in a business with the aim of making a
profit, which is subsequently shared. A partnership, like a sole proprietorship, is not a separate legal entity.
Consequently, a partnership cannot own assets, incur liabilities, enter into contracts, sue or be sued. Instead, the
rights and obligations of a partnership are vested in the partners.

The accounting entries related to income, expenses, assets and liabilities of a partnership are the same as for a
sole proprietorship. The differences between sole proprietorships and partnerships relate to the recording and
reporting of transactions involving the sharing of profit and equity.

For the purposes of this module, the examples will be restricted to partnerships that have two partners. However,
the same accounting procedures apply if there are more than two partners.

3.2 Equity Accounts in A Partnership

According to Lodewyckx et al. (2013:266) the equity of a partnership includes the capital accounts and the current
accounts. Separate capital accounts are opened for each partner. Capital contributed by each partner may be
in the form of cash or other assets and is credited to the respective capital account of the partner. The capital
accounts are used strictly for capital contributions or capital decreases.

Current accounts are also opened for each partner. These accounts are used to record items such as salaries,
bonuses, interest on capital, interest on drawings and the share of profits or losses that belong to each partner.
The drawings of each partner (e.g. withdrawals of cash, trading inventory etc.) are also recorded in separate
accounts. The drawings accounts are closed off to the respective current accounts of the partners at the end of
the financial year.

3.3 Sharing Profits in A Partnership

Lodewyckx et al. (2013:268) state that the profit of a partnership is calculated in the same way as one would for a
sole proprietorship. Instead of transferring the profit to the capital account as is the case of a sole proprietorship,
there is a need to record the partners’ salaries, bonuses and interest on capital before the remaining profit (loss)
is shared. If a partner withdraws more than he/she is entitled to, the current account of that partner will show a
debit balance.

3.3.1 Partners’ salaries

Since many partnerships pay partners regular salaries in their capacities as owners, partners’ salaries
should be treated as an appropriation of profit and not a business expense. To record a partner’s
salary, the partner’s salary account will be debited and respective current account will be credited.

51 MANCOSA
 Financial Reporting and Analysis

3.3.2 Partners’ bonus and commission

If a partnership agreement provides for a bonus or commission to partners, these are also treated an
appropriation of profits.

3.3.3 Interest on capital

Interest on capital is provided for in partnership agreements to be fair to partners where the capital
contributions are different and profits are not shared in the same ratio as the capital contributed. Interest
on capital is not treated as an expense since it arises from a transaction with partners in their capacity as
equity participants. It is recorded by debiting the interest on capital account and crediting the respective
current accounts of the partners.

3.3.4 Interest on drawings

Partnership agreements may provide for interest on drawings specially to cater for instances where
partners draw varying amounts or withdraw at different times during the year. Interest on drawings is not
treated as an income to the business since it arises from a transaction with partners in their capacity as
equity participants. It is recorded by debiting the respective current accounts of the partners and crediting
the interest on drawings account.

3.3.5 Share of the remaining profit or loss

After taking into account the net profit (or loss), salaries, bonuses, interest on capital and interest on
drawings, the remaining profit or loss is shared between the partners in the profit-sharing ratio as
contained in the partnership agreement. The partners’ respective current accounts are credited with
the remaining profit.
The following example reflects how the profit is appropriated in a partnership”

Example 1
The information given below was extracted from the accounting records of Sebcom Traders, a partnership
business with Seb and Com as partners.

Required
Use the information provided to calculate the
■ remaining profit or loss of each partner.
■ current account balances of each partner.

MANCOSA 52
Financial Reporting and Analysis

Information

Balances in the General ledger on 28 February 20.15

Capital: Seb 200 000

Capital: Com 150 000

Current a/c: Seb (01 March 20.14) 20 000 CR

Current a/c: Com (01 March 20.14) 4 000 DR

Drawings: Seb 40 000

Drawings: Com 60 000

On 28 February 20.15 the statement of comprehensive income reflected a net profit of R194 200.
The following must be taken into account:
(a) Interest on capital at 15% p.a. on the balances on the capital accounts must be provided for.
(b) Interest on drawings was calculated at R1 200 for Seb and R1 000 for Com.
(c) The partners are entitled to an annual salary of R30 000 each.
(d) The balance of the profit must be shared between Seb and Com in the ratio 2:3 respectively.

Solution
 Calculation of the remaining profit or loss of each partner.
Interest on capital is calculated as follows:
Seb: R200 000 X 15/100 = R30 000
Com: R150 000 X 15/100 = R22 500
Remaining profit = Net profit + Interest on drawings – Salaries – Interest on capital
= R194 200 + R2 200 – R60 000 – R52 500
= R83 900
Seb’s share = R83 900 X 2/5
= R33 560
Com’s share = R83 900 X 3/5
= R50 340
Note: The ratio 2:3 implies that there are 5 shares.
Seb gets 2 of the 5 shares (2/5), and
Com gets 3 of the 5 shares (3/5).

53 MANCOSA
 Financial Reporting and Analysis

 Calculation of the current account balances of each partner

The credit balance of R20 000 on 01 March 20.14 in the Current account: Seb means that the
partnership owes Seb R20 000. The debit balance of R4 000 on 01 March 20.14 in Current account:
Com means that Seb owes the partnership R4 000.

Current account balance of each partner =

Opening balance + Interest on capital + Salaries + Remaining profit – Interest on drawings – Drawings
Current account: Seb
= R20 000 + R30 000 + R30 000 + R33 560 – R 1 200 – R40 000
= R72 360
Current account: Com
= – R4 000 + R22 500 + R30 000 + R50 340 – R 1 000 – R60 000
= R37 840

3.4 Preparation of The Financial Statements of a Partnership

The basic financial statements of a partnership, like a sole proprietorship, consist of a statement of comprehensive
income, statement of changes in equity and a statement of financial position. These financial statements must
fairly present the financial performance and financial position of the business.

3.4.1 Statement of Comprehensive Income

The financial result of the business is reflected in the statement of comprehensive income. The statement of
comprehensive income will reflect all the income earned and expenses incurred during the accounting period.

The following example will be used to illustrate the preparation of a statement of comprehensive income, statement
of changes in equity, statement of financial position and notes to the financial statements.

Example 1
The information below was extracted from the accounting records of Matrix Traders, a partnership with Mathew
and Rixon as partners.

Required
Use the given information for Matrix Traders to prepare the:
Statement of Comprehensive Income for the year ended 28 February 20.15.
Statement of Changes in Equity for the year ended 28 February 20.15.
Statement of Financial Position as at 28 February 20.15
Notes to the financial statements for the year ended 28 February 20.15.

MANCOSA 54
Financial Reporting and Analysis

Matrix Traders
Debit (R) Credit (R)
Balance Sheet Accounts Section
Capital: Mathew 200 000
Capital: Rixon 150 000
Current account: Mathew 3 660
Current account: Rixon 1 200
Drawings: Mathew 40 000
Drawings: Rixon 64 000
Land and buildings 265 600
Equipment 54 500
Accumulated depreciation on equipment (01 March 20.14) 24 500
Fixed deposit: Den Bank (16% p.a.) 12 000
Loan: Den Bank (20% p.a.) 35 000
Debtors control 18 900
Creditors control 18 000
Bank 123 000
Cash float 300

Nominal Accounts Section

Sales 717 000
Opening inventory 65 000
Purchases 434 000
Sales returns 9 000
Purchases returns 3 800
Interest on fixed deposit 1 440
Bank charges 600
Water and electricity 7 500
Telephone 4 900
Insurance 5 900
Interest on loan 7 000
Sundry expenses 17 400
Consumable stores 2 900
Advertising 19 700
1 153 400 1 153 400

55 MANCOSA
 Financial Reporting and Analysis

PRE-ADJUSTMENT TRIAL BALANCE AS AT 28 FEBRUARY 20.15

Adjustments and additional information
1. The loan at Den Bank is an unsecured loan granted on 01 March 20.14 for a period of five years. Equal
annual instalments commence on 01 March 20.15. Interest payments are up to date.

2. According to a physical stocktaking the following stocks were on hand on 28 February 20.15:
Trading inventory R61 600
Consumable stores R400

3. The advertising amount includes a contract for R1 200 that was taken for the period
01 June 20.14 to 31 May 20.15.

4. A debtor who owed R800 was declared insolvent. His account must now be written off.

5. Provide for outstanding interest on fixed deposit. The investment in fixed deposit was made on 01
February 20.14 and it matures on 31 January 20.17.

6. Provide for depreciation on equipment at 20% p.a. using the fixed instalment method.

7. The telephone account for February 20.15 has not yet been paid, R450.

8. A part of the building has been leased to a tenant on 01 February 20.15 at R30 000 per annum. The rent
for February 20.15 has not yet been received.

9. The partnership agreement provides for the following which must be taken into account:

9.1 A salary of R5 000 is awarded to each partner monthly.

9.2 Interest on capital at 12% p.a. is allowed on the capital balances. Note that on
01 March 20.14 Mathew increased his capital by R50 000 while Rixon decreased his capital by R30 000.
These capital changes have been recorded.

9.3 Rixon is entitled to a bonus of R12 000.

9.4 Interest on partners’ drawings is charged on daily balances. The amounts for each partner are as follows:
Mathew R3 000
Rixon R3 200
9.5 The remaining profit (loss) is shared equally between Mathew and Rixon.

MANCOSA 56
Financial Reporting and Analysis

Solution
Matrix Traders
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED
28 FEBRUARY 20.15
R
Sales (717 000 – 9 000) 708 000
Cost of sales (433 600)
Opening inventory (65 000) 65 000
Purchases (434 000 – 3 800) 430 200
Closing inventory (61 600)
Gross profit 274 400
Other operating income 2 500
Rent income 2 500
Gross operating income 276 900
Operating expenses (70 350)
Bank charges (600) 600
Water and electricity (7 500) 7 500
Telephone (4 900 + 450) 5 350
Insurance (5 900) 5 900
Sundry expenses (17 400) 17 400
Consumable stores (2 900 – 400) 2 500
Advertising (19 700 – 300) 19 400
Bad debts 800
Depreciation 10 900
Operating profit 206 550
Interest income: on fixed deposit (1 440 + 480) 1 920
Interest expense: on loan (7 000) (7 000)
Net profit for the year 201 470

57 MANCOSA
 Financial Reporting and Analysis

REMARKS
 The effects of the adjustments and additional information on the financial statements are as follows:
Effect on Statement of Comprehensive Effect on Statement of Financial Position, Statement
Income of Changes In Equity and Notes to the financial
statements
1. No change R7 000 (R35 000/5) treated as current portion of loan
2. Closing inventory R61 600 Merchandise (note 4) R61 600
Consumable stores – R400 Consumable inventory (Note 4) R400
3. Advertising – R300 (R1 200 X 3/12) Prepaid expenses R300
4. Bad debts +R800 Trade debtors – R800
5. R12 000 X 16% = R1 920 (interest for
year)
(R1 920 – R1 440 = R480 owing)
Interest income + R480 Accrued income R480
6. Depreciation R10 900 Depreciation for the year R10 900 (Note 2)
(R54 500 X 20%)
7. Telephone +R450 Accrued expenses R450
8. Rent income R2 500 (R30 000/12) Accrued income R2 500
9.1 No change Statement of changes in equity
Salaries (R5 000 X 12):
Mathew: R60 000
Rixon: R60 000
9.2 No change Statement of changes in equity
Changes in capital (bracket for decrease)
Interest on capital:
Mathew: R24 000 (R200 000 X 12%)
Rixon: R18 000 (R150 000 X 12%)
9.3 No change Statement of changes in equity
Bonus:
Rixon: R12 000
9.4 No change Statement of changes in equity
Interest on drawings:
Mathew R3 000
Rixon R3 200

MANCOSA 58
Financial Reporting and Analysis

9.5 No change Statement of changes in equity

Remaining profit is R33 670
[R201 470 – R120 000 – R42 000 – R12 000 + 6 200]
R33 670 ÷ 2 = R16 835 for each partner

3.4.2 Statement of Changes in Equity

The statement of changes in equity shows the movements in capital and current accounts of partners. These
movements include:
 the opening and closing balances of each partner.
 the transactions with partners including increases and decreases in capital and current accounts.
 the distribution of profit to the partners.

Example 2
Using the information from example 1 and the statement of comprehensive income drawn up, the statement of
changes in equity for Matrix Traders will be completed as follows:

Matrix Traders
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 28 FEBRUARY 20.15
Capital Accounts Mathew (R) Rixon (R) Total (R)
Balance as at 28 February 20.14 150 000 180 000 330 000
Changes in capital 50 000 (30 000) 20 000
Balance as at 28 February 20.15 200 000 150 000 350 000

Current Accounts
Balance as at 28 February 20.14 3 660 (1 200) 2 460
Net profit for the year 97 835 103 635 201 470
Interest on Capital 24 000 18 000 42 000
Salaries 60 000 60 000 120 000
Bonus - 12 000 12 000
Interest on drawings (3 000) (3 200) (6 200)
Profit Share 16 835 16 835 33 670

Drawings (40 000) (64 000) (104 000)

Balance as at 28 February 20.15 61 495 38 435 99 930

59 MANCOSA
 Financial Reporting and Analysis

REMARKS
A suggested sequence for completing the current accounts is as follows. Note that the use of brackets is to
denote a negative effect on the partners’ current account balances.
 Record balance at 28 February 20.14 (bracket the debit balance).
 Fill in total column of net profit for the year, R201 470.
 Calculate and enter the amounts for interest on capital, salaries and bonus.
 Enter interest on drawings (remember to bracket the amounts).
 Now calculate total profit share as follows:
Net profit for year – Interest on capital – Salaries – Bonus + Interest on drawings
R201 470 – R42 000 – R120 000 – R12 000 + R6 200 = R33 670
 Share the profit between the partners according to the partnership agreement:
R33 670 ÷ 2 = R16 835 for each partner
 Next calculate the net profit for the year for each partner (using the figures in the block below).
 Record the drawings of both partners (remember to bracket the amounts).
 Lastly, calculate the balance as at 28 February 20.15 by using the following in the calculation:

Balance as at 28 February 20.14 + Net profit for the year – Drawings

(Note that when a calculation results in a negative value, the amount must be bracketed.)
In this statement, the partnership owes Mathew R61 495 and Rixon R38 435.

3.4.3 Statement of Financial Position and Notes to the Financial Statements

The statement of financial position and notes to the financial statements are drawn up in the same way as for sole
proprietorships except for the equity section. The equity section of the statement of financial position of a
partnership consists of the partners’ capital accounts and current accounts as opposed to the capital account only
of a sole proprietorship. The balance as at 28 February 20.15 (total) for capital and current accounts (from the
statement of changes in equity) are now transferred to the statement of financial position under equity.

