About Financial Accounting Volume 2 8th Doussy
About Financial Accounting Volume 2 8th Doussy
About Financial Accounting Volume 2 8th Doussy
Financial Accounting
Volume 2
Eighth Edition
Abboutt
Fin
nanc Accoun
cial A nting
g
Volu
ume 2
Eightth Edition
Contribu
C ting auth
hors
B Ceki
RN N
Ngcobo
A Re
ehwinkel
D Scheepers (edittor)
Volu
ume 1
Eightth Edition
Contribu
C ting auth
hors
B Ceki
F Dousssy (editor)
D Scott
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© 2019
ISBN 978-0
0-6390-0866-0
0
E-Book ISBN 978-0-6390
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First edition
n 2005, reprintted 2006 Fifth edition 2014
Second edition 2007 Sixth e
edition 2016
Third edition 2008 Seven nth edition 2018
Fourth editioon 2011
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Contents
Page
1. Introduction to the preparation and presentation of financial statements .... 1
2. Establishment and financial statements of a partnership ............................. 65
3. Changes in the ownership structure of partnerships.................................... 99
4. The liquidation of a partnership .................................................................... 163
5. Close corporations ........................................................................................ 225
6. Introduction to companies ............................................................................ 269
7. Statement of cash flows ................................................................................ 325
8. Analysis and interpretation of financial statements ...................................... 389
9. Branches ....................................................................................................... 409
10. Manufacturing entities .................................................................................. 447
11. Budgets ........................................................................................................ 471
Index ....................................................................................................................... 497
v
CHAPTER 1
Introduction to the preparation and
presentation of financial statements
Contents
Page
Overview of the introduction to the preparation and presentation of financial
statements ............................................................................................................... 4
1.1 Introduction ................................................................................................... 4
1.2 Financial reporting requirements in South Africa ........................................ 7
1.2.1 Introduction...................................................................................... 7
1.2.2 The current regulatory South African financial reporting
requirements .................................................................................... 8
1.3 The IFRS Conceptual Framework for Financial Reporting ............................ 11
1.3.1 Introduction...................................................................................... 12
1.3.2 Purpose and status of the Conceptual Framework ......................... 13
1.3.3 Chapter 1: The objective of general purpose financial reporting.... 13
1.3.4 Chapter 2: Qualitative characteristics of useful financial
information ....................................................................................... 14
1.3.4.1 Fundamental qualitative characteristics ......................... 14
1.3.4.2 Enhancing qualitative characteristics ............................. 16
1.3.4.3 The cost constraint on useful financial reporting ............ 16
1.3.5 Chapter 3: Financial statements and the reporting entity ............... 17
1.3.5.1 Objective and scope of financial statements .................. 17
1.3.5.2 Reporting period ............................................................. 17
1.3.5.3 Going concern assumption ............................................. 17
1.3.5.4 The reporting entity ......................................................... 18
1.3.6 Chapter 4: The elements of financial statements ............................ 18
1.3.6.1 Introduction ..................................................................... 18
1.3.6.2 Definitions of an asset and an economic resource ......... 18
1.3.6.3 Definitions of a liability and an obligation ........................ 19
1.3.6.4 Definition of equity ........................................................... 20
1.3.6.5 Definitions of income and expenses ............................... 21
1.3.7 Chapter 5: Recognition and derecognition ..................................... 21
1.3.7.1 The recognition process ................................................. 21
1.3.7.2 Recognition criteria ......................................................... 23
1.3.7.3 Derecognition .................................................................. 23
1.3.8 Chapter 6: Measurement ................................................................. 24
1.3.8.1 Introduction ..................................................................... 24
1.3.8.2 Measurement bases ........................................................ 24
1
2 About Financial Accounting: Volume 2
Page
1.3.8.3
Factors to consider when selecting a measurement
basis ................................................................................ 25
1.3.8.4 The measurement of equity ............................................. 26
1.3.9 Chapter 7: Presentation and disclosure .......................................... 26
1.3.9.1 Presentation and disclosure objectives and
principles ......................................................................... 26
1.3.9.2 Classification ................................................................... 26
1.3.9.3 Aggregation .................................................................... 27
1.3.10 Chapter 8: Concepts of capital and capital maintenance............... 27
1.3.10.1 The concepts of capital ................................................... 27
1.3.10.2 The concepts of capital maintenance and the
determination of profit ..................................................... 28
1.3.11 Summary and example – Conceptual Framework application........ 28
1.4 Presentation of Financial Statements (IAS 1) ................................................ 33
1.4.1 Introduction...................................................................................... 35
1.4.2 Definitions ........................................................................................ 35
1.4.3 The purpose of financial statements ............................................... 36
1.4.4 General features .............................................................................. 37
1.4.4.1 Fair presentation and compliance with IFRS .................. 37
1.4.4.2 Going concern ................................................................ 38
1.4.4.3 Accrual basis of accounting ........................................... 38
1.4.4.4 Materiality and aggregation ............................................ 38
1.4.4.5 Offsetting ......................................................................... 38
1.4.4.6 Frequency of reporting .................................................... 38
1.4.4.7 Comparative information ................................................. 39
1.4.4.8 Consistency of presentation ............................................ 39
1.4.5 Structure and content ...................................................................... 39
1.4.5.1 Introduction ..................................................................... 39
1.4.5.2 Identification of the financial statements ......................... 39
1.4.5.3 Statement of financial position ........................................ 39
1.4.5.4 Statement of profit or loss and other
comprehensive income ................................................... 41
1.4.5.5 Statement of changes in equity ....................................... 43
1.4.5.6 Statement of cash flows .................................................. 43
1.4.5.7 Notes ............................................................................... 43
1.5 Financial instruments .................................................................................... 45
1.5.1 Introduction...................................................................................... 46
1.5.2 Definitions ........................................................................................ 46
1.5.2.1 Financial instrument ........................................................ 46
1.5.2.2 Financial asset (IAS 32.11) ............................................. 47
1.5.2.3 Financial liability (IAS 32.11) ........................................... 47
1.5.2.4 Equity instrument (IAS 32.11) .......................................... 47
1.5.2.5 Fair value (IAS 32.11) ...................................................... 48
1.5.2.6 Contract ........................................................................... 48
Chapter 1: Introduction to the preparation and presentation of financial statements 3
Page
1.5.3 Identification of financial assets and financial liabilities .................. 48
1.5.4 Classification, recognition and measurement of financial
instruments ...................................................................................... 49
1.5.4.1 Classification of financial assets ..................................... 49
1.5.4.2 Classification of financial liabilities .................................. 50
1.5.4.3 Recognition ..................................................................... 51
1.5.4.4 Measurement .................................................................. 51
1.6 An illustration of disclosure according to the requirements of IAS 1 and
IFRS 9 ........................................................................................................... 53
1.7 Special notes to the reader of Volume 2 ....................................................... 59
1.7.1 Cash transactions ............................................................................ 59
1.7.2 Calculations ..................................................................................... 59
1.7.3 References to gender ...................................................................... 60
1.7.4 Taxation rates .................................................................................. 60
1.7.5 The use of account names versus financial statement
terminology ...................................................................................... 60
1.7.6 Interest calculations......................................................................... 60
1.7.6.1 Simple interest ................................................................. 60
1.7.6.2 Compound interest .......................................................... 60
1.7.6.3 Effective interest rate ....................................................... 61
1.8 Summary ....................................................................................................... 61
4 About Financial Accounting: Volume 2
3. Financial Instruments (IAS 32, IAS 39, IFRS 7 & IFRS 9) Par 1.5
1.1 Introduction
STUDY OBJECTIVES
continued
Chapter 1: Introduction to the preparation and presentation of financial statements 5
continued
6 About Financial Accounting: Volume 2
l list the minimum information that must be disclosed in the statement of profit
or loss and other comprehensive income, and in the statement of financial po-
sition, according to IAS 1;
l list the items that may, according to IAS 1, be disclosed on either the faces of
the statement of profit or loss and other comprehensive income and the
statement of financial position, or in the notes thereto;
l discuss the purpose of notes in line with IAS 1;
l discuss the order in which the notes should be presented as indicated by
IAS 1;
l explain what is meant by a “financial instrument”;
l identify when an asset is classified as a financial asset;
l identify when a liability is classified as a financial liability;
l explain what is meant by an “equity instrument”;
l define the concept “fair value”;
l explain when an entity must recognise a financial asset and a financial liability;
l explain what is meant by “transaction costs”; and
l briefly explain the initial and subsequent measurement of a financial instru-
ment, as well as the recording of any resulting gain or loss in consequence of
a subsequent measurement.
In About Financial Accounting Volume 1 the reader was introduced to the subject
“Financial Accounting”. The IFRS Conceptual Framework for Financial Reporting
(issued in March 2018 and referred to as the “Conceptual Framework” in this textbook)
was the starting point of study in this volume. Various concepts and procedures were
discussed that enabled the reader to record business transactions in journals, post the
journal entries to ledger accounts, and to prepare a trial balance based on the bal-
ances of all the general ledger accounts of a reporting entity. The collection, classifica-
tion and recording of accounting data enabled the reader to prepare the financial
statements of a sole proprietorship. At this point it is necessary to emphasise that a
thorough knowledge of Volume 1 is essential before studying About Financial Account-
ing Volume 2.
In Volume 2, the Conceptual Framework and IAS 1 Presentation of Financial State-
ments serve as the starting point of study. Both these documents are addressed in
much detail in this volume. Further, Volume 2 also addresses the preparation of the
financial statements of partnerships, close corporations and companies, the purpose
of which is to enable the reader to prepare a full set of financial statements for these
types of business entities. Other important issues regarding partnerships and close
corporations, for example changes in ownership, dissolutions and conversions, are
also dealt with in Volume 2, as these events significantly impact on financial statement
disclosures. Volume 2 also deals with:
l The preparation of a statement of cash flows:
flows Although a statement of cash flows
is part of a set of financial statements of a reporting entity, it is dealt with separately
Chapter 1: Introduction to the preparation and presentation of financial statements 7
from the preparation of the other financial statements because a statement of cash
flows is prepared from the information disclosed in the other financial statements
and the notes thereto, and not from a trial balance and other relevant additional in-
formation, as the other financial statements are.
l An introduction to the financial reporting in respect of companies: The reader is
introduced to the company as a form of business ownership, and a company is
compared with a partnership and close corporation, specifically in respect of its
capital structure. Further, an introduction to the preparation of the financial state-
ments of companies is provided.
l The analysis and interpretation of financial statements: The purpose of, and the
methods used to analyse and interpret the information as disclosed in financial
statements are discussed.
l Branches: A business operating as an entity with branches is discussed, with the
main focus placed on the recording of business transactions between a head of-
fice and its branches.
l Manufacturing entities: Manufacturing entities and related issues are discussed,
with specific reference to the recording of business transactions that are unique to
these entities.
l Budgets: The function and the preparation of various types of budgets are dis-
cussed.
The main objective of this chapter is to provide important background information on
the preparation and presentation of financial statements, such as the necessity of
complying with relevant regulatory reporting practices, the Conceptual Framework,
IAS 1, and the reporting standards concerning financial instruments.
State-owned companies are either listed as public entities or are owned by municipal-
ities. The names of these companies must end with “SOC Ltd”.
Private companies are not state-owned. The Memorandum of Incorporation (MOI) of a
SA private company may not offer securities to the public, and it must also restrict the
transfer of its securities. The name of a private company must end with “Proprietary
Limited” or “(Pty) Ltd”.
Personal liability companies are private companies that have personal liabilities. The
MOI of such a type of SA company must state that it is a personal liability company.
The name of a personal liability company must end with Incorporated or Inc.
Public companies are profit companies that are not state-owned. The name of a SA
public company must end with “Limited” or “Ltd”.
In terms of the Companies Act 71 of 2008, a non-on-profit company
company (NPC) is a company
that is incorporated for a public benefit, and the income and property of such a com-
pany may not be distributed to its incorporators, members, directors, officers, or to
persons who are related to them. The name of a non-profit company must end with
“NPC”.
Regulation 27 of the Companies Regulations, 2011, requires the application of specific
financial reporting standards for the different categories of companies. These require-
ments are disclosed in Table 1.1.
Table1.1 Financial Reporting Standards applicable to categories of companies
Category of company Financial Reporting Standard
State-owned companies and non-profit com- IFRS, but in the case of any conflict of IFRS
panies that require an audit. with any of the requirements in terms of the
Public Finance Management Act, the latter
has the reporting authority.
Public companies listed on an exchange. IFRS.
Public companies not listed on an exchange. One of:
(a) IFRS; or
(b) IFRS for SMEs.
Profit companies other than state-owned or One of:
public companies. (a) IFRS; or
Profit companies, other than state-owned or (b) IFRS for SMEs.
public companies, with a public interest
score (PIS) of at least 350, or companies that
hold assets in excess of R5 million in a fidu-
ciary capacity.
Profit companies, other than state-owned or
public companies, with a PIS of at least 100,
but less than 350.
continued
10 About Financial Accounting: Volume 2
(Note that a public interest score (PIS) is calculated for a financial period. The calcula-
tions of public interest scores fall outside of the scope of this textbook.)
Most close corporations and partnerships have a PIS of less than 100, and their finan-
cial records and statements are usually prepared internally. Although there is no legal
requirement for these entities to prepare their financial statements in terms of IFRS or
the IFRS for SMEs, the examples and exercises in this textbook require the preparation
of all financial statements according to IFRS, appropriate to the business of a reporting
entity. In the case of a close corporation, it is required that financial statements be
prepared in terms of the Close Corporations Act 69 of 1984 and the requirements of
IFRS.