Example 3
Using the information from example 1 as well as the statement of changes in equity (example 2), the statement of
financial position and notes to the financial statement of Matrix Traders can now be completed as follows:

MANCOSA 60
Financial Reporting and Analysis

Matrix Traders

STATEMENT OF FINANCIAL POSITION AS AT 28 FEBRUARY 20.15

Note R
ASSETS
Non-current assets 296 700
Property, plant and equipment 2 284 700
Financial assets (12 000) 3 12 000
Current assets 206 680
Inventories 4 62 000
Trade and other receivables 21 380
Trade debtors (18 900 – 800) 18 100
Prepaid expenses (300) 300
Accrued income (480 + 2 500) 2 980
Cash and cash equivalents 123 300
Bank (123 000) 123 000
Cash float (300) 300
Total assets 503 380

EQUITY AND LIABILITIES

Equity 449 930
Capital 350 000
Current accounts 99 930
Non-current liabilities 28 000
Long-term borrowings 5 28 000
Current liabilities 25 450
Trade and other payables 18 450
Trade creditors (18 000) 18 000
Accrued expenses (450) 450
Current portion of long-term borrowings 5 7 000
Total equity and liabilities 503 380

61 MANCOSA
 Financial Reporting and Analysis

NOTES TO THE FINANCIAL STATEMENTS

1. Accounting policy
The accounting policy of Matrix Traders is consistent with that of the previous year, and is as follows:
1.1 Measurement basis
The financial statements are based on the historical cost and comply with Generally Accepted Accounting
Practice.

1.2 Property, plant and equipment

Equipment is written off at 20% per annum on cost.

1.3 Inventories
Inventories are measured at the lower of cost, on the FIFO method, and net realisable value, whichever is lower.
2. Property, plant and equipment

Land and
buildings Equipment Total
Carrying value at beginning of year 265 600 30 000 295 600
Cost 265 600 54 500 320 100
Accumulated depreciation (24 500) (24 500)
Depreciation for the year (10 900) (10 900)
Carrying value at end of year 265 600 19 100 284 700
Cost 265 600 54 500 320 100
Accumulated depreciation (35 400) (35 400)

3. Financial assets

Fixed deposit: Den Bank (16% p.a.) maturing on 31 January 20.14 12 000
12 000

4. Inventories

Inventories consist of:

Merchandise 61 600
Consumable inventory 400
62 000

5. Long term borrowings

Unsecured
Loan from Den Bank. Interest rate is 20% p.a. 35 000
Less: Instalment payable within one year, transferred to current liabilities (7 000)
28 000

MANCOSA 62
Financial Reporting and Analysis

3.5 Self-Assessment Activities

3.5.1 Required
Calculate the share of the remaining profit for each partner (Ed and Con) from the following information.

Information
The balances in the capital accounts in the ledger of Edcon Traders on 28 February 20.15 (end of the financial
year) are as follows:

Capital: Ed R75 000

Capital: Con R50 000

Additional information
 The net profit for the year according to the statement of comprehensive income amounted to R80 000.
 Interest on capital at 15% p.a. on the balances on the capital accounts must be provided for. On 01
December 20.14 Ed increased his capital by R25 000 while Con decreased his capital by R25 000. These
capital changes have been recorded.
 Interest on drawings amounts to R800 for Ed and R900 for Con.
 The remaining profit or loss must be shared by the partners in the ratio of their capital contributions at the
end of the financial year.

3.5.2 The information given below was extracted from the accounting records of Samsing Traders, a
partnership business with Sam and Sing as partners.
Required
Use the information provided to calculate the current account balance of each partner as at 28
February 20.15.
Information
Balances in the ledger as at 28 February 20.15
Capital: Sam R400 000
Capital: Sing R300 000
Current a/c: Sam (01 March 20.14) R10 000 (CR)
Current a/c: Sing (01 March 20.14) R13 000 (DR)
Drawings: Sam R52 000
Drawings: Sing R60 000

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 Financial Reporting and Analysis

On 28 February 20.15 the statement of comprehensive income reflected a net profit of R74 800.
The following must be taken into account:
(a) Interest on capital at 12% p.a. must be calculated on the balances on the capital accounts up to 31 August
20.14. On 01 September 20.14, the rate of interest on capital was increased to 15% p.a.
(b) Interest on drawings for the year for each partner are as follows:
Sam R2 700
Sing R3 000
(d) The balance of the profit/loss must be shared between Sam and Sing in the ratio of their capital balances.

3.5.3 The information given below was extracted from the accounting records of Protea Traders, a
partnership business with Hashim and Steyn as partners.

Required
■ Prepare the Statement of Changes In Equity for the year ended 28 February 20.15
■ Prepare an extract of the Statement of Financial Position showing only the equity.

Information
Balances in the ledger on 28 February 20.15
R
Capital: Hashim 200 000
Capital: Steyn 300 000
Current a/c: Hashim (01 March 20.14) 22 000 CR
Current a/c: Steyn (01 March 20.14) 10 000 DR
Drawings: Hashim 45 000
Drawings: Steyn 55 000

The following must be taken into account:

(a) On 28 February 20.15 the statement of comprehensive income reflected a net profit of R250 000.
(b) Interest on capital at 12% p.a. on the balances on the capital accounts must be provided for. On 01 June
20.14 Hashim decreased his capital by R100 000. On
01 December 20.14 Steyn increased his capital by R60 000. The capital changes have been recorded.
(c) Interest on drawings has been calculated on the daily balance of the drawings accounts. The amounts for
the year are as follows:
Hashim R2 250
Steyn R2 750
(d) The balance of the profit (loss) must be shared between Hashim and Steyn in the ratio of their capital
balances at the end of the financial year.

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Financial Reporting and Analysis

3.5.4 The information below was extracted from the accounting records of Kiveshnie Traders, a partnership with
Kivesh and Niemand as partners.

Required
Use the given information for Kiveshnie Traders to prepare the:
■ Statement of Comprehensive Income for the year ended 28 February 20.15.
■ Statement of Changes in Equity for the year ended 28 February 20.15.

65 MANCOSA
 Financial Reporting and Analysis

Kiveshnie Traders PRE-ADJUSTMENT TRIAL BALANCE AS AT 28 FEBRUARY 20.15

Adjustments and additional information

Debit (R) Credit (R)

Balance Sheet Accounts Section
Capital: Kivesh 370 000
Capital: Niemand 330 000
Current account: Kivesh 7 320
Current account: Niemand 2 400
Drawings: Kivesh 80 000
Drawings: Niemand 128 000
Land and buildings 531 200
Equipment 109 000
Accumulated depreciation on equipment (01 March 20.14) 49 000
Fixed deposit: Vin Bank (8% p.a.) 24 000
Loan: Vin Bank (16% p.a.) 70 000
Trading inventory 130 000
Debtors control 37 800
Creditors control 36 000
Bank 232 000
Cash float 600

Nominal Accounts Section

Sales 1 409 920
Cost of sales 860 400
Sales returns 23 000
Interest on fixed deposit 960
Rent income 26 000
Bank charges 10 200
Water and electricity 15 000
Telephone 9 800
Insurance 11 800
Interest on loan 14 000
Sundry expenses 34 800
Consumable stores 5 800
Advertising 39 400
2 299 200 2 299 200

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Financial Reporting and Analysis

1. According to physical stocktaking the following inventories were on hand on

28 February 20.15:
Merchandise R128 500
Consumable stores R300
2. The loan at Vin Bank is an unsecured loan granted on 01 February 20.14 and will be repaid in 10 equal
annual repayments commencing on 01 April 20.15. Interest has been paid in advance.
3. A debtor who owed R700 disappeared without trace. Her account must now be written off.
4. Provide for outstanding interest on fixed deposit. Two fixed deposit accounts were opened on 01 June
20.14. One of the fixed deposits, R 9 000, matures on 31 May 20.15. The other matures on 31 May
20.16.
5. Provide for depreciation on equipment at 20% p.a. using the diminishing balance method.
6. The water and electricity account for February 20.15 has not yet been paid, R1 300.
7. Rent has been received up to 31 March 20.15.
8. The partnership agreement provides for the following which must be taken into account:
8.1 A salary of R9 000 is allowed to each partner monthly.
8.2 Interest on capital at 15% p.a. is allowed on the capital balances. Note that on
01 September 20.14 Niemand increased his capital by R60 000 while Kivesh decreased her capital by
R48 000. These capital changes have been recorded.
8.3 Kivesh is to receive a bonus of R15 000.
8.4 Interest on the partners’ drawings is charged on the daily balances. The amounts for each partner for the
year are as follows:
Kivesh R4 000
Niemand R6 400
8.5 The remaining profit (loss) is shared in the ratio 3:2 between Kivesh and Niemand respectively.

3.6 Suggested Solutions

3.5.1 Calculation of interest on capital
Ed
Balance on 01 March 20.13 R50 000 X 15% X 9/12 = R5 625
Capital increase on 1 December 20.13 R25 000
Balance on 28 February 20.14 R75 000 X 15% X 3/12 = R2 812.50
R8 437.50

Note: Since the balance in the capital account on 28 February 20.14 was R75 000 and there was a capital increase
on 01 December 20.13 (that was recorded), the balance on 01 March 20.13 was less than R75 000 (i.e. R75 000
– R25 000 = R50 000).

67 MANCOSA
 Financial Reporting and Analysis

Con
R75 000 X 15% X 9/12 = R8 437.50
Balance on 01 March 20.13
(R25 000)
Capital decrease on 1 December 20.13
R50 000 X 15% X 3/12 = R1 875.00
Balance on 28 February 20.14
R10 312.50

Note: Since the balance in the capital account on 28 February 20.14 was R50 000 and there was a capital decrease
on 01 December 20.13 (that was recorded), the balance on 01 March 20.13 was more than R50 000 (i.e. R50 000
+ R25 000 = R75 000).

Total interest on capital = R8 437.50 + R10 312.50 = R18 750

Calculation of remaining profit

Net profit + Interest on drawings – Interest on capital
= R80 000 + R1 700 – R18 750 = R62 950

Calculation of share in remaining profit

Ed: R62 950 X 3/5 = R37 770
Con: R62 950 X 2/5 = R25 180
Note: Ratio of capitals at the end of the year R75 000:R50 000 = 75:50 = 3:2

3.5.2
 Interest on capital is calculated as follows:
Sam
R400 000 X 12% X 6/12 = R24 000
R400 000 X 15% X 6/12 = R30 000
R54 000
Sing
R300 000 X 12% X 6/12 = R18 000
R300 000 X 15% X 6/12 = R22 500
R40 500
 The share of the remaining shortfall (Sam R8 000 and Sing R6 000) is calculated as follows:
(Note: There was a remaining shortfall as the profit calculated in the statement of comprehensive
income, even with the interest on drawings, was not enough to cover the interest on capital.)

Remaining shortfall
= Net profit + Interest on drawings – Interest on capital
= R74 800 + R5 700 – R94 500

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Financial Reporting and Analysis

= (R14 000)
Sam’s share = R14 000 X 4/7
= R8 000
Sing’s share = R14 000 X 3/7
= R6 000

Note: The ratio of their capitals is R400 000:R300 000 = 4:3

 Current account: Sam
= R10 000 + R54 000 – R 2 700 – R52 000 – R8 000
= R1 300 (i.e. a credit balance)
Current account: Sing
= – R13 000 + R40 500 – R3 000 – R60 000 – R6 000
= – R41 500 (i.e. a debit balance)

3.5.3
Protea Traders
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 28 FEBRUARY 20.15
Capital Accounts Hashim (R) Steyn (R) Total (R)
Balance as at 28 February 20.14 300 000 240 000 540 000
Changes in capital (100 000) 60 000 (40 000)
Balance as at 28 February 20.15 200 000 300 000 500 000

Current Accounts
Balance as at 28 February 20.14 22 000 (10 000) 12 000
Net profit for the year 103 710 146 290 250 000
Interest on Capital 27 000 30 600 57 600
Interest on drawings (2 250) (2 750) (5 000)
Profit Share 78 960 118 440 197 400
Drawings (45 000) (55 000) (100 000)
Balance as at 28 February 20.15 80 710 81 290 162 000

REMARKS
■ The capital balances that are provided are the financial year end balances. Hence they are entered in the
line: Balance as at 28 February 20.15. The capital changes (decrease is bracketed) are shown above these
balances. Now the balance as at 28 February 20.14 is determined.
■ Follow the sequence (steps) suggested for example 2 to complete the current accounts.

69 MANCOSA
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■ Interest on capital is calculated as follows:

Calculate interest on the capital from the beginning of the year until the date of change of the balance.
Then calculate interest from the date of change of the balance until the end of the financial year. Thus the
interest is calculated as follows:
Hashim
R300 000 X 12% X 3/12 = R9 000
R200 000 X 12% X 9/12 = R18 000
Interest for financial year R27 000
Steyn
R240 000 X 12% X 9/12 = R21 600
R300 000 X 12% X 3/12 = R9 000
Interest for financial year R30 600

■ The profit share is calculated as follows:

First calculate total profit share:
Net profit for year – [Interest on capital – Interest on drawings]
250 000 – [57 600 – 5 000] = R197 400
Share the profit between the partners according to the ratio of their capital balances at the end of the
financial year viz. R200 000: R300 000 = 2:3

Hashim’s share = R197 400 X 2/5 = R78 960

Steyn’s share = R197 400 X 3/5 = R118 440

Protea Traders
Extract of Statement of Financial Position as at 28 February 20.15
EQUITY AND LIABILITIES
Equity 662 000
Capital 500 000
Current accounts 162 000

REMARKS
■ The balance as at 28 February 20.15 (total) for capital and current accounts from the statement of changes in
equity are transferred to the equity section of the Statement of Financial Position.

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3.5.4

Kiveshnie Traders
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED
28 February 20.15
R
Sales (1 409 920 – 23 000) 1 386 920
Cost of sales (860 400) (860 400)
Gross profit 526 520
Other operating income 24 000
Rent income (26 000 – 2 000) 24 000
Gross operating income 550 520
Operating expenses (142 000)
Bank charges (10 200) 10 200
Water and electricity (15 000 + 1 300) 16 300
Telephone (9 800) 9 800
Insurance (11 800) 11 800
Sundry expenses (34 800) 34 800
Consumable stores (5 800 – 300) 5 500
Advertising (39 400) 39 400
Bad debts 700
Trading stock deficit (130 000 – 128 500) 1 500
Depreciation 12 000
Operating profit 408 520
Interest income: on fixed deposit (960 + 480) 1 440
Interest expense: on loan (14 000 – 2 800) (11 200)
Net profit for the year 398 760

71 MANCOSA
 Financial Reporting and Analysis

REMARKS
The effects of the adjustments and additional information on the financial statements are as follows:
Effect on Statement of Comprehensive Effect on Statement of Financial Position,
Income Statement of Changes in Equity and Notes to the
Financial Statements
1. Trading stock deficit R1 500 Merchandise R128 500 (Note 4)
(R130 000 – R128 500)
Consumable stores – R300 Consumable inventory R300 (Note 4)
2. R70 000 X 16% = R11 200
(R14 000 – R11 200)
Interest expense – R2 800 Prepaid expenses R2 800
Current portion of loan R7 000
(R70 000/10)
3. Bad debts R700 Trade debtors – R700
4. Interest income + R480 Accrued income R480
(R1 440 – R960)
R24 000 X 8% X 9/12 = R1 440
5. Depreciation R12 000 Depreciation for year R12 000 (Note 2)
(R109 000 – R49 000) X 20% =
R12 000
6. Water and electricity +R1 300 Accrued expenses R1 300
7. Rent income – R2 000 Income received in advance R 2000
8.1 No entry Salaries:
Kivesh: R108 000 (R9 000 X 12)
Niemand: R108 000 (R9 000 X 12)
8.2 No entry Interest on capital R51 000 + R53 100
(Refer to workings below statement of changes in
equity.)
8.3 No entry Bonus:
Kivesh: R15 000
8.4 No entry Interest on drawings R4 000 + R6 400
8.5 No entry Profit share R44 436 + R29 624
(Refer to workings below statement of changes in
equity.)

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 Financial Reporting and Analysis

Kiveshnie Traders
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 28 FEBRUARY 20.15
Capital Accounts Kivesh Niemand (R) Total
(R) (R)
Balance as at 28 February 20.14 310 000 378 000 688 000
Changes in capital 60 000 (48 000) 12 000
Balance as at 28 February 20.15 370 000 330 000 700 000

Current Accounts
Balance as at 28 February 20.14 7 320 (2 400) 4 920
Net profit for the year 214 436 184 324 398 760
Interest on Capital 51 000 53 100 104 100
Salaries 108 000 108 000 216 000
Bonus 15 000 - 15 000
Interest on drawings (4 000) (6 400) (10 400)
Profit Share 44 436 29 624 74 060
Drawings (80 000) (128 000) (208 000)
Balance as at 28 February 20.15 141 756 53 924 195 680

REMARKS
■ The capital balances provided in the information are the end of the financial year balances. Hence they are entered
in the line: Balance as at 28 February 20.15. The capital changes (decrease is bracketed) are shown above these
balances. Now the balance as at 28 February 20.14 is determined.
■ Follow the sequence (steps) suggested for example 2 to complete the current accounts.
■ Interest on capital is calculated as follows:
Calculate interest on the capital from the beginning of the year until the date of change of the balance. Then
calculate interest from the date of change of the balance until the end of the financial year. Thus the interest is
calculated as follows:

Kivesh
R310 000 X 15% X 6/12 = R23 250
R370 000 X 15% X 6/12 = R27 750
Interest for financial year R51 000
Niemand
R378 000 X 15% X 6/12 = R28 350
R330 000 X 15% X 6/12 = R24 750
Interest for financial year R53 100

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 Financial Reporting and Analysis

■ The profit share is calculated as follows:

First calculate total profit share:
Net profit for year – Interest on capital – Salaries – Bonus + Interest on drawings
R398 760 – R104 100 – R216 000 – R15 000 + R10 400 = R74 060

Share the profit between Kivesh and Niemand according to the ratio 3:2.
Kivesh’s share = R74 060 X 3/5 = R44 436
Niemand’s share = R74 060 X 2/5 = R29 624

Kiveshnie Traders
STATEMENT OF FINANCIAL POSITION AS AT 28 FEBRUARY 20.15
Note R
ASSETS
Non-current assets 594 200
Property, plant and equipment 2 579 200
Financial assets 3 15 000
Current assets 410 780
Inventories 4 128 800
Trade and other receivables 40 380
Trade debtors (37 800 – 700) 37 100
Prepaid expenses (2 800) 2 800
Accrued income (480) 480
Cash and cash equivalents 241 600
Fixed deposit 9 000
Bank 232 000
Cash float 600
Total assets 1 004 980

EQUITY AND LIABILITIES

Equity 895 680
Capital 700 000
Current accounts 195 680
Non-current liabilities 63 000
Long term borrowings 5 63 000
Current liabilities 46 300
Trade and other payables 39 300
Trade creditors 36 000

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Financial Reporting and Analysis

Accrued expenses (1 300) 1 300

Income received in advance (2 000) 2 000
Current portion of long term borrowings 5 7 000
Total equity and liabilities 1 004 980

NOTES TO THE FINANCIAL STATEMENTS

1. Accounting policy
The accounting policy of Kiveshnie Traders is consistent with that of the previous year, and is as follows:
1.1 Measurement basis
The financial statements are based on the historical cost and comply with Generally Accepted
Accounting Practice.

1.2 Property, plant and equipment

Equipment is written off at 20% per annum on the diminishing balance.

1.3 Inventories
Inventories are measured at the lower of cost, on the FIFO method, and net realisable value, whichever
is lower.

2. Property, plant and equipment

Land and
buildings Equipment Total
Carrying value at beginning of year 531 200 60 000 591 200
Cost 531 200 109 000 640 200
Accumulated depreciation (49 000) (49 000)
Depreciation for the year (12 000) (12 000)
Carrying value at end of year 531 200 48 000 579 200
Cost 531 200 109 000 640 200
Accumulated depreciation (61 000) (61 000)

3. Financial assets

Fixed deposit: Vin Bank (8% p.a.) 24 000

Less: Fixed deposit maturing on 31 May 20.15 (9 000)
15 000

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 Financial Reporting and Analysis

4. Inventories

Inventories consist of:

Merchandise 128 500
Consumable inventory 300
128 800

5. Long term borrowings

Unsecured
Loan from Vin Bank. Interest rate is 16% p.a. 70 000
Less: Instalment payable within one year, transferred to current liabilities (7 000)
63 000

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 Financial Reporting and Analysis

Unit
4: Financial Statements of a Company

77 MANCOSA
 Financial Reporting and Analysis

Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

4.1 Introduction  Introduce topic areas for the unit

4.2 Transactions related to companies  Disclose share capital, company tax, dividends and retained
earnings correctly in the financial statements of a company

4.3 Financial reporting for companies  Understand the role played by the International Accounting
Standards Board (IASB) in setting accounting standards

4.4 Preparation of the Financial  Prepare the financial statements of a company

Statements of a company

Prescribed / Recommended Readings

 Kew, J and Warson, A. (2013) Financial Accounting: An introduction. 4th

edition. Cape Town: Oxford University Press.

 Lodewyckx, E., Lötter, W., Rhodes, N. and Seedat, C. (2013) Introduction

to Financial Accounting: Fresh Perspectives. 2nd edition. Cape Town:
Pearson.

MANCOSA 78
Financial Reporting and Analysis

4.1 Introduction
A company is an association of people who work together in order to make a profit (Lodewyckx et al., 2013:290).
It is a legal person and is incorporated in accordance with the Companies Act No. 71 of 2008. Its existence is
independent of the shareholders (owners) and consequently the liability of shareholders for the debts of the
company is limited to the amount that they have invested in the enterprise.

A company invites the public (including the business community) to invest in it. To make it possible for many
people (hundreds or even thousands) to invest in a company, it divides the capital it requires (e.g. R500 000) into
small units called shares. Shareholders obtain a share of the profit by receiving a dividend per share. The shares
of a public company are freely transferable.

There are two basic types of companies viz. for-profit companies and non-profit companies. For-profit companies
include public companies, private companies, state-owned companies, and personal liability companies. Non-
profit companies are companies that are formed with the aim of benefitting the public or for cultural or social
activities.

A company must be established in accordance with the requirements of the Companies Act No. 71 of 2008. The
people who start a company are called incorporators or promoters. One or more persons may start a for-profit
company. The promoters complete and sign a document called the Memorandum of Incorporation (MOI) and file
a Notice of Incorporation with an organisation called Companies and Intellectual Properties Commission (CIPC).

The first shareholders of the company are the subscribers to the MOI. Public companies issue a document called
a prospectus to invite the public to buy shares in the company. The first issue of shares is called the Initial Public
Offering (IPO).

4.2 Transactions Related to Companies

4.2.1 Share Capital
The MOI stipulates the maximum number of shares that a company is authorised to issue and this is
called the authorised share capital (Lodewyckx et al., 2013:295). Companies usually register an
authorised share capital that is larger than what is needed at the time. The shares that are actually sold
are called the issued share capital.

Preference shares and ordinary shares are main classes of shares in a public company.
Preference shares provide holders of them with a fixed percentage dividend. These shareholders have
preferential rights to dividends over other shareholders and in respect of claims in the event of liquidation.

Ordinary shares only qualify for dividends once preference shareholders have been paid. The share in the profit
varies and depends on the availability of profits and the amount of dividend approved. It is possible for a company
to buy back its own shares.

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 Financial Reporting and Analysis

4.2.2 Debentures
Public companies are entitled to raise capital by issuing debentures. A debenture is a long-term loan (non-current
liability) and is redeemed at the end of its term. Debenture holders receive a fixed percentage interest usually paid
annually to them. The interest on debentures is an expense and is taken into account when the profit is calculated.

4.2.3 Dividends and Retained Earnings

Dividends may only be declared from the profit after tax. The board of directors makes a recommendation in
respect of the proposed dividend to shareholders at the annual general meeting. The proposed dividend is stated
as the number of cents per share. A current liability, shareholders for dividends, is created. When the dividend is
paid, the liability is settled. The directors may be authorized to pay an interim dividend during the financial year.
The total dividends for the year are reflected in the statement of changes in equity.

Companies usually do not distribute all the profits after tax as dividends. A portion of it is retained, often to finance
expansion. The portion of the profit after tax that is retained by the company is reflected in an account called
retained earnings.

4.2.4. Company Tax

Companies pay tax each year at a specific rate (e.g. 28%) on their taxable income. From 01 April 2012 Dividends
Tax replaced Secondary Tax on Companies. The Dividends Tax is levied at a rate of 15% of the amount of
dividends paid by a company. It is a form of withholding tax in that company withholds the tax before paying the
net amount to the shareholders (dividends less dividends tax).

Companies are required to make two provisional tax payments to the South African Revenue Services (SARS).
The first payment is made at the end of the first six months of the financial year and the second is made by the last
day of the financial year. The first payment should equal half the company’s estimated total tax liability for the
year. The second payment is for the balance. If the actual tax liability exceeds the estimated amount, then the
amount owing is reflected as a current liability and a third payment is made to SARS within 6 months after the
financial year-end. The provisional tax payments are debited to an account called South African Revenue
Services. Remember that the actual total tax liability for the year is credited to this same account. Thus the
account will reveal the balance owing to SARS (current liability) or by SARS (current asset). The actual tax liability
for the year is reflected in the statement of comprehensive income.

4.3 Financial Reporting for Companies

Financial statements are intended to provide information about the financial position, financial performance and
changes in the financial position of an enterprise, which will enable the various users to make economic decisions.
Each year financial statements are presented during the annual general meeting of the company. Companies
usually produce different sets of financial statements aimed at different users. Financial statements that are

MANCOSA 80
Financial Reporting and Analysis

prepared for internal use (the focus of this topic) are similar to that of sole proprietorships and partnerships.
Statements for internal use are prepared in detail and contain information required by management. Financial
statements are also prepared for external users such as shareholders and South African Revenue Services (for
income tax purposes). Financial statements submitted to SARS reflect the profit on which the company tax is
based. Financial statements that are made available to shareholders or the public contain as little information as
possible but must contain certain minimum requirements as prescribed by the Companies Act. The Companies
Act also compels companies to comply with certain standards especially in relation to the valuation of assets and
liabilities as well as the reporting on revenue and expenses.

The International Accounting Standards Board (IASB) plays an important role in setting accounting standards for
professional accountants and auditors throughout the world (Kew and Watson, 2013:444). An important function
of this body is to develop the International Financial Reporting Standards (IFRS) which is made up of statements
on how particular types of transactions should be reported in the financial statements. Issues that are addressed
by the IASB by means of the IFRS include inventory valuations, treatment of tangible and intangible assets,
pensions etc. IFRS also covers the presentation of financial statements. Public companies must comply with
IFRS in the preparation and presentation of its financial statements, and in doing so financial statements of different
companies can be easily compared.

4.4 PREPARATION OF THE FINANCIAL STATEMENTS OF A COMPANY

4.4.1 Statement of Comprehensive Income, Statement of Changes in Equity and Statement of
Financial Position
The preparation of statement of comprehensive income, statement of changes in equity and statement of
financial position a company for internal use will be illustrated by means of the following example:
Example 1
The information that follows was taken from the accounting records of Hart Ltd on
30 June 20.15 (the end of the financial year).

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 Financial Reporting and Analysis

Hart Ltd
TRIAL BALANCE AS AT 30 JUNE 20.15
Balance Sheet Accounts Section Debit (R) Credit (R)
Ordinary share capital 400 000
Retained earnings 432 000
Land and buildings 991 600
Vehicles (cost) 80 000
Equipment (cost) 150 000
Accumulated depreciation on vehicles 14 000
Accumulated depreciation on equipment 28 000
Long-term loan: Mac Bank (14% p.a.) 264 000
Debentures (13% p.a.) 200 000
Investment in Vac (Pty) Ltd 48 000
Inventory (30 June 20.14) 112 000
Debtors control 128 000
Provision for bad debts 2 560
Bank 114 260
Creditors control 54 260
South African Revenue Services: Company tax 35 000

Nominal accounts section

Sales 1 055 080
Purchases 458 000
Sales returns 10 000
Purchases returns 12 000
Customs duty 10 800
Carriage on purchases 35 000
Carriage on sales 6 000
Sundry expenses 29 740
Salaries 128 000
Motor expenses 3 600
Interest on loan 36 960
Discount allowed 3 880
Commission income 36 100
Directors’ fees 60 000
Auditor’s fee 12 000
Ordinary share dividends (interim) 16 000
Repairs 29 160
2 498 000 2 498 000

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Financial Reporting and Analysis

Additional information
1. The provision for bad debts must be increased by R1 840.
2. Trading inventory according to stocktaking on 30 June 20.15 amounted to R96 000.
3. Capital repayments totalling R24 000 are payable on the unsecured loan from Mac Bank in the next
financial year.
4. Depreciation must be provided for as follows:
 on vehicles at 20% on cost
 on equipment at 28% on cost
5. A dividend of 20% of the investment value has been declared by Vac (Pty) Ltd. The dividend has not yet
been received.
6. The authorised share capital consists of 500 000 ordinary shares.
Note: On 01 July 20.14, the company increased the ordinary share capital by issuing 100 000 shares at R1
each.
7. A non-distributable asset replacement reserve of R100 000 must be created.
8. Debentures consist of 20 000 13% debentures of R10 each, issued on 01 July 20.13 and redeemable on 30
June 20.18. The debentures are secured by a first mortgage bond over land. Provision must be made for
the current year’s interest.
9. The company tax for the year amounted to R62 400.
10. The directors declared a final dividend of 8 cents per share.