In this paragraph, it is noted that IFRS deals with the recognition, measurement,
presentation and disclosure requirements of financial statements, and that the stand-
ards are based on the IFRS Conceptual Framework for Financial Reporting (issued by
the IASB under the IFRS Foundation). This framework is discussed in the next para-
graph.
Chapter 1: Introduction to the preparation and presentation of financial statements 11
The CF describes the objective of, and the concepts for general purpose financial
reporting
CF objective/purpose:
The CF:
• assists the IASB to develop IFRS;
• assists preparers of financial statements to develop consistent accounting pol-
icies when no Standard applies to a transaction or event, or when a choice be-
tween policies is allowed; and
• assists all parties to understand and interpret the Standards.
Relevance Comparability
Materiality Verifiability
Faithfull representation Timeliness
Understandability
continued
12 About Financial Accounting: Volume 2
Assets Income
Liabilities Expenses
Equity
Chapter 6: Measurement
1.3.1 Introduction
The Conceptual Framework can be described as a group of interrelated objectives
and fundamental theoretical principles that serve as a frame of reference for financial
accounting, and more specifically financial reporting. The Conceptual Framework is
both normative (prescriptive) and descriptive (explanatory) in nature, with an overrid-
ing requirement for financial information to be useful (meaning that information must be
relevant and faithfully represented).
In March 2018, the IASB issued the latest version of the IFRS Conceptual Framework
for Financial Reporting (hereafter referred to as the Conceptual Framework). Mainly,
the Conceptual Framework consists of an explanation of the purpose of the Conceptu-
al Framework, the status thereof, eight chapters, and a glossary of terms. The eight
chapters are titled as follows:
Chapter 1: The objective of general purpose financial reporting;
Chapter 2: Qualitative characteristics of useful financial information;
Chapter 3: Financial statements and the reporting entity;
Chapter 4: The elements of financial statements;
Chapter 5: Recognition and derecognition;
Chapter 6: Measurement;
Chapter 7: Presentation and disclosure; and
Chapter 8: Concepts of capital and capital maintenance.
Chapter 1: Introduction to the preparation and presentation of financial statements 13
The Conceptual Framework forms the basis of introductory financial accounting and
reporting studies. It does, however, also include aspects that are more advanced. In
this textbook, the discussion of the Conceptual Framework is introductory and suitable
for students who are commencing with accounting and reporting studies.
Materiality
Materiality is not a qualitative characteristic but is used to decide what information
would be relevant to users. Relevance is therefore affected by materiality. It is based
on the nature and/or magnitude of the information in the context of the financial
statements of the entity. Information is material if omitting or misstating it could influ-
ence the decisions that could be made by the primary users of the information. Materi-
ality is entity-specific, and hence a uniform quantitative threshold cannot be
prescribed (Conceptual Framework: 2.11).
(b) Faithful representation
For information to be faithfully represented, the Conceptual Framework requires that
the substance of economic phenomena (such as business transactions) be disclosed,
rather than their legal form
form. This can be illustrated as follows: Assume an entity en-
tered into a legal contract to lease a vehicle for most of its useful life. The legal form of
the transaction is the lease. However, because the vehicle was leased for the majority
of its useful life, the entity in effect purchased the vehicle by financing it with a lease
agreement. Therefore, the substance of the transaction is the purchase of the vehicle.
In terms of the Conceptual Framework, an entity is thus required to record the pur-
chase of the vehicle by debiting a vehicles account (which is an asset) and crediting a
lease account (which is a liability) with the cost price of the vehicle. The monthly lease
payments must be recorded as the repayment of the interest and the capital of the
liability. The recording and reporting of leases fall outside the scope of this textbook.
For financial information to be faithfully represented, the Conceptual Framework further
requires that the information must be complete, neutral and free from error (Concep-
tual Framework: 2.12 to 2.13).
In terms of the Conceptual Framework, complete means that all the information that is
necessary (such as descriptions, amounts and explanations) for a user to understand
a financial report is disclosed (Conceptual Framework: 2.14).
In terms of the Conceptual Framework, neutral disclosure means that information is
presented without bias, meaning that such information may not be manipulated to
influence the behaviour of the users of the information; either favourably or unfavoura-
bly (Conceptual Framework: 2.15).
Financial information can be neutral if prudence is exercised. Prudence requires the
exercise of caution when making judgements under uncertain conditions. Prudence
means that assets, income, liabilities and expenses should not be over- or understated
(Conceptual Framework: 2.16).
Free from error does not mean accurate in all respects, but simply that there are no
errors or omissions in the descriptions of phenomena, and that the selection and use
of the processes to produce the reported information were without error. When
amounts cannot be observed (verified), they must be estimated, and these estimates
are often referred to as measurement uncertainty. Reasonable estimates do not un-
dermine the usefulness of information, provided that the estimates are clearly and
accurately described and explained (Conceptual Framework: 2.18 to 2.19).
16 About Financial Accounting: Volume 2
entity is under such financial distress, its financial statements are usually prepared in
terms of different bases (for example by measuring assets at their liquidation values
instead of at cost or fair value). In such a case, it must be mentioned in the financial
statements of the reporting entity, and/or the notes thereto, that different measurement
bases were applied. These alternative measurement bases must also be clearly de-
scribed (Conceptual Framework: 3.9).
1.3.5.4 The reporting entity
A reporting entity is an entity that is required (or chooses) to prepare financial
statements. Reporting entities are not necessarily legal entities; for example, sole
proprietorships and partnerships are not legal entities, but close corporations and
companies are. (Conceptual Framework: 3.10). When a reporting entity is not a legal
entity, its boundary for reporting purposes is determined by the information needs of
the primary users of such an entity’s financial statements (Conceptual Framework:
3.14). Each financial statement must clearly mention the name and type of reporting
entity to which it pertains in its heading.
An asset is:
is:
l a present economic resource
l controlled by a reporting entity
l as a result of past events.
An economic resource is:
is:
l a right
l that has the potential to produce economic benefits.
Chapter 1: Introduction to the preparation and presentation of financial statements 19
A liability is::
l a present obligation of a reporting entity
l to transfer an economic resource
l as a result of past events.
An obligation is:
l a duty that a reporting entity has
l that it cannot practically avoid.
20 About Financial Accounting: Volume 2
An obligation can be a legal obligation (for example a contract that was entered into,
or taxes that must be paid, by a reporting entity), a constr
constructive obligation (for exam-
ple an obligation that resulted from past customary practices, or from issued policies,
such as a policy to rehabilitate the environment), or an obligation can be a conditional
obligation (for example when an entity has acknowledged a future condition that it
must adhere to). Accounting for constructive and conditional obligations fall outside of
the scope of this textbook.