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 Financial Reporting and Analysis

Solution
Hart Ltd
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 30 JUNE 20.15
R
Sales (1 055 080-10 000) 1 045 080
Cost of sales (507 800)
Opening inventory 112 000
Purchases (458 000-12 000) 446 000
Customs duty (10 800) 10 800
Carriage on purchases (35 000) 35 000
Closing inventory (96 000)
Gross profit 537 280
Other operating income 36 100
Commission income (36 100) 36 100
Gross operating income 573 380
Operating expenses (332 220)
Carriage on sales (6 000) 6 000
Sundry expenses (29 740) 29 740
Salaries (128 000) 128 000
Motor expenses (3 600) 3 600
Discount allowed (3 880) 3 880
Directors’ fees (60 000) 60 000
Auditor’s fees (12 000) 12 000
Repairs (29 160) 29 160
Provision for bad debts adjustment 1 840
Depreciation (16 000+42 000) 58 000
Operating profit 241 160
Dividend income 9 600
Interest expense: on loan (36 960) (36 960)
: on debentures (26 000)
Profit before tax 187 800
Company tax (62 400)
Profit after tax 125 400

MANCOSA 84
Financial Reporting and Analysis

REMARKS
The effects of the adjustments and additional information on the financial statements are as follows:
Effect on Statement of Effect on Statement of Financial Position, Statement
Comprehensive Income of Changes in Equity and Notes to the financial
statements
1. Provision for bad debts adjustment Provision for bad debts +R1 840
R1 840
2. Closing inventory R96 000 Trading inventory R96 000
3. – Long-term loan – R24 000
Current portion of loan R24 000
4. Depreciation on: Note 3 Depreciation for the year:
Vehicles (R80 000 X 20%) = R16 000 Vehicles R16 000
Equipment (R150 000 X 28%) = Equipment R42 000
R42 000
5. Dividend income R48 000 X 20% = Accrued income R9 600
R9 600
6. – Information available to complete the note for Share
capital and statement of changes in equity
7. – Recorded in statement of changes in equity
8. Interest on debentures Accrued expenses R26 000
R200 000 X 13% = R26 000
9. Company tax R62 400 SARS-Income tax R62 400 – R35 000
10. – Dividend on preference shares
R300 000 X 12% = R36 000
Dividends on ordinary shares
400 000 shares X R0.08 = R32 000
Shareholders for dividends
R36 000 + R32 000 = R68 000

85 MANCOSA
 Financial Reporting and Analysis

Hart Ltd
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 30 JUNE 20.15
Ordinary Asset replace Retained
share capital reserve earnings Total
R R R R
Balance on 01 July 20.14 300 000 432 000 732 000
Issue of share capital 100 000 100 000
Profit for the year 125 400 125 400
Transfer to asset replacement. reserve 100 000 (100 000) 0
Dividends:
Ordinary interim (16 000) (16 000)
Ordinary final (32 000) (32 000)
Balance on 30 June 20.15 400 000 100 000 409 400 909 400

Hart Ltd
STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE 20.15
Note R
ASSETS
Non-current assets 1 169 600
Property, plant and equipment 2 1 121 600
Financial assets 3 48 000
Current assets 343 460
Inventories 4 96 000
Trade and other receivables 133 200
Trade debtors (128 000) 128 000
Provision for bad debts (2 560+1840) (4 400)
Accrued income (9 600) 9 600
Cash and cash equivalents 114 260
Bank (114 260) 114 260
Total assets 1 513 060

MANCOSA 86
Financial Reporting and Analysis

EQUITY AND LIABILITIES

Equity 909 400
Share capital 5 400 000
Other reserves 100 000
Retained earnings 409 400
Non-current liabilities 440 000
Long-term borrowings 6 440 000
Current liabilities 163 660
Trade and other payables 80 260
Trade creditors (54 260) 54 260
Accrued expenses (26 000) 26 000
Current portion of long-term borrowings 6 24 000
South African Revenue Services: Company tax (62 400–35 000) 27 400
Shareholders for dividends 32 000
Total equity and liabilities 1 513 060

NOTES TO THE FINANCIAL STATEMENTS

1. Accounting policy
The accounting policy of Hart Ltd is consistent with that of the previous year, and is as follows:
1.1 Measurement basis
The financial statements are based on the historical cost and comply with Generally Accepted
Accounting Practice.

1.2 Property, plant and equipment

Depreciation has been provided as follows:
Vehicles: 20% per annum on the cost price
Equipment: 28% per annum on the cost price.

1.3 Financial assets

Financial assets are measured at fair value.

1.4 Inventories
Inventories are measured at the lower of cost, on the FIFO method, and net realisable value, whichever
is lower.

87 MANCOSA
 Financial Reporting and Analysis

1.5 Revenue recognition

Sales are recognised upon delivery of products.

2. Property, plant and equipment

Land and
buildings Equipment
Vehicles Total

Carrying value at beginning of year 991 600 66 000 122 000 1 179 600
Cost 991 600 80 000 150 000 1 221 600
Accumulated depreciation (14 000) (28 000) (42 000)
Depreciation for the year (16 000) (42 000) (58 000)
Carrying value at end of year 991 600 50 000 80 000 1 121 600
Cost 991 600 80 000 150 000 1 221 600
Accumulated depreciation (30 000) (70 000) (100 000)

3. Financial assets

Investment in Vac (Pty) Ltd at fair value 48 000

4. Inventories

Inventories consist of:

Merchandise 96 000

5. Share capital

Authorised
500 000 ordinary shares

Issued
300 000 ordinary shares in issue at beginning of year 300 000
100 000 ordinary shares of R1 each issued during the year 100 000
400 000

MANCOSA 88
Financial Reporting and Analysis

6. Long term borrowings

Unsecured
Loan from Mac Bank payable in instalments commencing 01 July 20.15. Interest rate is 14% p.a.
264 000
Less: Instalment payable within one year, transferred to current liabilities (24 000)
240 000
Secured
13% Debentures, secured by a first mortgage bond over land. The debentures are redeemable
on 30 June 20.15. 200 000
440 000

4.4.2 Cash flow statement

Kew and Watson (2013:500) describe a cash flow statement (or statement of cash flows) as a statement that
reflects all the cash flows of an entity in a standardised format. The cash flow statement was developed to fulfil
the needs of the users of financial statements in respect of the cash position of an entity. This is largely due to the
fact that the statement of comprehensive income is based on the accrual basis and does not show the cash flows
from operating activities and also does not provide valuable information relating to cash flows from investing and
financing activities (except for some related expenses and income). The main purpose of a cash flow statement
is to provide information about the cash receipts and cash payments of an entity for a specific period. The
statement provides reasons why cash and cash equivalents changed during the period by reflecting the net cash
utilised or generated by operating activities, investing activities and financing activities.

Having an understanding of a company’s cash flows and the reasons for the cash flows are important to
investors, managers, and other decision-makers. To be able to grow, a company must generate adequate cash
flows to pay its bills, repay its debt, and provide an adequate return to its owners. Information obtained from a
cash flow statement is used for evaluating past performance and future prospects.

 Operating activities
The cash flows from operating activities are derived from the main revenue-generating activities of the entity. They
are cash flows that result from transactions reflected in the statement of comprehensive income. However, due to
the determination of income and expenses according to the accrual basis, certain non-cash items are also included
and they need to be excluded to determine the cash resulting from operating activities.

The cash flow statement can be presented using two different formats. These formats only differ in the manner in
which “cash generated from operations” is disclosed on the face of the statement. The remaining parts of the cash
flow statement are identical for both formats.

89 MANCOSA
 Financial Reporting and Analysis

The first format called the direct method prescribes that the operating cash flows be disclosed according to the
entity’s major classes of gross cash receipts and gross cash payments. The following is an illustration of the
disclosure on the face of the cash flow statement of cash generated from operations using this method.
Direct method

Cash received from customers

Cash paid to suppliers and employees R
2 000 000
(950 000)
Cash generated from operations 1 050 000

The second format is called the indirect method (which will be followed in this module). Using this method, the
cash flows from operating activities are calculated by adjusting the profit before interest and tax in order to
determine cash generated from operations. The adjustments involve the following:
* items relating to investing and financing decisions e.g. loss on sale of equipment
* non-cash flow adjustments e.g. depreciation
* the effect of using the accrual basis (changes in working capital).

The following is an illustration of the disclosure on the face of the cash flow statement of cash generated from
operations using the indirect method.

Indirect method
R
Profit before interest and tax 1 450 000
Adjustments to convert to cash from operations

Non-cash flow adjustments 100 000

Add: Depreciation 60 000
Add: Foreign exchange loss 40 000

Profit before working capital changes 1 550 000

Working capital changes (500 000)

Increase in inventory (400 000)

Increase in receivables (200 000)
Increase in payables 100 000

Cash generated from operations 1 050 000

MANCOSA 90
Financial Reporting and Analysis

Note that increases in current assets (inventory and receivables) and decreases in current liabilities (payables) are
reported as operating uses of cash (and is indicated by bracketing the amount). On the other hand, decreases in
current assets (inventory and receivables) and increases in current liabilities (payables) are reported as operating
sources of cash

 Investing activities
This category of the cash flow statement provides details about specific expenditures made to generate future
income and outflows. It relates mainly to the purchase and sale of non-current assets. Separate disclosure of
investing activities to expand operations is recommended. Examples of cash flows from investing activities include:
 payments to acquire non-current assets;
 receipts from sale of non-current assets;
 payments to acquire other entities and other equity or debt instruments;
 receipts from sale of interests in other entities, and sale of other equity or debt instruments;
 loans made to other parties or receipts from the repayment of such loans.

The following is an example of how cash flow from investing activities would appear on the face of the cash flow
statement:
R
Cash flow from investing activities (50 000)
Additions to plant and equipment (200 000)
Proceeds from sale of land and buildings 150 000
Note that any use of cash (e.g. additions to plant and equipment) is indicated by bracketing the amount.

4.4.2.3 Financing activities

Cash flows from financing activities provide information relating to cash flows to and from providers of capital.
This is useful to investors who wish to predict any future claims on the cash of the entity. Examples of cash
flows from financing activities include:
 proceeds from the issue of shares;
 proceeds from loans, bonds and debentures ;
 repayments of amounts borrowed.

The following is an example of the disclosure of cash flow from financing activities on the face of the cash flow
statement:
R
Cash flow from financing activities 250 000
Proceeds from issue of shares 300 000
Long-term borrowings redeemed (50 000)

91 MANCOSA
 Financial Reporting and Analysis

Note again that any use of cash (e.g. long-term borrowings redeemed) is indicated by bracketing the amount.
The following example illustrates how the cash flow statement is drawn up:

Example 2
Required
Use the information provided below to prepare the cash flow statement of Schion Ltd for the year ended 31
December 20.14.

Information
Schion Ltd
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED
31 DECEMBER 20.14
R
Sales
1 800 000
Cost of sales
(1 125 000)
Gross profit 675 000
Operating expenses (474 000)
Directors’ fees 127 500
Auditor’s fees 67 500
Depreciation 81 000
Loss on sale of asset 21 000
Other non-disclosable costs 177 000
Operating profit 201 000
Investment income 24 600
Interest expense: on debentures (3 900)
Profit before tax 221 700
Company tax (77 595)
Profit for the year 144 105

MANCOSA 92
Financial Reporting and Analysis

Schion Ltd
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20.14
Ordinary Retained Total
share capital earnings
R R R
Balance on 01 January 20.14 525 000 263 775 788 775
Issue of share capital 150 000 150 000
Profit for the year 144 105 144 105
Dividends:
Ordinary interim (18 750) (18 750)
Ordinary final (35 250) (35 250)
Balance on 31 December 20.14 675 000 353 880 1 028 880

Schion Ltd
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER
20.14 20.13
R R
ASSETS
Non-current assets 996 090 858 075
Property, plant and equipment (See Note 1) 790 590 699 600
Financial assets: Investment – Subsidiary company 85 500 60 000
Investment – Listed shares (at cost) 120 000 98 475
Current assets 188 925 203 505
Inventories 120 690 119 700
Trade and other receivables 67 335 82 305
Trade debtors 67 335 82 305
Cash and cash equivalents 900 1 500
Bank - -
Petty cash 900 1 500
Total assets 1 185 015 1 061 580

93 MANCOSA
 Financial Reporting and Analysis

EQUITY AND LIABILITIES

Equity 1 028 880 788 775
Share capital 675 000 525 000
Retained earnings 353 880 263 775
Non-current liabilities 30 000 135 000
Long-term borrowings: 13% Debentures 30 000 135 000
Current liabilities 126 135 137 805
Trade and other payables 43 185 59 805
Trade creditors 43 185 59 805
South African Revenue Services (Company tax payable) 45 000 30 000
Shareholders for dividends 35 250 39 000
Bank overdraft 2 700 9 000
Total equity and liabilities 1 185 015 1 061 580

Note 1
Property, plant and equipment
20.14 20.13
Land and Land and
buildings Equip Vehicles buildings Equip Vehicles
R R R R R R
Cost 462 000 242 340 300 000 346 500 188 100 300 000

Accumulated
depreciation (82 500) (131 250) (45 000) (90 000)
Carrying value 462 000 159 840 168 750 346 500 143 100 210 000

Additional information
1. Equipment was sold for cash, R16 500. The cost price of the equipment sold was R39 750 and the
accumulated depreciation on it to the date of sale was R2 250. Equipment was also purchased for cash.
2. Additions were made to the buildings for cash.

MANCOSA 94
Financial Reporting and Analysis

Solution
Schion Ltd
CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20.14
R
Cash flows from operating activities 200 715
Profit before interest and tax (a) 201 000
Adjustments to convert to cash from operations
Non-cash flow adjustments 102 000
Add: Depreciation (b) 81 000
Loss on disposal of asset (c) 21 000
Profit before working capital changes 303 000
Working capital changes (2 640)
Increase in inventory (d) (990)
Decrease in receivables (e) 14 970
Decrease in payables (f) (16 620)
Cash generated from operations 300 360
Interest paid (g) (3 900)
Investment income (h) 24 600
Dividends paid (i) (57 750)
Company tax paid (j) (62 595)
Cash flow from investing activities (240 015)
Investment in listed shares (k) (21 525)
Investment in subsidiary company (l) (25 500)
Non-current assets purchased (m) (209 490)
Proceeds from sale of equipment (n) 16 500
Cash flow from financing activities 45 000
Proceeds from issue of ordinary shares (o) 150 000
Long-term borrowings redeemed (p) (105 000)
Net increase in cash and cash equivalents 5 700
Cash and cash equivalents at beginning of year (q) (7 500)
Cash and cash equivalents at end of year (r) (1 800)

95 MANCOSA
 Financial Reporting and Analysis

Calculations and explanatory notes

(a) Profit before interest and tax
This amount is obtained from the statement of comprehensive income (operating profit).

(b) Depreciation
The amount is obtained from the statement of comprehensive income.

(c) Loss on disposal of asset

The amount is obtained from the statement of comprehensive income.

(d) Increase in inventory

The increase is calculated by comparing the inventory figures for both years:
R120 690 – R119 700 = R990 (The amount is bracketed as it represents a use of cash.)

(e) Decrease in receivables

The decrease is calculated by comparing the Trade and other receivables figures for both years:
R82 305 – R67 335 = R14 970 (The amount represents a source of cash.)

(f) Decrease in payables

The decrease is calculated by comparing the Trade and other payables figures for both years:
R59 805 – R43 185 = R16 620 (The amount is bracketed as it represents a use of cash.)

(g) Interest paid

The amount is obtained from the statement of comprehensive income.

(h) Investment income

The amount is obtained from the statement of comprehensive income.

(i) Dividends paid

The amount paid is calculated as follows:
Dividends due on 31 December 20.13 (39 000)
Dividends for the year (54 000)
Dividends due on 31 December 20.14 35 250
(57 750)

MANCOSA 96
Financial Reporting and Analysis

Note:
 Dividends due on 31 December 20.13/20.14 is obtained from the item “Shareholders for dividends” in
the statement of financial position.
 Dividends for the year are obtained from the statement of changes in equity:
R13 200 + R21 000 + R35 250 = R69 450

(j) Company tax paid

The amount paid is calculated as follows:
Company tax due on 31 December 20.13 (30 000)
Company tax for the year (77 595)
Company tax due on 31 December 20.14 45 000
(62 595)

Note:
 Company tax due on 31 December 20.13/20.14 is obtained from the item “South African Revenue
Services” in the statement of financial position.
 Company tax for the year is obtained from the statement of comprehensive income.

(k) Investment in listed shares

The amount is calculated by comparing the figures for “Investment – Listed shares” (in the statement of
financial position) for both years:
R120 000 – R98 475= R21 525 (The amount is bracketed as it represents a use of cash.)

(l) Investment in subsidiary company

The amount is calculated by comparing the figures for “Investment – Subsidiary company” (in the
statement of financial position) for both years:
R85 500 – R60 000= R25 500 (The amount is bracketed as it represents a use of cash.)

(m) Non-current assets purchased

The amount is obtained by using the figures for both years for Land and buildings and Equipment in the
statement of financial position and after consideration was given to the additional information:
Land and buildings purchased: R462 000 – R346 500 = R115 500
Equipment purchase is calculated as follows:
Carrying value of equipment on 31 December 20.13 143 100
Additions (Purchase) *93 990

97 MANCOSA
 Financial Reporting and Analysis

Disposals at carrying value (Cost R39 750 – Acc. dep. R2 250) (37 500)
Depreciation (R45 000 – R2 250) – (R82 500) (39 750)
Carrying value of equipment on 31 December 20.14 159 840
*Purchase of equipment is calculated as follows:
(R143 100 – R37 500 – R39 750) – (R159 840) = R93 990
Non-current assets purchased = R115 500 + R93 990 = R209 490

(n) Proceeds from sale of equipment

The amount is calculated by using figures from the statement of comprehensive income (Loss on sale of
equipment) and after consideration was given to the additional information:
Carrying value of equipment sold is:
Cost R39 750 – Acc. dep. R2 250 = R37 500
However, the equipment was sold at a loss of R21 000. Therefore the proceeds from the sale of
equipment is R16 500 (R37 500 – R21 000).

(o) Proceeds from issue of ordinary shares

The amount is obtained from the statement of changes in equity.

(p) Long-term borrowings redeemed

The amount is obtained by comparing the figures for both years for “13% Debentures” (Long-term
borrowings) in the statement of financial position:
R135 000 – R30 000 = R105 000 (The amount is bracketed as it represents a use of cash.)

(q) Cash and cash equivalents at beginning of year

This is calculated by using the figures for Cash and cash equivalents and Bank overdraft as at 31
December 20.13:
Cash and cash equivalents 1 500
Bank overdraft (9 000)
Net unfavourable balance (7 500)

(r) Cash and cash equivalents at end of year

This is calculated by using the figures for Cash and cash equivalents and Bank overdraft as at 31
December 20.14:
Cash and cash equivalents 900
Bank overdraft (2 700)
Net unfavourable balance (1 800)

MANCOSA 98
Financial Reporting and Analysis

Other calculations:
 Profit before working capital changes
R201 000 + R102 000 = R303 000
 Cash generated from operations:
R303 000 – R2 640 = R300 360
 Cash flows from operating activities:
R300 360 – R3 900 + R24 600 – R57 750 – R62 595 = R200 715
 Net increase in cash and cash equivalents
This amount can be calculated by comparing the cash balances of 20.13 and 20.14 i.e. a net unfavourable
balance of R7 500 (2013) turned into a net unfavourable balance of R1 800 (2014) resulting in a net
increase in cash and cash equivalents of R5 700.
The net increase can be verified as follows:
R200 715 – R240 015 + R45 000 = R5 700

4.5 Self-Assessment Activities

4.5.1 The information given below was extracted from the accounting records of Ralco Ltd on 31 December
20.14 (the end of the financial year).
Information
Ralco Ltd
PRE-ADJUSTMENT TRIAL BALANCE AS AT 31 DECEMBER 20.14
Balance Sheet Accounts Section Debit (R) Credit (R)
Ordinary share capital 300 000
Retained earnings 58 900
Land and buildings 390 210
Vehicles (cost) 142 000
Equipment (cost) 88 000
Accumulated depreciation on vehicles 51 120
Accumulated depreciation on equipment 39 600
Loan from Nero Bank (14% p.a.) 120 000
Debentures (12% p.a.) 150 000
Investment (10 000 shares in DSL Ltd) 55 000
Debtors control 36 200
Provision for bad debts 3 100
Bank 24 700
Creditors control 48 300
South African Revenue Services: Company tax 18 000

99 MANCOSA
 Financial Reporting and Analysis

Nominal accounts section

Sales 666 100
Opening inventory 104 000
Purchases 423 500
Sales returns 3 100
Purchases returns 12 500
Carriage on purchases 7 000
Maintenance 2 780
Rates 2 670
Commission on sales 4 400
Carriage on sales 3 900
Wages and salaries 72 000
Stationery 1 430
Bad debts 890
Sundry expenses 990
Insurance 1 250
Telephone 4 800
Water and electricity 5 300
Directors’ fees 48 000
Auditor’s fees 8 000
Interest on loan 12 000
Ordinary share dividends 7 500
Rent income 18 000
1 467 620 1 467 620

Additional information
1. Provision for bad debts must be adjusted to 5% of trade debtors.
2. Trading inventory according to stocktaking on 31 December 20.14 amounted to
R112 000.
3. Depreciation must be provided for as follows:
* on vehicles at 20% per annum on the diminishing balance
* on equipment at 15% on cost
4. Debentures consist of 30 000 12% debentures of R5 each, that were issued on
31 December 20.13 and are redeemable on 31 December 20.19. The debentures are secured by a first
mortgage bond on land.

MANCOSA 100
 Financial Reporting and Analysis

5. The unsecured loan from Nero bank is payable in equal instalments of R12 000 per annum commencing on
01 July 20.14. Provide for the outstanding interest on loan.
6. A dividend of R3 000 is receivable on the listed shares in DSL Ltd.
7. An asset replacement reserve (non-distributable) of R40 000 must be created.
8. The authorised share capital consists of 250 000 ordinary shares. Note that on
01 July 20.14 the company issued 50 000 shares at R2 each.
9. The company tax for the year amounted to R18 500.
10. A final dividend of 9 cents per share was declared by the directors.

4.5.2 The information given below was extracted from the accounting records of Starc Ltd.

Required
Prepare the Cash flow statement for the year ended 31 December 20.14.
Information from the Statement of Financial Position as at 31 December:
20.14 20.13
R R

Ordinary share capital 800 000 590 000

Retained earnings 110 000 10 000
Property, plant and equipment (see note 1) 460 000 390 000
Investments 330 000 220 000
12.5% Debentures 40 000 120 000
Inventory 248 000 240 000
Trade debtors 74 000 57 000
Prepaid expenses (Rates) - 3 000
Trade creditors 50 000 85 000
Bank overdraft 42 000 50 000
South African Revenue Services (Income tax payable) 10 000 15 000
Shareholders for dividends 60 000 40 000

101 MANCOSA
 Financial Reporting and Analysis

Extract from the Statement of Comprehensive Income for the year ended
31 December 20.14
R

Profit before interest and tax 299 000

Depreciation on equipment 10 000
Dividends received on investment 36 000
Interest on debentures 15 000
Income tax 100 000
Extract from Statement of changes in equity for the year ended 31 December 20.14
R
Dividends on ordinary shares 120 000

Note 1
20.14 20.13
Property, plant and equipment R R
Land and buildings at cost 400 000 320 000
Equipment at carrying value 60 000 70 000
460 000 390 000

Additional information
1. No equipment was purchased or sold during the financial year ended 31 December 20.14.
2. Ordinary shares were issued during the year.

MANCOSA 102
Financial Reporting and Analysis

4.6 Suggested Solutions

4.5.1
Ralco Ltd
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED
31 DECEMBER 20.14
R
Sales (666 100-3 100) 663 000
Cost of sales (410 000)
Opening inventory (104 000) 104 000
Purchases (423 500-12 500) 411 000
Carriage on purchases (7 000) 7 000
Closing inventory (112 000)
Gross profit 253 000
Other operating income 19 290
Rent income (18 000) 18 000
Provision for bad debts adjustment 1 290
Gross operating income 272 290
Operating expenses (187 786)
Maintenance (2 780) 2 780
Rates (2 670) 2 670
Commission on sales (4 400) 4 400
Carriage on sales (3 900) 3 900
Wages and salaries (72 000) 72 000
Stationery (1 430) 1 430
Bad debts (890) 890
Sundry expenses (990) 990
Insurance (1 250) 1 250
Telephone (4 800) 4 800
Water and electricity (5 300) 5 300
Directors’ fees (48 000) 48 000
Auditor’s fees (48 000) 8 000
Depreciation (18 176+13 200) 31 376
Operating profit 84 504
Dividends earned 3 000
Interest expense: on loan (12 000+4 800) (16 800)
: on debentures (18 000)
Profit before tax 52 704
Company tax (18 500)
Profit for the year 34 204

103 MANCOSA
 Financial Reporting and Analysis

REMARKS
The effects of the adjustments and additional information on the financial statements are as follows:
Effect on Statement of Comprehensive Effect on Statement of Financial Position,
Income Statement of Changes in Equity and Notes to the
Financial Statements

1. Provision for bad debts adjustment Provision for bad debts

R3 100 – R1 810 = R1 290 (decrease) (R36 200 X 5%) = R1 810
2. Closing inventory R112 000 Trading inventory R112 000
3. Depreciation on: Note 3 Depreciation for the year:
Vehicles (R142 000 – R51 120) X 20% = Vehicles R18 176
R18 176
Equipment R13 200
Equipment (R88 000 X 15%) = R13 200

4. Interest on debentures Accrued expenses R18 000

R150 000 X 12% = R18 000
5. Interest on loan Accrued expenses
R120 000 X 14% = R16 800 (R16 800 – R12 000) = R4 800
Loan 120 000 – R12 000 = R108 000
Current portion of loan R12 000

6. Dividend income R3 000 Accrued income R3 000

7. – Recorded in statement of changes in equity
8. – Information available to complete the note for share
capital and statement of changes in equity

9. Company tax R18 500 SARS-Company tax

R18 500 – R18 000 = R500 (owing)
10. – Dividends on ordinary shares
150 000 shares X R0,09 = R13 500
(N.B. R300 000 ÷R2 = 150 000 shares)
Shareholders for dividends R13 500

MANCOSA 104
Financial Reporting and Analysis

Ralco Ltd
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20.14
Ordinary Asset Retained
replace earnings
share Total
reserve
capital
R R R R
Balance on 01 January 20.14 200 000 58 900 258 900
Issue of share capital 100 000 100 000
Profit for the year 34 204 34 204
Transfer to asset replacement reserve 40 000 (40 000) 0
Dividends: Ordinary interim (7 500) (7 500)
Ordinary final (13 500) (13 500)
Balance on 31 December 20.14 300 000 40 000 32 104 372 104

Ralco Ltd
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20.14
Note R
ASSETS
Non-current assets 553 114
Property, plant and equipment 2 498 114
Financial assets 3 55 000
Current assets 174 090
Inventories 4 112 000
Trade and other receivables 37 390
Trade debtors (36 200) 36 200
Provision for bad debts (3 100 – 1 290) (1 810)
Accrued income (3 000) 3 000
Cash and cash equivalents 24 700
Bank (24 700) 24 700
Total assets 727 204

105 MANCOSA
 Financial Reporting and Analysis

EQUITY AND LIABILITIES

Equity 372 104
Share capital 5 300 000
Other reserves 40 000
Retained earnings 32 104
Non-current liabilities 258 000
Long-term borrowings 6 258 000
Current liabilities 97 100
Trade and other payables 71 100
Trade creditors (48 300) 48 300
Accrued expenses (18 000 + 4 800) 22 800
Current portion of long-term borrowings 6 12 000
South African Revenue Services: Company tax 500
Shareholders for dividends 13 500
Total equity and liabilities 727 204

NOTES TO THE FINANCIAL STATEMENTS

1. Accounting policy
The accounting policy of Ralco Ltd is consistent with that of the previous year, and is as follows:
1.1 Measurement basis
The financial statements are based on the historical cost and comply with Generally Accepted Accounting
Practice.
1.2 Property, plant and equipment
Depreciation has been provided as follows:
Vehicles: 20% per annum on the diminishing balance
Equipment: 15% per annum on cost
1.3 Financial assets
Listed shares are measured at market value.
1.4 Inventories
Inventories are measured at the lower of cost, on the FIF0 method, and net realisable value, whichever is
lower.
1.5 Revenue recognition
Sales is recognised upon delivery of products.

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2. Property, plant and equipment

Land and
buildings Vehicles Equipment Total
Carrying value at beginning of year 390 210 90 880 48 400 529 490
Cost 390 210 142 000 88 000 620 210
Accumulated depreciation (51 120) (39 600) (90 720)
Depreciation for the year (18 176) (13 200) (31 376)
Carrying value at end of year 390 210 72 704 35 200 498 114
Cost 390 210 142 000 88 000 620 210
Accumulated depreciation (69 296) (52 800) (122 096)

3. Financial assets

Investment in listed shares in DSL Ltd at market value 55 000

4. Inventories

Inventories consist of:

Merchandise 112 000

5. Share capital

Authorised
250 000 ordinary shares

Issued
100 000 ordinary shares in issue at beginning of year 200 000
50 000 shares of R2 each issued during the year 100 000
300 000

6. Long term borrowings

Unsecured
Loan from Nero Bank payable in equal instalments commencing on 01 July 20.14. Interest rate
is 14% p.a. 120 000
Less: Instalment payable within one year, transferred to current liabilities (12 000)
108 000

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 Financial Reporting and Analysis

Secured
12% Debentures, secured by a first mortgage bond over land. The debentures are redeemable
on 31 December 20.19 150 000
258 000

4.5.2
Starc Ltd
CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20.14
R
Cash flows from operating activities 68 000
Profit before interest and tax (a) 299 000
Adjustments to convert to cash from operations
Non-cash flow adjustments 10 000
Add: Depreciation (b) 10 000
Profit before working capital changes 309 000
Working capital changes (57 000)
Increase in inventory (c) (8 000)
Increase in receivables (d) (14 000)
Decrease in payables (e) (35 000)

Cash generated from operations 252 000

Interest paid (f) (15 000)
Investment income (g) 36 000
Dividends paid (h) (100 000)
Company tax paid (i) (105 000)

Cash flow from investing activities (190 000)

Increase in investments (j) (110 000)
Non-current assets purchased (k) (80 000)

Cash flow from financing activities 130 000

Proceeds from issue of ordinary shares (l) 210 000
Long-term borrowings redeemed (m) (80 000)
Net increase in cash and cash equivalents 8 000
Cash and cash equivalents at beginning of year (n) (50 000)
Cash and cash equivalents at end of year (o) (42 000)

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Calculations and explanatory notes

(a) Profit before interest and tax
This amount is obtained from the statement of comprehensive income.

(b) Depreciation
The amount is obtained from the statement of comprehensive income.