A present obligation is an obligation that exists at the reporting date of the entity and is
always due to one or more other parties. A present obligation must have the potential
to require of an entity to transfer of its economic resources to one or more other parties
(Conceptual Framework: 4.37). In other words, a liability exists if a present obligation
of a reporting entity has the potential to require of the entity to transfer an asset that it
owns to another party. Similar to the potential of a present economic resource, the
potential of a present obligation does not have to be certain or likely, it merely must
have a small possibility to require of an entity to transfer of its economic resources to
one or more other parties.
An obligation to transfer an economic resource, for example, can be an obligation of
an entity to pay cash, deliver goods, or to provide a service (Conceptual Framework:
4.39). For an obligation to be recognised as a present obligation, it must have resulted
from a past event. In other words, an obligated entity must have already received an
economic benefit for which it is required to transfer an economic resource to the party
who has provided the benefit (Conceptual Framework: 4.43).
1.3.6.4 Definition of equity (Conceptual Framework: 4.63)
Equity is
l the residual interest in the assets of a reporting entity
l after deducting all of its liabilities.
Equity is often referred to as “net wealth”. The equity of a reporting entity is determined
by subtracting its total liabilities from its total assets. If the total assets are greater than
the total liabilities, the entity has favourable equity, but if the total liabilities exceed the
total assets, the entity has unfavourable equity, which technically means that the entity
is insolvent.
The equity of a company comprises issued share capital and reserves, and that of a
close corporation, members contributions and reserves. The equity of a partnership
includes capital contributions, current account balances and reserves.
Equity claims are claims that do not meet the definition of a liability, and therefore they
are not recognised as obligations. Equity claims can be established by means of
contracts, legislation or similar means. An equity claim is a claim on the assets of an
entity after the liabilities of the entity have been deducted from its assets.
In respect of companies, different categories of equity claims exist, for example,
ordinary and preference shares. Ordinary and preference shareholders are referred to
as the “holders” of a company’s equity claims (Conceptual Framework: 4.64).
Chapter 1: Introduction to the preparation and presentation of financial statements 21
Income is:
l increases in assets, or decreases in liabilities
l that result in increases in equity
l other than those pertaining to contributions that were received for the purchases
of equity claims.
Expenses are:
l decreases in assets, or increases in liabilities
l that result in decreases in equity
l other than those pertaining to distributions that were made to the holders of equi-
ty claims.
Income and expenses are the elements of financial statements that reflect the financial
performance of a reporting entity.
In terms of the paragraph 4.70 of the Conceptual Framework, income arises from
increases in equity that do not result from contributions received from the holders of
equity claims (that is, a capital contribution received from a partner, or shares issued
to shareholders are not recognised as income but as financing activities). Expenses
arise from decreases in equity that do not result from distributions that were made to
the holders of equity claims (that is, the payment of dividends to shareholders is not
recognised as an expense).
Examples of income transactions are sales, fees earned, services rendered, interest
earned, rent earned, and dividends received. Examples of expense transactions are
cost of sales, rental expenses, and interest expenses.
The users of financial statements need information about both an entity’s financial pos-
ition and its financial performance to make well-informed economic decisions. There-
fore, information about income and expenses is as important as information about
assets and liabilities (Conceptual Framework: 4.71).
Further, recognition involves the disclosure of the identified elements in the relevant
financial statement – either alone or in aggregation with other items – in words and by
a monetary amount, and including that amount in one or more totals in that statement.
The amount at which an asset, a liability or equity is recognised in the statement of
financial position is referred to as its ‘carrying amount’ (Conceptual Framework: 5.1).
The statement of financial position and the statement of profit or loss and other com-
prehensive income disclose the identified assets, liabilities, equity, income and ex-
penses of the reporting entity in the form of structured summaries.
summaries These summaries
are designed to make financial information more understandable and comparable
(Conceptual Framework: 5.2).
By means of the recognition process, the elements, the statement of financial position
and the statement of profit or loss and other comprehensive income are linked as
follows: (Conceptual Framework: 5.3):
Statement of financia
financiall position:
position: as at the beginning of the reporting period
Assets = Equity + Liabilities
PLUS
Statement of profit or loss and other comprehensive income for the period
Income minus Expenses
PLUS
Statement of changes in equity
Contributions from holders of equity claims minus
distributions to holders of equity claims
EQUALS
Statement of financial position:
position: as at the end of the reporting period
Assets = Equity + Liabilities
Source: Conceptual Framework: 5.4, as adjusted.
The financial statements are linked because the recognition of one item (or of a
change in its carrying amount) requires the recognition or derecognition of one or
more other items (or of changes in the carrying amount of one or more other items)
(Conceptual Framework: 5.4).
The initial recognition of assets or liabilities that result from economic transactions may
sometimes require, in addition, the simultaneous recognition of related income and/or
expenses. For example, the sale of inventories for cash: According to the perpetual
recording system of inventories, the cash received is initially recognised as an in-
crease in the assets of the entity (debit: Bank). The contra entry is to derecognise the
sold inventories (credit: Inventories). In addition, simultaneously to this initial recogni-
tion of cash, the expense and income related to this transaction must be recognised
by debiting the cost of sales account, which is an expense, and crediting the sales
Chapter 1: Introduction to the preparation and presentation of financial statements 23
If elements do not meet the recognition criteria, they cannot be recognised in the
financial statements. If an item that meets the definition of an asset or liability is not
recognised, the reporting entity may need to provide information about that item in the
notes to the financial statements (Conceptual Framework: 5.11).
For an asset or liability to be recognised, it must be measured (Conceptual Frame-
work: 5.19). Such measurements often require the making of estimates, and the faithful
representation of estimates are questioned from time to time. It is important to note that
it is stated in paragraph 2.19 of the Conceptual Framework that the use of reasonable
estimates does not undermine the usefulness of financial information provided that the
estimates are clearly and accurately described and explained.
1.3.7.3 Derecognition
Derecognition is the removal from the statement of financial position of a reporting
entity, an entire asset or liability, or a part thereof. Derecognition usually occurs when
an item no longer meets the definition of an asset or a liability. An asset is derecog-
nised when the reporting entity loses control of the entire asset or part thereof, and a
liability is derecognised when the entity no longer has a present obligation for all or part
of the liability (Conceptual Framework: 5.26).
24 About Financial Accounting: Volume 2
capital of the entity. Alternatively, if the main concern of the users of the financial
statements of a reporting is with its operating capability, the physical concept of capi-
tal should be used.
1.3.10.2 The concepts of capital maintenance and the determination of profit
The concept of capital maintenance is concerned with how an entity defines the cap-
ital that it seeks to maintain (Conceptual Framework: 8.4). If the capital of an entity at
the end of its reporting period is equal to the capital of the entity at the beginning of its
reporting period, it is concluded that the entity has maintained its capital. Any amount
in excess of that required to maintain capital is recognised as profit (Conceptual
Framework: 8.6).