(c) Increase in inventory

The increase is calculated by comparing the Inventory figures for both years:
R248 000 – R240 000 = R8 000 (The amount is bracketed as it represents a use of cash.)

(d) Increase in receivables

The increase is calculated by comparing the Trade and other receivables figures (Trade debtors and
Prepaid expenses) for both years:
R74 000 – (57 000 + 3 000) = R14 000 (The amount is bracketed as it represents a use of cash.)

(e) Decrease in payables

The decrease is calculated by comparing the Trade and other payables figures (Trade creditors) for
both years:
R85 000 – R50 000 = R35 000 (The amount is bracketed as it represents a use of cash.)

(f) Interest paid

The amount is obtained from the statement of comprehensive income.

(g) Investment income

The amount is obtained from the statement of comprehensive income (Dividends received).
(h) Dividends paid
The amount paid is calculated as follows:
Dividends due on 31 December 20.13 (40 000)
Dividends for the year (120 000)
Dividends due on 31 December 20.14 60 000
(100 000)

Note:
 Dividends due on 31 December 20.13/20.14 is obtained from the item “Shareholders for dividends” in the
statement of financial position.
 Dividends for the year are obtained from the statement of changes in equity.

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(i) Company tax paid

The amount paid is calculated as follows:
Company tax due on 31 December 20.13 (15 000)
Company tax for the year (100 000)
Company tax due on 31 December 20.14 10 000
(105 000)

Note:
 Company tax due on 31 December 20.13/20.14 is obtained from the item “South African Revenue Services” in
the statement of financial position.
 Company tax for the year is obtained from the statement of comprehensive income.

(j)
Increase in investments

The amount is calculated by comparing the figures for “Investments” (in the statement of financial position) for both
years:
R330 000 – R220 000= R110 000 (The amount is bracketed as it represents a use of cash.)

(k)
Non-current assets purchased
The amount is obtained by comparing the figures for both years for Land and buildings in the note to the statement
of financial position and after consideration was given to the additional information:
R400 000 – R320 000 = R80 000
(l)

Proceeds from issue of ordinary shares

The amount is obtained by comparing the figures for Ordinary share capital in the statement of financial position
for both years:

R800 000 – R590 000 = R210 000

(m)

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Long-term borrowings redeemed

The amount is obtained by comparing the figures for both years for “12,5% Debentures” in the statement of financial
position:

R120 000 – R40 000 = R80 000 (The amount is bracketed as it represents a use of cash.)

(n)
Cash and cash equivalents at beginning of year

There was only a Bank overdraft of R50 000.

(o)
Cash and cash equivalents at end of year

There was only a Bank overdraft of R42 000.

Other calculations

Profit before working capital changes
R299 000 + R10 000 = R309 000

Cash generated from operations:
R309 000 – R57 000 = R252 000

Cash flows from operating activities:
R252 000 – R15 000 + R36 000 – R100 000 – R105 000 = R68 000

Net increase in cash and cash equivalents

This amount can be calculated by comparing the cash balances of 20.13 and 20.14 i.e. an unfavourable balance
of R50 000 (20.13) turned into an unfavourable balance of R42 000 (20.14) resulting in a net increase in cash and
cash equivalents of R8 000.

The net increase can be verified as follows:

R68 000 – R190 000 + R130 000 = R8 000

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Unit
5: Analysis of Financial Statements

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Financial Reporting and Analysis

Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

5.1 Introduction  Introduce topic areas for the unit

5.2 Types of comparison  Distinguish between industry comparative and time-series

analysis.

5.3 Profitability ratios  Calculate profitability ratios

5.4 Liquidity ratios  Calculate liquidity ratios

5.5 Activity ratios  Calculate activity ratios

5.6 Debt(solvency ratios)  Calculate debt ratios

5.7 Securities market ratios  Calculate market ratios

Prescribed / Recommended Readings

 Bartlett, G., Beech, G., de Hart, F., de Jager, P., de Lange, J., Erasmus, P.,
Hefer, J., Madiba, T., Middelberg, S., Plant, G., Streng, J., Thayser, D. and van
Rooyen, S. (2014) Financial Management: Turning theory into practice. 1st
Edition. Cape Town: Oxford University Press.
 Lodewyckx, E., Lötter, W., Rhodes, N. and Seedat, C. (2013) Introduction to
Financial Accounting: Fresh Perspectives. 2nd edition. Cape Town: Pearson.
 Marx, J., de Swardt, C., Smith, M.B. and Erasmus, P. (2014) Financial
Management in Southern Africa. 4th Edition. Cape Town: Pearson Education.

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5.1 Introduction
Financial statements provide insight into the financial performance and financial position of an entity. According
to Marx and Swardt (2014:65) the statements need to be further analysed by means of financial ratios in order to
extract more meaningful conclusions in order to diagnose and make a prognosis.

A ratio may be defined as the relationship between two sets of values. Ratios provide the means to summarise
complex accounting information into a small number of key indicators. They make figures more easily comparable.

The purpose of financial analysis is to either evaluate the financial performance and financial position of an entity
during the past accounting period or to evaluate the future plans of the entity based on the pro forma (budgeted)
financial statements. Financial analysis can also be used to identify and assess risks. The information required
for financial analysis is obtained from the statement of comprehensive income (income statement) and statement
of financial position (balance sheet).

Marx and Swardt (2014:65) add that the financial performance of a company cannot be ascribed to management
alone as economic conditions and competitive forces within the relevant industry also have an influence. During
periods of economic expansion, most firms usually experience rising sales, improved cash flows, lower bad debts
and higher profitability. The opposite is true during periods of economic contraction. Entities that have no or few
competitors usually achieve superior profitability compared to entities that have many competitors.
Financial ratios may be divided into five basic groups:
■ Profitability ratios
■ Liquidity ratios
■ Activity ratios
■ Debt (solvency) ratios
■ Securities market ratios

The most commonly used financial ratios are shown in Figure 5-1 :

Profitability Liquidity Activity Debt/Solvency Securities market

Gross margin Current ratio Inventory turnover Debt to assets Earnings per share
Profit margin Acid test Debtors collection Debt/equity Dividend per share
period
Return on assets Creditor payment Interest coverage Price/Earnings ratio
period
Return on equity Earnings yield
Dividend yield
Figure 4Figure 5-1 Financial ratios

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This topic will explain the calculation and interpretation of the ratios indicated in Figure 5-1 above, and the
possible corrective actions that management may consider using wherever required.

5.2 Types Of Comparison

Ratio analysis does not involve only the calculation of ratios. The interpretation of the ratios is more important.
One must be able to ascertain whether the ratio is favourable or unfavourable; whether the ratio is too high or too
low, and so on. The interpretation is facilitated by having meaningful benchmarks or by means of comparisons.
Marx and Swardt (2014:66) distinguish between industry comparative and time-series analysis.

5.2.1 Industry comparative analysis

This involves a comparison of the financial ratios of different entities at the same point in time. This enables one
to determine how well an entity has performed in relation to its competitors. This is also known as the
“benchmarking approach” since the entity’s performance may be compared to the industry leader or industry
average.

5.2.2 Time-series analysis

This is undertaken to evaluate the performance of an entity over time. Comparing current performance with past
performance using ratio analysis allows one to determine whether an entity is progressing as planned. Significant
year-to-year changes should be investigated to determine whether they are symptomatic of major problems.

The most appropriate approach to ratio analysis is one that combines industry comparative and time-series
analyses.

The ratios indicated in Figure 5-1 will be explained using figures from the statement of comprehensive income
(income statement) and statement of financial position (balance sheet).as contained in Figure 5-2 and Figure 5-3
respectively:
Spire Limited
Statement of Comprehensive Income for the year ended 31 December:
20.14 20.13
Sales (all credit) 1 672 400 1 574 800
Cost of sales (all credit) (878 700) (812 600)
Gross profit 793 700 762 200
Operating expenses: (487 900) (466 600)
Selling, general and administrative 396 300 371 200
Other expenses 91 600 95 400
Operating profit 305 800 295 600
Other income: 2 700 3 300

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 Financial Reporting and Analysis

Interest income 2 700 3 300

Profit before interest 308 500 298 900
Interest expense (11 100) (10 900)
Profit before tax 297 400 288 000
Company tax (74 350) (72 000)
Profit after tax 223 050 216 000

Figure 5Figure 5-2: Statement of Comprehensive Income

Spire Limited
Statement of Financial Position as at 31 December:
Assets 20.14 20.13
Non-current assets 814 300 783 000
Current assets: 637 900 606 600
Inventories 231 200 203 000
Accounts receivable 289 100 277 800
Cash and cash equivalents 117 600 125 800
Total assets 1 452 200 1 389 600

Equity and liabilities

Equity 653 100 628 900
Ordinary share capital (600 000 shares) 600 000 600 000
Retained earnings 53 100 28 900
Non-current liabilities 323 700 378 800
Current liabilities 475 400 381 900
Accounts payable 108 100 100 800
Other current liabilities 367 300 281 100
Total Equity and liabilities 1 452 200 1 389 600

Figure 6Figure 5-3: Statement of Financial Position

5.3 Profitability Ratios

According to Marx and Swardt (2014:69) there are many measures of profitability, all of which relate the returns of
the entity relative to sales, assets or equity. Profitability ratios evaluate the effectiveness and efficiency of
management and employees in generating profit by means of sales and in their productive use of the assets and
equity. The most common measures of profitability include:
Gross margin
Profit margin
Return on assets

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Financial Reporting and Analysis

Return on equity
These ratios are now explained.

5.3.1 Gross margin (Gross profit margin)

The gross margin ratio indicates the profit of the firm relative to sales after deducting the cost of sales. It reflects
the contribution from an entity’s core business towards covering the operating expenses. It is calculated by
expressing the gross profit as a percentage of sales:

Gross margin = Gross profit X 100

Sales 1

In the case of Spire Limited the gross margin is as follows:

20.14 20.13
Gross margin = Gross profit X 100 Gross margin = Gross profit X 100
Sales 1 Sales 1
= R793 700 X 100 = R762 200 X 100
R1 672 400 1 R1 574 800 1
= 47,46% = 48,40%

A gross margin decline of 0.94% occurred from the previous year. Gross margin can be affected by a
combination of changes in:
■ the price charged for products sold.
■ the price paid for products purchased.
■ any variation in the product mix of the business.

The gross margin ratio may be improved by:

■ attempting to produce at a lower cost or buy at better prices, whilst maintaining the current selling price.
■ selling a greater proportion of goods that have a higher mark-up.
■ purchasing goods in bulk to get quantity discounts.

5.3.2 Profit margin (Net profit margin)

This ratio pertains to the relationship of profit after taxes to sales and is indicative of management’s ability to
operate the enterprise profitably. To be successful an enterprise must not only recover the cost of the merchandise,
the operating expenses, and the cost of borrowed funds but also there must also be reasonable compensation to

117 MANCOSA
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the owners for putting their capital at risk. The profit margin ratio is important to operating managers since it reflects
an enterprise’s pricing strategy and its ability to control operating costs.
Profit margin is calculated by expressing the Profit after taxes as a percentage of sales:
Profit margin = Profit after tax X 100
Sales 1

The profit margin of Spire Limited is as follows:

20.14 20.13
Profit margin Profit margin
= Profit after tax X 100 = Profit after tax X 100
Sales 1 Sales 1
= R223 050 X 100 = R216 000 X 100
R1 672 400 1 R1 574 800 1
= 13.34% = 13.72%

A small decline of 0.38% from 20.13 is noted signifying a slight drop in profitability. Net profit margin is
significantly lower than the gross margin and is probably due to the high operating expenses.

The profit margin ratio may be improved by:

■ increasing sales through more effective and efficient marketing.
■ reducing expenses by ranking them from the greatest to the lowest and considering reductions in each type
of expense, such as cutting down on overtime.

5.3.3 Return on assets (Operating profit on total assets)

Return on assets (ROA) measures the efficiency of management in generating profits with its available assets. It
differs from return on equity since it measures profit as a percentage of the funds provided by both owners and
creditors as opposed to funds provided by the owners only. ROA is calculated as follows:

Return on assets = Operating profit X 100

Total assets 1

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Return on assets of Spire Limited is calculated as follows:

20.14 20.13
Return on assets Return on assets
= Operating profit X 100 = Operating profit X 100
Total assets 1 Total assets 1
= R305 800 X 100 = R295 600 X 100
R1 452 200 1 R1 389 600 1
= 21,06% = 21,27%

Spire Limited experienced a slight decline in profitability. A comparison of this return to the inflation rate, return
on alternative investments, and interest rate on borrowed capital is required to determine whether the return is
satisfactory or not.
The return on assets may be improved by:
■ increasing sales through effective marketing strategies.
■ reducing investment in current assets such as inventories and accounts receivable during periods of declining
sales.
■ unbundling of business assets that achieve low or no profitability.
■ evaluating the effectiveness and efficiency of fixed assets with a view to improving productivity.

5.3.4 Return on equity (ROE)

Return on equity measures the rate of return on shareholders’ investment. It enables one to check whether the
return made on an investment is better than the alternatives available. It is calculated by expressing the net profit
after tax on the equity (as a percentage):
Return on equity = Profit after tax X 100
Equity 1

Return on equity for Spire Limited is calculated as follows:

20.14
Return on equity
= Profit after tax X 100
Equity 1
= R223 050 X 100
R653 100 1
= 34,15%

20.13

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 Financial Reporting and Analysis

Return on equity
= Profit after tax X 100
Equity 1
= R216 000 X 100
R628 900 1
= 34,35%

Owners often compare this return to the return offered on alternative investments. In the case of Spire Limited,
the owners should be satisfied with the return of over 34% which is higher than the inflation rate (although there
was a slight decline in profitability). A good return on equity fuels investment interest from prospective investors.
It increases share prices and makes it easier for the company to borrow money.
The return on equity may be improved in the following ways:
■ increasing revenue by generating more sales through effective marketing strategies.
■ reducing operating expenses.
■ buying back some of the entity’s ordinary shares by raising more long-term loans.

5.4 Liquidity Ratios

Marx and Swardt (2014:72) define liquidity ratios as the measure of the ability of an enterprise to meet its short-
term obligations as they become due. These ratios focus on the liquid assets of the enterprise i.e. current assets
that can readily be converted into cash on the assumption that they form a cushion against default. The most
commonly used liquidity ratios are the current ratio and acid test ratio.

5.4.1 Current ratio

The current ratio shows the relationship between current assets and current liabilities and is an attempt to show
the safety of current debt holders’ claims in the case of default. A current ratio of at least 2:1 is usually
considered to be an acceptable value. However, this depends on the industry in which the entity operates. The
current ratio is calculated as follows:

Current ratio = Current assets

Current liabilities

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The current ratio for Spire Limited is as follows:

20.14 20.13
Current ratio Current ratio
= Current assets = Current assets
Current liabilities Current liabilities
= R637 900 = R606 600
R475 400 R381 900
= 1,34:1 = 1,59:1

A decline in the ratio (from 1,59:1 to 1,34:1) is largely due to the increase in current liabilities from the previous
year. Based on the norm of at least 2:1, Spire Limited may experience liquidity problems. An enterprise with a
low current ratio may not be able to convert its current assets into cash to meet maturing obligations. From a
debt holder’s point of view, a higher ratio appears to provide a cushion against losses in the event of business
failure. A large excess of current assets over current liabilities seems to protect claims. However, from a
management point of view a very high current ratio may point towards slack management practices. It may
indicate idle cash, high inventory levels that may be unnecessary and poor credit management resulting in
overextended accounts receivable.

If the current ratio is not satisfactory, then management should consider:

■ accelerating cash inflow by offering cash discounts for early settlement of debtors’ accounts.
■ improving its management of inventories by, for example, purchasing goods that satisfy the needs of the
target market.
■ selling more goods on credit, but ensuring that debtors settle their accounts on time.

Think Point
Some current assets have a higher return than others do. Can you think of
an example?.

5.4.2 Acid test ratio (Quick ratio)

This ratio is a more stringent test of liquidity. The intention of the acid test ratio is to test the collectability of current
liabilities under distress conditions, on the assumption that inventories would have no value at all. In the case of
a real crisis creditors may realise little cash from the sale of inventory. The acid test ratio is similar to the current
ratio except that the current assets (numerator) are reduced by the value of the inventory. An acid test ratio of at
least 1:1 is considered acceptable. The calculation is done as follows:

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Acid test ratio = Current assets – Inventory

Current liabilities

Spire Limited’s acid test ratio is as follows:

20.14 20.13
Acid test ratio Acid test ratio
= Current assets – Inventory = Current assets – Inventories
Current liabilities Current liabilities
= R637 900 – R231 200 = R606 600 – R203 000
R475 400 R381 900
= 0,86:1 = 1,06:1

It is clear that a ratio of less than 1:1 would pose liquidity problems in the event of a crisis. Spire Limited faces this
position at the end of 20.14 as the ratio indicates there only R0,86 of liquid assets is available to settle every R1
of current liabilities.

Corrective actions to improve the acid test ratio are similar to those of the current ratio.

5.5 Activity Ratios

Marx and Swardt (2014:75) state that activity ratios are used to measure the speed with which various accounts
are converted into sales or cash. We will focus on the rate at which inventory is sold, the time taken by debtors to
pay accounts and the time taken to settle creditors accounts.

5.5.1 Inventory turnover

In evaluating the effectiveness of an enterprise’s inventory management, it is common to use the number of times
inventory has turned over during the period of analysis. The higher the turnover rate the better, since low
inventories usually suggest a minimal risk of non-saleable merchandise and also indicates efficient use of capital.
Inventory turnover is calculated as follows:
Inventory turnover = Cost of sales
Average inventory

Average inventory refer to the average of the beginning and ending inventories. The inventory turnover
of Spire Limited is calculated as follows:
(Note: Inventories at the end of 20.12 amounted to R224 680.):

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Financial Reporting and Analysis

20.14 20.13
Inventory turnover Inventory turnover
= Cost of sales = Cost of sales
Average inventory Average inventory
= R878 700 = R812 600
R217 100 R213 840
= 4,05 times = 3,80 times

Note: Average inventory is calculated as follows:

20.14 20.13
= R231 200 + R203 000 = R203 000 + R224 680
2 2
= R217 100 = R213 840

The inventory turnover of Spire Limited shows an improvement from 3,80 times to 4,05 times per annum. The
inventory turnover of 4,05 times for 20.14 implies that merchandise remains in inventory for an average of 90
days (365 days ÷ 4,05 times) before being sold.
An entity may try to improve its inventory turnover by:
■ lowering inventory levels through more accurate demand forecasts.
■ having specials and monthly sales.

Think Point
What do you think are the implications for an enterprise if the:
 Inventory turnover is low.
 inventory turnover is high

5.5.2 Debtor collection period

This ratio tells us how long trade debtors take to meet their obligations to pay following the sale on credit. It
highlight’s the enterprise’s management of debtors (or accounts receivable) by evaluating credit and collection
policies. One would want to know whether the accounts receivable that are outstanding at the end of the period
closely approximate the amount of credit sales one would expect to remain outstanding under prevailing credit
terms. This is done as follows:

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Debtor collection period = Accounts receivable X 365

Credit sales

20.14 20.13
Debtor collection period Debtor collection period
= Accounts receivable X 365 = Accounts receivable X 365
Credit sales Credit sales
= R289 100 X 365 = R277 800 X 365
R1 672 400 R1 574 800
= 63,10 days = 64,39 days

The debtor collection period may be interpreted in two ways. One can say that Spire Limited has an average of
63,10 days’ worth of credit sales tied up in accounts receivable, or one can say that the average time lag between
sale and receipt of cash from the sale is 63,10 days. This collection period allows us to compare it with the terms
of sale. Thus if Spire Limited sells on 30 day terms, the collection period is very unsatisfactory. It could mean
that some customers had difficulty paying, or were abusing their credit privileges, or that some sales were made
on extended terms.

An entity with an unfavourable debtor collection period may consider doing the following:
■ Provide incentives to increase cash sales, thereby lowering credit sales and thus accounts receivable.
■ Accelerate the collection period by offering debtors discounts for early settlement.
■ Send account statements out early, using electronic and traditional means.
■ Charge interest on overdue accounts.

5.5.3 Creditor payment period

This ratio tells us how long, on average, an enterprise takes to pay for goods bought following the purchase on
credit. It is used to evaluate an enterprise’s performance with regard to the management of accounts payable
(creditors). The number of days of accounts payable (or creditor payment period) is compared to the credit terms
under which the enterprise makes purchases. Significant deviations from this norm can be detected. Optimal
management of accounts payable requires making payment within the stated terms and no earlier except for
taking advantage of discounts whenever offered for early payment

Creditor payment period may be calculated as follows:

Creditor payment period = Accounts payable X 365
Credit purchases

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20.14 20.13
Creditor payment period Creditor payment period
= Accounts payable X 365 = Accounts payable X 365
Credit purchases Credit purchases
= R108 100 X 365 = R100 800 X 365
R906 900 R790 920
= 43,51 days = 46,52 days

Note: Purchases are calculated as follows:

20.14 20.13
Cost of sales 878 700 812 600
Add: Closing inventory 231 200 203 000
1 109 900 1 015 600
Less opening inventory (203 000) (224 680)
Purchases 906 900 790 920

Since all the purchases are on credit, in this case total purchases = credit purchases. Spire Limited is probably
allowed credit terms of between 30 days and 60 days by creditors.
If the credit terms are exceeded, reasons for the late payment should be investigated and the entity should in future
adhere to the credit terms to avoid damaging its credit record.

5.6 Debt Ratios

According to Marx and Swardt (2014:78) lenders are concerned with an entity’s degree of indebtedness and ability
to service debts since the more indebted a firm, the greater the probability that the firm will be unable to satisfy the
claims of all its creditors.

An enterprise increases its financial leverage when it raises the proportion of debt relative to equity to finance the
business. The successful use of debt enhances the earnings for the owners of the enterprises since returns on
these funds, over and above the interest paid, belongs to the owners, and therefore increases the return on equity.
However, from the point of view of the lender, when earnings are insufficient to cover the interest cost, the fixed
interest and principal commitments must still be met. The most common measures of debt are the debt to assets
and debt/equity ratios.

5.6.1 Debt to assets (Debt ratio)

Debt to assets ratio is used to reflect the proportion of debt to the total claims against the assets of the
enterprise. The greater the ratio, the higher the risk. Debt to asset ratio is expressed as follows:

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Debt to assets = Total debt X 100

Total assets 1

The debt to assets ratio of Spire Limited is as follows:

20.14 20.13
Debt to assets Debt to assets
= Total debt X 100 = Total debt X 100
Total assets 1 Total assets 1
= R799 100 X 100 = R760 700 X 100
R1 452 200 1 R1 389 600 1
= 55,03% = 54,74%

The ratio indicates that more than half of Spire Limited assets, in book value terms, come from creditors of one
type or another. If the company is efficient in generating satisfactory returns on the assets at its disposal, then
the return on equity may be boosted as a result of using less equity and more debt.

If the debt to assets ratio is too high, management may consider:

■ buying back some of its ordinary shares by obtaining long-term loans.
■ reducing its current liabilities by accelerating cash inflow (e.g. having special offers and sales).

5.6.2 Debt to equity

This ratio attempts to show the relative proportions of non-current claims to ownership claims, and is used as a
measure of debt exposure. Debt to equity ratio is expressed as follows:
Debt to equity = Non-current debt X 100
Equity 1

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The debt to equity ratio of Spire Limited is as follows:

20.14 20.13
Debt to equity Debt to equity
= Non-current debt X 100 = Non-current debt X 100
Equity 1 Equity 1
= R323 700 X 100 = R378 800 X 100
R653 100 1 R628 900 1
= 49,56% = 60,23%

The ratio indicates that the non-current creditors supply Spire Limited with 49.65 cents for every Rand supplied
by the owners. The ratios over the two year period show a decrease in the use of non-current debt by the
company.

If the debt/equity ratio is too high, management should consider issuing new ordinary shares and using the cash
raised to pay off long-term debt.

5.6.3 Interest coverage (Times interest earned ratio)

Although this ratio is not a measure of debt, it does give some indication of a firm’s ability to cover the interest
payments that will result from any loan agreements it enters into. This ratio is based on the premise that annual
operating earnings are the basic source for debt service, and that any major change in this relationship may signal
difficulties. Debt holders often stipulate the number of times the business is expected to cover its debt service
obligations. The ratio for interest coverage is as follows:

Interest coverage = Operating profit

Interest expense

Spire Limited interest coverage ratio is as follows:

20.14 20.13
Interest coverage Interest coverage
= Operating profit = Operating profit
Interest expense Interest expense
= R305 800 = R295 600
R11 100 R10 900
= 27,55 times = 27,12 times

A value of between 3 and 5 times is usually recommended. Spire Limited interest coverage of 27, 55 times
means that the enterprise’s profit covers its interest obligations adequately.

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5.7 Securities Market Ratios

According to Marx and Swardt (2014:80) the earnings per share, dividend per share, price/earnings, earnings yield
and dividend yield ratios are applicable only to companies listed on a stock exchange such as the Johannesburg
Securities Exchange (JSE).

5.7.1 Earnings per share (EPS)

The earnings per share ratio is considered to be an indicator of profitability. It is a ratio that both management and
shareholders pay a great deal of attention to. It is also carefully monitored by investment analysts and portfolio
managers. The ratio simply involves dividing the profit after tax by the number of ordinary shares in issue:

Earnings per share = Profit after tax

Number of ordinary shares issued

Earnings per share for Spire Limited is calculated as follows:

20.14 20.13
Earnings per share Earnings per share
= Profit after tax Profit after tax
Number of ordinary shares issued Number of ordinary shares issued
= R223 050 X 100 = R216 000 X 100
600 000 600 000
= 37,18 cents = 36 cents

The earnings per share have increased by 1.18 cents per share, signalling a slight improvement in profitability.
Shareholders look forward to an increase in the earnings per share as their dividends per share depend on it.

If the EPS is too low, then management may consider:

■ buying back some of its ordinary shares by obtaining long-term loans to finance it.
■ improving the profitability of the entity by better marketing strategies etc.

5.7.2 Dividend per share (DPS)

Dividends are usually declared on a per share basis by the company’s board of directors. The board of directors
usually has a dividend policy in place. Because the value of ordinary shares is partly influenced by dividends

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paid and anticipated, the board has to deal with this periodic decision very carefully. DPS is calculated by dividing
the dividends for the year by the number of ordinary shares issued:
Dividend per share = Dividends for the year
Number of ordinary shares issued

If the dividends of Spire Limited for 20.14 and 20.13 were R105 000 and
R100 000 respectively, then the dividend per share is calculated as follows:

20.14 20.13
Dividend per share Dividend per share
= Dividends for the year Dividends for the year
Number of ordinary shares issued Number of ordinary shares issued
= R105 000 X 100 = R100 000 X 100
600 000 600 000
= 17,5 cents = 16,67 cents

The dividend per share has risen by 0.83 cents per share, probably due to the increase in the earnings per share.
If the dividend per share is too low, management should investigate ways of improving the profitability of the
entity.

5.7.3 Price/Earnings (P/E) ratio

This ratio is one of the most important measures used by investors and managers to evaluate the market price
of a company’s ordinary shares. It is also used to indicate how the stock market is judging the company’s earnings
performance and prospects. This is one reason why the EPS (used in the calculation) is reported prominently on
the face of the income statement. The price/earnings ratio is calculated as follows:

Price/Earnings ratio = Market price per share

Earnings per share

The price/earnings ratio for Spire Limited (the market price per share for 20.14 and 20.13 was 130 cents and
120 cents respectively) is calculated as follows:

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20.14 20.13

Price/Earnings ratio Price/Earnings ratio

= Market price per share = Market price per share

Earnings per share Earnings per share

= 130 cents = 120 cents

37,18 cents 36 cents

= 3,50 times = 3,33 times

The ratio shows that investors are willing to pay approximately 3.50 times the earnings for the shares. This ratio
needs to be compared to the average P/E ratio of similar companies. An above-average P/E ratio indicates that
the market price is high relative to the company’s current earnings, possibly because investors anticipate
favourable future developments such as increased EPS or higher DPS. Low P/E ratios usually indicate poor
earnings expectations.

The management of a company with a price/earnings ratio that is considered to be too low should focus on
improving profitability.

5.7.4 Earnings yield

The earnings yield ratio reflects the current profit-generating power per ordinary share at the current market price.
It is a way to measure returns, and it helps investors evaluate whether those returns are commensurate with
an investment's risk. It is the opposite of the price/earnings ratio. The ratio is thus:
Earnings yield = Earnings per share
Market price per share

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Earnings yield for Spire Limited is calculated as follows:

20.14 20.13
Earnings yield Earnings yield
= Earnings per share X 100 Earnings per share X 100
Market price per share Market price per share
= 37,18 cents X 100 = 36 cents X 100
130 cents 120 cents
= 28,60% = 30 %

The percentage return that the shareholders of Spire Limited achieved by way of total earnings on their investment
in terms of the market value of the shares has dropped from 30% to 28,60%. The earnings yield may be improved
by improving the profitability of the company or using leverage to reduce the number of ordinary shares.

5.7.5 Dividend yield

The dividend yield ratio reflects the percentage return that a shareholder receives by way of dividend on his/her
investment valued in terms of the market value of the shares in the company. The ratio is calculated as follows:

Dividend yield = Dividends per share

Market price per share

Dividend yield for Spire Limited is calculated as follows:

20.14 20.13
Dividend yield Dividend yield
= Dividend per share X 100 Dividend per share X 100
Market price per share Market price per share
= 17,5 cents X 100 = 16,67 cents X 100
130 cents 120 cents
= 13.46% = 13.89%

The dividend yield has dropped marginally. A higher dividend yield has been considered to be desirable among
many investors. A high dividend yield may be considered to be evidence that a stock is under-priced or that the
company has fallen on hard times and future dividends may not be as high as previous ones. Similarly a low
dividend yield can be considered evidence that the stock is overpriced or that future dividends might be higher.

131 MANCOSA
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A company needs to improve its profitability in order to improve the dividend yield.