As mentioned, the concept of financial capital gives rise to the concept of financial
capital maintenance, and the concept of physical capital gives rise to the concept of
physical capital maintenance.
(a) Financial capital maintenance
Under the concept of financial capital maintenance, a profit is deemed earned if the
financial amount of the net assets at the end of an entity’s reporting period exceeds
the financial amount of the net assets at the beginning of the entity’s reporting period.
Any distributions made to, and contributions received from the owners of a reporting
entity during a reporting period are excluded from this calculation.
(c) Trading inventory sold to clients during the 20.9 financial year. It is the policy of
the sole proprietorship to sell inventories either in cash, or on credit.
(d) A fixed-term deposit for a year, made on 31 March 20.9 at Control Bank in favour
of Mr X in his capacity as trading as a sole proprietorship. In terms of the deposit
agreement, the deposit, as well as the interest earned on it, will be paid by Control
Bank into the bank account of the business immediately after the expiry date of
the deposit.
(e) A prepayment made in March 20.9 for the April 20.9 salary of an employee, as per
a prepayment agreement between the business and the employee, stipulating that
services will be rendered by the employee in April 20.9 to settle the prepayment.
(f) Electricity expenses in arrears for March 20.9, payable to the local city council.
(g) Trade payables (in respect of the purchases of trading inventory) at the financial
year-end of the business (31 March 20.9).
(h) A delivery truck leased from 1 April 20.8. The term of the lease is five years which
is similar to the expected economic life of the truck. The truck is leased in aid of
transporting inventory sold to customers.
Required:
Apply the 2018 IFRS Conceptual Framework to identify, in respect of the sole proprie-
torship/reporting entity, the items that can be classified as either of the five elements in
its statement of financial position as at 31 March 20.9, and in its statement of profit or
loss and other comprehensive income for the year ended 31 March 20.9. Motivate
your answers according to the definitions provided in the Conceptual Framework.
Solution to Example 1.1:
Background information according to the 2018 IFRS Conceptual Framework:
Definition of an asset
Definition of a liability
Definition of income
Definition of an expense
(c) The trading inventory sold to clients during the 20.9 financial year must be
classified as income because:
l it increased
increased an asset of the reporting entity,
entity either as cash that was re-
ceived, or as an increase of the trade receivables of the business;
l it increased
increased the equity of the reporting entity,
entity by way of the sales transac-
tions that occurred; and
l the income did not result from contributions made to the business by the
holder of its equity (Mr X),
X) as the inventory was sold to clients.
(d) The fixed-
fixed-term deposit at 31 March 20.9 must be classified as an asset because:
l it is a present economic resource
resource held by Mr X, in his capacity as the
owner of the sole proprietorship, at 31 March 20.9:
o Mr X holds the legal right to receive the deposit in cash from Control bank
on behalf of the business, immediately after the term of the deposit has
expired; and
o the deposit has the potential to produce economic
economic benefits,
benefits as interest
is earned on it, and receivable immediately after the term of the deposit
has expired;
l the deposit is controlled by the reporting entity
entity, since the making of the de-
posit was initiated by the business, and the deposit conditions as set by Con-
trol Bank was accepted; and
l the current control of the deposit resulted from past events,
events namely when
the terms of the contract with Control Bank were accepted by Mr X on behalf
of the business, and the payment of the deposit was made.
(e) The prepaid salary of an employee for April 20.9 must be classified as an asset
because:
l it is a present economic resource ࣣ held by Mr X, in his capacity as the
owner of the sole proprietorship, at 31 March 20.9;
o the sole proprietorship holds, as per the prepayment agreement, the legal
right to services from the employee during April 20.9; and
o the prepayment has the potential to produce economic benefits,
benefits since
the services of the employee should contribute to the sales transactions of
the business;
l the realisation of the prepayment is controlled by the reporting entity,
entity
since Mr X has control over the rendering of the services by the employee to
the business during April 20.9, as per the prepayment agreement between the
business and the employee; and
l the current control of the prepaid salary resulted from past events,
events namely
when the prepayment agreement between the business and the employee
was finalised, and the payment of the employee’s April 20.9 salary was made
in March 20.9.
32 About Financial Accounting: Volume 2
(f) The electricity expenses in arrears for March 20.9 must be classified as a liabil-
liabil-
ity because:
l it is a present obligation of the reporting entity to settle the electricity account
for March 20.9;;
o the obligation is the legal responsibility of the business to settle the elec-
tricity bill for the electricity used; and
o the business has no practical ability to avoid the payment, as it is legally
enforceable by the city council;
l the obligation requires the transfer of an economic resource in the form of a
cash payment in April 20.9 to the city council; and
l the obligation resulted from past events,
events namely when Mr X, on behalf of the
business, has opened an electricity account at the city council, and electricity
was used by the business entity during 20.9.
(g) The trade payables (in respect of the purchases of trading inventory) at
31 March 20.9 must be classified as a liability because:
l it is a present obligation of the reporting entity to pay the trade payables ac-
cording to the settlement arrangements;
o the obligation is the legal responsibility of the business to settle the trade
payables according to the settlement arrangements; and
o the business has no practical ability to avoid the making of the pay-
ments, as it is legally enforceable by the trade creditors involved;
l the obligation requires the transfer of economic resources in the form of
cash payments to the trade creditors according to the settlement arrange-
ments; and
l the obligation resulted from past events,
events namely when the business pur-
chased the trading inventories on credit and took possession thereof for the
purpose of selling it.
(h) The delivery truck, leased for five years, must be classified as an asset (a right-
of-use asset) at the financial year-end of the business because:
l it is a present economic resource ࣣ the reporting entity has the right of use of
the truck at its financial year-end;
o the business holds, as per the lease agreement, the legal right to use the
truck for the remaining term of four years; and
o the truck has the potential to produce economic benefits,
benefits by accelerat-
ing the collection and delivery periods of trading inventories;
l the usage of the truck is controlled by the reporting entity,
entity since the busi-
ness has obtained the right of use of the truck during the lease term; and
l the current control of the truck resulted from past events,
events namely when the
lease agreement between the business and the lessor was finalised, and the
control of the truck was obtained by the business in terms of its right of use as
from 1 April 20.8.
Chapter 1: Introduction to the preparation and presentation of financial statements 33
Objective of IAS 1
IAS 1 prescribes the basis of the presentation of general purpose financial statements,
IAS 1 sets out the overall requirements for the presentation of financial statements,
provides guidelines for their structure and stipulates minimum requirements
Provides useful information to users and the result of management’s stewardship of the
resources entrusted to them
General features
continued
34 About Financial Accounting: Volume 2
continued
Chapter 1: Introduction to the preparation and presentation of financial statements 35
1.4.1 Introduction
The objective of IAS 1 is to prescribe the basis for the presentation of general purpose
financial statements to ensure comparability both with the entity’s financial statements
of previous periods and with the financial statements of other entities. Remember that
general purpose financial statements are those intended to meet the needs of users
who are not able to demand reports tailored to meet their particular information needs.