5.8 Self-Assessment Activities

5.8.1
Financial data for Zebcom Limited are as follows:

Statement of Comprehensive Income 20.14 20.13

Sales (all credit) 3 201 150 1 937 300
Cost of sales (all credit) 2 618 010 1 599 370
Profit before tax 183 140 122 642
Tax (25%) 45 785 30 660
Profit after tax 137 355 91 982

Statement of Financial Position as at 31 Dec 20.14 20.13

Current assets 2 866 530 4 974 530
Inventories 482 200 38 860
Accounts receivable 261 290 155 200
Marketable securities 326 950 2 306 440
Cash 1 796 090 2 474 030
Current liabilities 1 088 860 588 310
Accounts payable 190 660 192 040
Other current liabilities 898 200 396 270

Required
 Calculate the gross margin and profit margin for 20.14 and 20.13.
 Comment on your answers calculated in 5.8.1.1.
 Calculate the current ratio and acid test ratio at the end of each year. How has the enterprise’s liquidity changed
over this period?
 Compute the following for 20.14 (ratios for 20.13 are given in brackets):
 Inventory turnover (2013: 20 times)
 Debtors collection period (2013: 29,24 days)
 Creditors payment period (2013: 43,83 days)
 What is your interpretation of the enterprise’s performance with respect to your answers in 5.8.1.4?

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5.8.2 Answer the questions below based on the following information. Tax is calculated at 35% of profit.
Vuyo Traders Sipho
Stores
Operating profit R400 000 R420 000
Debt (at 10% interest) R200 000 R1 200 000
Equity R800 000 R300 000
Number of shares issued 300 000 100 000
Dividends for the year R140 000 R110 000
Market price per share 500 cents 600 cents

Required
 Calculate the return on assets for both enterprises.
 Calculate the return on equity for both enterprises.
 Why is the return on equity for Sipho Stores so much higher than Vuyo Traders?
 Should Vuyo Traders be satisfied with its return on assets? Explain.
 Calculate the earnings per share and dividend per share for both enterprises.
 Calculate the price/earnings ratio, earnings yield and dividend yield of both enterprises.

5.8.3 In 20.14, Mestle Wholesalers had R2 000 000 of assets, R600 000 of non-current liabilities and
R200 000 of current liabilities. Operating profit was R500 000, interest expense was R120 000 and the
tax rate was 40%.
Required
 Calculate the following ratios:
■ Debt to assets
■ Debt to equity
■ Interest coverage
 Comment on your answers obtained in 5.8.3.1.

5.8.4 INFORMATION
Impress Limited
Extract of Statement of Comprehensive Income for the year ended 31 December 20.14
R
Sales (all credit) 1 343 300
Cost of sales 1 023 610
Operating profit 257 150
Profit before tax 80 000
N.B. Income tax = 30% of the profit before tax

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Extract of Statement of Financial Position as at 31 December:

20.14 (R) 20.13 (R)
Non-current assets 3 416 720 2 900 080
Inventories 65 350 54 650
Trade and other receivables/Accounts receivable 267 350 230 260
Cash and cash equivalents 214 210 202 270
Owners’ equity 2 063 410 1 926 260
Non-current liabilities 1 232 580 940 580
Current liabilities 667 640 520 420

REQUIRED
 Calculate the gross margin for 20.14.
 Has the liquidity position of the company improved? Motivate your answer by doing the relevant calculations.
 Use two relevant ratios to comment on the effectiveness with which the company has employed two of the
current assets entrusted to it by the shareholders of the enterprise during 20.14.
 The effectiveness with which the management of Impress Limited has employed the total assets and own
capital is significant. Use the two applicable ratios and comment on the profitability of Impress Limited for
20.14 from the point of view of management.

5.8.5 INFORMATION
Gantt Limited
Extract of Statement of Comprehensive Income for the year ended 31 December 20.14
R
Sales 1 343 000
Cost of sales 803 000
Operating profit 257 000
Profit after tax 56 000

Extract of Statement of Financial Position as at 31 December:

20.14 (R) 20.13 (R)
Non-current assets 3 416 000 2 900 000
Inventories 65 000 54 000
Trade and other receivables/Accounts receivable 267 000 230 000
Cash and cash equivalents 214 000 202 000
Owners’ equity 2 063 000 1 926 000
Non-current liabilities 1 232 000 940 000
Current liabilities 667 000 520 000

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Additional information
■ Credit terms to debtors are 30 days.
■ All sales are on credit.

REQUIRED
Use the information provided below to answer the following questions. Answers to ratios must be expressed to
two decimal places.
 Calculate the gross margin for 20.14.
 Calculate the ratio that measures the efficiency with which the total assets of company were managed for
20.14.
 Has the liquidity position of the company improved since 20.13? Use two ratios to motivate your answer.
 Use a relevant ratio and assess the effectiveness of the credit administration of the company in respect of
its debtors for 20.14.
 Suggest two ways in which the management of Gantt Limited can improve its profit margin.

5.9 Solutions

THINK POINT 1!

Answers may vary. One possible answer:

Credit card customers in large retail firms such are a good source of income because interest is
charged on their accounts. Interest rates may range between 20% and 30%. If debtors’
balances in these companies are high, a large source of income is generated.

THINK POINT 1!

A low inventory turnover may mean that:

Demand for merchandise available on sale is low.

Items of inventory may be obsolete.

There is too much inventory.

A high inventory turnover may mean that:

There is a potential for inventory shortages and the resultant poor customer service.

There is a lower dependency on capital to carry inventory.

There is a lower dependency on capital to carry inventory.

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20.14 20.13
Profit margin Profit margin
= Profit after tax X 100 = Profit after tax X 100
Sales 1 Sales 1
= R137 355 X 100 = R91 982 X 100
R3 201 150 1 R1 937 300 1
= 4,29% = 4,75%

 Gross margin has increased marginally while profit margin showed a slight decrease. The cost of sales is
high in relation to sales. It thus appears that Zebcom Limited is operating on very low profit margins.
Operating expenses does appear to be high as there is a large difference between the gross margin and
profit margin.

5.9.1
20.14 20.13
Current ratio Current ratio
= Current assets = Current assets
Current liabilities Current liabilities
= R2 866 530 = R4 974 530
R1 088 860 R588 310
= 2,63:1 = 8,46:1

20.14 20.13
Acid test ratio Acid test ratio
= Current assets – Inventory = Current assets – Inventories
Current liabilities Current liabilities
= R2 866 530 – R482 200 = R4 974 530 – R38 860
R1 088 860 R588 310
= 2,19:1 = 8,39:1

The liquidity has deteriorated considerably from the previous year. However, one could say that high liquidity
ratios for 20.13 may point towards slack management in respect of the idle cash. The ratios for 20.14 have
dropped to more acceptable levels.

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5.9.2

20.14
Inventory turnover
= Cost of sales
Average inventory
= R2 618 010
R260 530
= 10,05 times

N.B. Average inventory = (R482 200 + R38 860) ÷2 = R260 530

20.14
Debtor collection period
= Accounts receivable X 365
Credit sales
= R261 290 X 365
R3 201 150
= 29,79 days

20.14
Creditor payment period
= Accounts payable X 365
Credit purchases
= R190 660 X 365
R3 061 350
= 22,73 days

Note: Credit purchases are calculated as follows:

Cost of sales 2 618 010
Add: Closing inventory 482 200
3 100 210
Less opening inventory (38 860)
Purchases (all credit) 3 061 350

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5.9.3 Inventory turnover has dropped sharply from 20 times to 10,05 times per annum suggesting that the
management may have not had efficient control over inventory. Debtors’ collections seem to be good, with
the outstanding debt expected to be collected within 30 days. Creditors accounts are being settled earlier
than the previous year and the enterprise should not settle accounts earlier than required unless a discount
for early settlement is forthcoming.
5.9.4

Vuyo Traders Sipho Stores

Return on assets Return on assets
= Operating profit X 100 = Operating profit X 100
Total assets 1 Total assets 1
= R400 000 X 100 = R420 000 X 100
R1 000 000 1 R1 500 000 1
= 40% = 28%

N.B. Total assets = R200 000 + R800 000 = R1 000 000 (Vuyo Traders)
Total assets = R1 200 000 + R300 000 = R1 500 000 (Sipho Stores)

5.9.5

Vuyo Traders
Return on equity
= Profit after tax X 100
Equity 1
= R247 000 X 100
R800 000 1
= 30,88%

N.B. Profit after tax = R400 000 – R20 000 (interest) – R133 000 (tax)
= R247 000

Sipho Stores
Return on equity
= Profit after tax X 100
Equity 1
= R195 000 X 100
R300 000 1
= 65%

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Financial Reporting and Analysis

N.B. Profit after tax = R420 000 – R120 000 (interest) – R105 000 (tax)
= R195 000
5.9.7 Sipho Stores higher return on own capital is due to its higher financial leverage. The enterprise is
financed more by debt than own capital.
5.9.8 Yes. A 40% return is greater than the cost of borrowing funds (10%). It is also greater than the inflation
rate and the return that one could get from alternative investments e.g. fixed deposits.

5.9.9

Vuyo Traders Sipho Stores

Earnings per share Earnings per share
= Profit after tax Profit after tax
Number of ordinary shares issued Number of ordinary shares issued
= R247 000 X 100 = R195 000 X 100
300 000 100 000
= 82,33 cents = 195 cents
Vuyo Traders Sipho Stores
Dividend per share Dividend per share
= Dividends for the year Dividends for the year
Number of ordinary shares issued Number of ordinary shares issued
= R140 000 X 100 = R110 000 X 100
300 000 100 000
= 46,67 cents = 110 cents

5.9.10

Vuyo Traders Sipho Stores

Price/Earnings ratio Price/Earnings ratio
= Market price per share = Market price per share
Earnings per share Earnings per share
= 500 cents = 600 cents
82,33 cents 195 cents
= 6,07 times = 3,08 times

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 Financial Reporting and Analysis

Vuyo Traders Sipho Stores

Earnings yield Earnings yield
= Earnings per share X 100 Earnings per share X 100
Market price per share Market price per share
= 82,33 cents X 100 = 195 cents X 100
500 cents 600 cents
= 16,47% = 32,50 %

Vuyo Traders Sipho Stores

Dividend yield Dividend yield
= Dividend per share X 100 Dividend per share X 100
Market price per share Market price per share
= 46.67 cents X 100 = 110 cents X 100
500 cents 600 cents
= 9,33% = 18,33%

5.9.11

Debt to assets
= Total debt X 100
Total assets 1
= R800 000 X 100
R2 000 000 1
= 40%

Debt to equity
= Non-current debt X 100
Equity 1
= R600 000 X 100
R1 200 000 1
= 50%

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Financial Reporting and Analysis

N.B. Equity = R2 000 000 – R800 000 = R1 200 000

Interest coverage
= Operating profit
Interest expense
= R500 000
R120 000
= 4,17 times

5.9.12

The debt to assets ratio indicates that 40% of Mestle Wholesalers assets come from borrowed funds.
The debt to equity ratio indicates that the non-current debt suppliers provide Mestle Wholesalers with 50 cents
for every Rand supplied by the owners.

Mestle Wholesalers earned its interest obligations 4,17 times over in 20.14; or one could say that profit before
interest and tax was 4,17 times as large as interest.
5.9.13

Gross margin = Gross profit X 100

Sales 1

= R319 690 X 100

R1 343 300 1

= 23,80%

5.9.14

20.14 20.13
Current ratio Current ratio
= Current assets = Current assets
Current liabilities Current liabilities
= R546 910 = R487 180
R667 640 R520 420
= 0,82:1 = 0,94:1

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 Financial Reporting and Analysis

20.14 20.13
Acid test ratio Acid test ratio
= Current assets – Inventory = Current assets – Inventories
Current liabilities Current liabilities
= R546 910 – R65 350 = R487 180 – R54 650
R667 640 R520 420
R481 560 R432 530
R667 640 R520 420
= 0,72:1 = 0,83:1

No. The liquidity has deteriorated as evidenced by the decrease in both the current and acid test ratios.
Etc.

5.9.15

20.14
Inventory turnover
= Cost of sales
Average inventory
= R1 023 610
R60 000
= 17,06 times

Debtor collection period

= Accounts receivable X 365
Credit sales
= R267 350 X 365
R1 343 300
= 72,64 days

Inventory turnover rate is fairly high.

f credit terms are 30 days, then debtors are taking too long to pay. Etc.

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Financial Reporting and Analysis

5.9.16

20.14
Return on assets
= Operating profit X 100
Total assets 1
= R257 150 X 100
R3 963 630 1
= 6,49%

20.14
Return on own capital
= Profit before tax X 100
Own capital 1
= R80 000 X 100
R2 063 410 1
= 3,88%

The return for both ratios are very low when compared to return on alternative investments, inflation rate, interest
rate on borrowed money, owners’ expectations etc.

5.9.17

Gross margin
= Gross profit X 100
Sales 1
= R540 000 X 100
R1 343 000 1
= 40,21%
5.9.18

Return on assets
= Operating profit X 100
Total assets 1
= R257 000 X 100
R3 962 000 1
= 6,49%

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5.9.19

20.14 20.13
Current ratio Current ratio
= Current assets = Current assets
Current liabilities Current liabilities
= R546 000 = R486 000
R667 000 R520 000
= 0,82:1 = 0,93:1

20.14 20.13
Acid test ratio Acid test ratio
= Current assets – Inventory = Current assets – Inventories
Current liabilities Current liabilities
= R546 000 – R65 000 = R486 000 – R54 000
R667 000 R520 000
= R481 000 = R432 000
R667 000 R520 000
= 0,72:1 = 0,83:1

No. The current and acid test ratios have dropped.

5.9.20
Debtor collection period
= Accounts receivable X 365
Credit sales
= R267 000 X 365
R1 343 000
= 72,57 days

The company has been ineffective in debt collection. Debtors are exceeding their credit terms of 30 days. Etc
5.9.21
* Reduce administrative expenses by cutting down on overtime.
* Institute control measures to prevent the misuse of company resources such as telephone, vehicles etc.
* Develop effective marketing strategies to increase sales.
* Negotiate with suppliers for higher discounts, to reduce costs.
* Seek alternative suppliers for better deals.
* Etc.

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Bibliography
 Bartlett, G., Beech, G., de Hart, F., de Jager, P., de Lange, J., Erasmus, P., Hefer, J., Madiba, T., Middelberg,
S., Plant, G., Streng, J., Thayser, D. and van Rooyen, S. (2014) Financial Management: Turning theory into
practice. 1st Edition. Cape Town: Oxford University Press.Conradie, W.M. and Fourie, C.M.W. (2013) Basic
Financial Management. 1st Edition. Cape Town: Juta & Co.
 Kew, J and Warson, A. (2013) Financial Accounting: An Introduction. 4th edition. Cape Town: Oxford University
Press.
 Lodewyckx, E., Lötter, W., Rhodes, N. and Seedat, C. (2013) Introduction to Financial Accounting: Fresh
Perspectives. 2nd edition. Cape Town: Pearson.
 Marx, J., de Swardt, C., Smith, M.B. and Erasmus, P. (2014) Financial Management in Southern Africa. 4th
Edition. Cape Town: Pearson Education.
 Schutte, M. (2014) Accounting for All. 1st Edition. Cape Town: Juta & Company Ltd.
 www.smallbusiness.chron.com
 www.studymode.com

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