To achieve this objective, IAS 1 sets out overall requirements for the presentation of
financial statements, guidelines for their structure and minimum requirements for their
content (IAS 1: 1 to 7).
IAS 1 uses terminology that is suitable for profit-orientated entities, including public
sector business entities. Entities with not-for-profit activities in the private sector, public
sector and government seeking to apply this standard can amend the descriptions
used for particular line items in the financial statements and for the financial state-
ments themselves (IAS 1: 5). Similarly, entities that do not have equity and entities whose
share capital is not equity, and entities whose equity does not consist of share capital,
may need to adapt the presentation in the financial statements to members’ or unit
holders’ interests (IAS 1: 6).
1.4.2 Definitions
IAS 1: 7 gives the following definitions of terms used in this Standard:
General purpose financial statements (referred to as financial statements) are those
intended to meet the needs of users who are not in a position to require an entity to
prepare reports tailored to their particular information needs.
Impracticable: Applying a requirement is impracticable when the entity cannot apply it
after making every reasonable effort to do so.
International Financial Reporting Standards (IFRS) are Standards and Interpretations
adopted by the International Accounting Standards Board (IASB). They comprise:
(a) International Financial Reporting Standards (IFRSs);
(b) International Accounting Standards (IASs); and
36 About Financial Accounting: Volume 2
report on its operations for a shorter period than a year. In such cases, the fact that
amounts presented in the financial statements are not entirely comparable must also
be mentioned (IAS 1: 36).
1.4.4.7 Comparative information
IAS 1: 38 states that comparative information shall be disclosed in respect of the
preceding period for all amounts reported in the current period’s financial statements.
Comparative information shall also be included for narrative and descriptive infor-
mation if it is relevant to understand the current period’s financial statements. In this
volume of the textbook, however, comparative information, except where it is abso-
lutely necessary for the purpose of an explanation or calculation, is omitted to ease
presentation.
1.4.4.8 Consistency of presentation
The presentation and classification of items in the financial statements shall be retained
from one period to the next (IAS 1: 45). An entity changes the presentation of its financial
statements from one period to the next only if the changed presentation or classifica-
tion is more appropriate or an IFRS requires a change in presentation (IAS 1: 45).
l intangible assets;
l financial assets (for example an equity instrument of another entity held for invest-
ment purposes or a cash investment);
l inventories;
l trade and other receivables;
l cash and cash equivalents;
l trade and other payables;
l financial liabilities (for example a contractual obligation to deliver cash or another
financial asset to another entity or to exchange financial assets or financial liabil-
ities under conditions that are potentially unfavourable to the entity); and
l issued capital and reserves.
(Only those items applicable to this volume of the textbook are mentioned.)
IAS 1: 55 to 57 further state that an entity shall present additional line items, headings
and subtotals in the statement of financial position when such presentation is relevant
to an understanding of the entity’s financial position.
An entity shall present current and non-current assets, and current and non-current
liabilities as separate classifications in the statement of financial position (IAS 1: 60).
(a) Current assets
According to IAS 1: 66, an asset shall be classified as “current” when it satisfies any of
the following criteria:
l it is expected to be realised in, or intended for sale or consumption in the entity’s
normal operating cycle;
l it is held primarily for the purpose of being traded;
l it is expected to be realised within twelve months after the reporting period; or
l it is cash or a cash equivalent, unless it is restricted from being exchanged or used
to settle a liability for at least twelve months after the reporting period.
IAS 1: 68 explains the operating cycle of an entity as the time between the acquisition
of assets for processing and their realisation in cash or cash equivalents. When the
entity’s normal operating cycle is not clearly identifiable, its duration is assumed to be
twelve months. Current assets include assets (such as inventories and trade receiv-
ables) that are sold, consumed or realised as part of the normal operating cycle, even
when they are not expected to be realised within twelve months after the reporting
period. Current assets also include assets held primarily for the purpose of being
traded (financial assets held for trading) and the current portion of non-current finan-
cial assets.
All other assets that do not conform to the above criteria shall be classified as “non-
current assets” and include tangible, intangible and financial assets of a long-term
nature (IAS 1: 67). This Standard does not prohibit the use of alternative descriptions
as long as the meaning is clear (IAS 1: 67), for example the term “fixed assets” could
be used in place of “non-current assets”. However, in this textbook, the terminology of
this Standard is preferred and used.
Chapter 1: Introduction to the preparation and presentation of financial statements 41
(c) comprehensive income for the period being the total of profit or loss and other
comprehensive income.
(a) Information to be presented in the profit or loss section.
The profit or loss section shall include line items that present the following amounts for
the period (IAS 1: 82) (only those items that are applicable to this volume of the text-
book, are mentioned):
l revenue;
l finance costs;
l tax expense;
(b) Information to be presented in the other comprehensive income section
(IAS 1: 82A):
l each component of other comprehensive income classified by nature.
Additional line items, headings and subtotals shall be presented in the statement of
profit or loss and other comprehensive income when such presentation is relevant to
an understanding of the entity’s financial performance (IAS 1: 85).
No items of income or expense shall be presented as extraordinary items in the state-
ment of profit or loss and other comprehensive income or in the notes (IAS 1: 87).
(c) Information to be presented in the statement of profit or loss and other com-
prehensive income or in the notes
According to IAS 1: 97 to 98, when items of income or expenses are material, their
nature and amount shall be disclosed separately, for example:
l the write-down of inventories to the net realisable value and reversal of such write-
downs;
l the disposal of items of property, plant and equipment; and
l the disposal of investments.
IAS 1: 99 further states that an entity shall present an analysis of expenses using a
classification based on either the nature of the expense or its function within the entity,
whichever provides the information that is reliable and more relevant. In this textbook,
expenses are analysed according to their function within an entity (also called the cost
of sales method according to IAS 1: 103). Hereby expenses are classified according
to their function as part of cost of sales or, for example, as part of administrative activi-
ties. Under this classification method, an entity must disclose its cost of sales separ-
ately from its other expenses (IAS 1: 103). An example of the classification of
expenses according to their function within an entity is:
Chapter 1: Introduction to the preparation and presentation of financial statements 43
R
Revenue XXX XXX
Cost of sales (XX XXX)
Gross profit XX XXX
Other income XXX
Distribution costs (XXX)
Administrative expenses (XXX)
Other expenses (XXX)
Profit X XXX
IAS 1: 104 also requires of entities that classify expenses by function to disclose add-
itional information on the nature of the expenses, such as on depreciation, amortisation
and employee-benefit expenses.
1.4.5.5 Statement of changes in equity
(a) Information to be presented in the statement of changes in equity
According to IAS 1: 106, an entity shall present a statement of changes in equity. This
statement includes the following:
l total comprehensive income for the period;
l the amounts of transactions with owner(s) acting in their capacity as owners, show-
ing contributions by and distribution to owners separately; and
l for each component of equity, a reconciliation between the carrying amount at the
beginning and the end of the period, separately disclosing each change.
(Only those items that are applicable to this volume of the textbook are mentioned.)
(b) Information to be presented in the statement of changes in equity or in the
notes
According to IAS 1: 107 the amount of dividends recognised as distribution to owners
during the period, and the related amount per share can be presented in the state-
ment or in the notes. In this textbook, dividends paid will be presented in the statement
of changes in equity.
1.4.5.6 Statement of cash flows
According to IAS 1: 111, cash flow information provides users of financial statements
with a basis to assess the ability of the entity to generate cash and cash equivalents
and the needs of the entity to utilise those cash flows. IAS 7 Statement of cash flows
sets out the requirements for the presentation and disclosure of cash flow information.
The statement of cash flows is dealt with in Chapter 7.
1.4.5.7 Notes
(a) Introduction
Notes contain information in addition to that presented in the statement of financial
position, statement of profit or loss and other comprehensive income, statement of
changes in equity and statement of cash flows. Notes provide narrative descriptions or
disaggregation of items disclosed in those statements and information about items that
do not qualify for recognition in those statements (IAS 1: 7).
44 About Financial Accounting: Volume 2
(b) Structure
IAS 1: 112 states that the notes shall:
l present information about the basis of preparation of the financial statements and
the specific accounting policies used;
l disclose the information required by IFRS that is not presented elsewhere in the
financial statements; and
l provide additional information that is not presented elsewhere in the financial
statements but is relevant to understanding any of them.
Notes must, as far as practicable, be presented in a systematic manner. Each item in
the statement of financial position and the statement of profit or loss and other compre-
hensive income, as well as the statement of changes in equity and the statement of
cash flows shall be cross-referenced to any related information in the notes (IAS 1: 113).
According to IAS 1: 114, notes are normally presented in the following order, which
assists the users in understanding the financial statements and comparing them to
financial statements of other entities:
l a statement of compliance with IFRS;
l a summary of the significant accounting policies applied;
l the supporting information for items presented in the statements of financial pos-
ition and the statement of profit or loss and other comprehensive income as well as
in the statements of changes in equity and statement of cash flows, in the order in
which each statement or line item is presented; and
l other disclosures such as contingent liabilities which falls outside the scope of this
textbook.
(c) Disclosure of accounting policies
Paragraph 117 of IAS 1 deals specifically with the disclosure of accounting policies
and states that an entity shall disclose its significant accounting policies comprising:
l the measurement basis (or bases) used in preparing the financial statements; and
l the other accounting policies used that are relevant to an understanding of the
financial statements.
Similar to the discussions on the Conceptual Framework, only those paragraphs in
IAS 1 that are at an introductory accounting level are discussed in this textbook.
The next section of the chapter deals specifically with an introduction to financial
instruments as this important topic is extensively presented in later accounting studies.
Chapter 1: Introduction to the preparation and presentation of financial statements 45
Amortised costs
Financial Financial Amortised costs
assets: Fair value through profit liabilities:
classification Fair value
classifi- or loss
through profit
cation Fair value through other or loss
comprehensive income
1.5.1 Introduction
In Volume 1 of the textbook, the concept of financial instruments was discussed. As
the topic is of great importance this section elaborates the discussion and focus on the
reporting thereof.
Currently there is one International Accounting Standard (IAS) and two International
Financial Reporting Standards (IFRSs) that deal with financial instruments. They are:
l IAS 32: Financial instruments: Presentation. The objective of this standard is to
establish principles for presenting financial instruments as assets, liabilities or
equity and for offsetting financial assets and financial liabilities (IAS 32: 2). It com-
plements the principles contained in IFRS 7 and IFRS 9 and defines most of the
important concepts.
l IFRS 7: Financial Instruments: Disclosures. The objective of this Standard is to
require entities to provide disclosure in their financial statements to enable users to
evaluate the significance of financial instruments for an entity’s financial position
and performance and to inform users of the nature and extent of related risks of
financial instruments and how those risks are managed (IFRS 7: 1).
l IFRS 9: Financial Instruments. The objective of this Standard is to establish prin-
ciples for the financial reporting of financial assets and financial liabilities that will
present relevant and useful information to users of financial statements for their
assessment of the amounts, timing and uncertainty of the entity’s future cash flows
(IFRS 9: 1.1). Similarly, to the Conceptual Framework, IFRS 9 also consist of differ-
ent chapters which are:
Chapter 1: Objective;
Chapter 2: Scope;
Chapter 3: Recognition and derecognition;
Chapter 4: Classification;
Chapter 5: Measurement; and
Chapter 6: Hedge Accounting.
In this textbook, only the chapters and paragraphs in the standard that are applicable
to an introductory accounting level are addressed. The requirements surrounding
financial instruments are not only applicable to companies. Paragraph 14 of IAS 32
clearly states that the concept of “entity” (as used in the Standards) includes individu-
als, partnerships, incorporated bodies, trusts and government agencies.
1.5.2 Definitions
1.5.2.1 Financial instrument
According to IAS 32: 11, a financial instrument is any contract that gives rise to a
financial asset for one entity and a financial liability or equity instrument for
another entity. All the above elements must be present in order to classify an item as a
financial instrument. IAS 32 further distinguishes between primary financial instruments
and derivative financial instruments. Primary financial instruments are the basic instru-
ments, such as receivables, payables and equity (IAS 32: AG15). Derivative financial
instruments are more advanced instruments, such as futures, forwards, options, swaps
Chapter 1: Introduction to the preparation and presentation of financial statements 47
and currency swops (IAS 32: AG15). In this textbook, the focus is placed on meas-
urement and presentation, and primary financial instruments.
1.5.2.2 Financial asset (IAS 32: 11)
A financial asset is any asset that is:
(a) cash (for example current account with a favourable balance, a cash deposit with
a bank or similar financial institution, or cash on hand (petty cash));
(b) an equity instrument of another entity (for example investment in the shares of
another entity);
(c) a contractual right (‘contract or contractual right’ refer to an agreement between
two or more parties that has economic consequences which the parties can’t
avoid because the agreement is enforceable by law (IAS 32: 13):
(i) to receive cash or another financial asset from another entity (for example
trade debtors, interest receivable, loans receivable and debtors that will
settle their debts by issuing shares); or
(ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity (for example a pur-
chase option under condition where the Rand or domestic currency deterior-
ates); or
(d) a contract that will or may be settled in the entity’s own equity instruments (for
example a trade debtor can undertake to settle its account (a fixed amount) by
issuing a number of ordinary shares equal to the amount of the outstanding debt).
(In this textbook, examples of paragraphs (a) to (c)(i) of the above definition are mostly
given.)
1.5.2.3 Financial liability (IAS 32: 11)
A financial liability is any liability that is:
(a) a contractual obligation:
(i) to deliver cash or another financial asset to another entity (for example trade
creditors, loans payable, interest payable and notes payable in government
bonds); or
(ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity; or
(b) a contract that will or may be settled in the entity’s own equity instruments (for
example a contract that provides that an entity must issue a variable number of its
own ordinary shares to settle the fixed contract amount).
(In this textbook the emphasis will only fall on paragraph (a)(i) of the above definition.)
1.5.2.4 Equity instrument (IAS 32: 11)
An equity instrument is any contract that evidences a residual interest in the assets of
an entity after deducting all of its liabilities. This is represented by the equation
“E = A – L” as dealt with in Volume 1 of About Financial Accounting. The reader must
note that an entity’s own equity instrument (capital, members’ contributions or shares
issued) is never a financial asset or liability.
48 About Financial Accounting: Volume 2
l Assets (such as prepaid expenses) for which the future economic benefit is the
receipt of goods or services, rather than the right to receive cash or another finan-
cial asset, are not financial assets (IAS 32: AG11).
l Liabilities (such as income received in advance, for example rental income) can be
argued along the same lines as prepaid expenses and are thus not financial liabil-
ities.
l Liabilities or assets that are not contractual (such as income taxes that are created
as a result of statutory requirements imposed by governments) are not financial
liabilities or assets (IAS 32: AG12).
A financial asset shall be measured at fair value through other comprehensive income
if i) the financial asset is held within a business model with the objective to collect con-
tractual cash flows and selling financial assets and ii) the contractual terms give rise to
cash flows that are solely payments of principal (capital) and interest. Both the con-
ditions must be met for a classification as fair value through other comprehensive in-
come (IFRS 9: 4.1.2A) An entity may make an irrevocable election at initial recognition
for particular investments in equity instruments that would otherwise be measured at
fair value through profit or loss, to present subsequent changes in fair value in other
comprehensive income (IFRS 9: 4.1.4). Financial assets measured at fair value through
other comprehensive income fall outside the scope of this textbook. It must be noted
that financial assets measured at fair value through profit or loss are those that are not
classified in either of the above categories. IFRS 9: 4.1.4 defines a financial asset
measured at fair value through profit or loss as financial assets not measured at amor-
tised costs or those measured at fair value through other comprehensive income. An
entity may also at initial recognition, irrevocable designate a financial asset as meas-
ured at fair value through profit or loss provided that it provides relevant information
(IFRS 9: B4.1.27).
Examples of financial assets that can be classified and accounted for at fair value
through profit or loss in accordance with to IFRS 9 include:
l investments in the shares of a listed company;
l investments in the shares of unlisted companies only if the investment was des-
ignated to be at fair valued through profit or loss. If not the investment could be
valued at fair value through other comprehensive income; and
l investments in government bonds.
The three categories for the classification of financial assets can be summarised as
follows:
Financial assets at fair value Financial assets at amortised Financial assets at fair value
through profit or loss costs through other comprehensive
income
(FVTPL)
(FVTOCI)
Financial liabilities at amortised costs Financial liabilities at fair value through profit
or loss
1.5.4.3 Recognition
The action of recording of financial assets and liabilities is referred to as the recog-
nition of the financial asset or liability.
In terms of IFRS 9: 3.1.1, an entity shall recognise a financial assets or financial liability
in its statement of financial position only when the entity becomes a party to the con-
tractual provisions of the instrument. This implies that receivables or payables are rec-
ognised as assets or liabilities when the entity becomes a party to the contract (selling
or purchasing the goods) and as a consequence has a legal right to receive or a legal
obligation to pay cash (IFRS 9: B3.1.2).
1.5.4.4 Measurement
(a) Initial measurement of financial assets and liabilities
When an entity first recognises a financial asset, the entity must classify it in accord-
ance with the information provided in paragraph 1.5.4.1. When an entity first recog-
nises a financial liability it must be classified in accordance with the information
provided in paragraph 1.5.4.2.
At initial recognition an entity shall measure a financial asset (except for trade receiv-
ables) or a financial liability at its fair value (IFRS 9: 5.1.1). Fair value is normally the
transaction price (the fair value of the consideration given or received) (IFRS 9: B5.1.1).
Transaction costs are incremental costs that are directly attributable to the acquisition,
issue or disposal of a financial asset or financial liability (IFRS 9 Appendix A). Trans-
action costs include fees and commissions paid to agents, advisors, brokers and
dealers, levies by regulatory agencies and security exchanges and transfer taxes and
duties. Financing costs and internal administrative costs are specifically excluded from
transaction costs (IFRS 9 Appendix A).
Transaction costs incurred in relation to all financial assets and financial liabilities
measured at fair value through profit or loss are accounted for as an expense. Trans-
action costs incurred in relation to financial assets and financial liabilities measured at
amortised cost and financial assets measured at fair value through other comprehen-
sive income are capitalised against the carrying amount of the asset or liability (IFRS 9:
5.1.1).
52 About Financial Accounting: Volume 2
Solution:
Example Traders CC
General Journal
Debit Credit
20.0 R R
Jan 2 Investment: Shares in National Ltd 10 000
Investment expenses (transaction costs) 1 500
Bank 11 500
Initial recognition of investment at cost and record-
ing of investment expenses
Dec 31 Profit or loss account 1 500
Investment expenses 1 500
Closing off of investment expenses
Investment: Shares in National Ltd 2 000
Gain on financial asset at fair value through profit
or loss 2 000
Gain on subsequent measurement of investment in
the shares of National Ltd at year end
Gain on financial asset at fair value through profit or 2 000
loss
Profit or loss account 2 000
Closing off of gain on financial asset at fair value
through profit or loss
Note R R
20.1 20.0
Revenue (This number refers to the note number in the com- 3 (Figures of
ponent: “Notes for the year ended . . .”) previous year
to assist with
comparability)
Cost of sales
Gross profit
Other income
Profit on sale of non-current asset: Vehicle
Dividend income: Listed share investment1 4
Interest income
Fair value adjustments: Listed share investment2 5
(Expenses listed according to their function in the entity)
Distribution, administrative and other expenses
Advertising
Bank charges
Telephone expenses
Water and electricity
Salaries
Insurance
Delivery expenses
Credit losses
Stationery consumed
Investment expenses
Depreciation
Loss on sale of non-current asset: Machinery
Fair value adjustments2:: Listed share investment 5
Finance costs
Interest on long-term loan
Interest on mortgage
Interest on bank overdraft
Profit before tax3
Income tax expense3
Profit for the year
Other comprehensive income for the year
Fair value adjustments2 5
Total comprehensive income for the year
Comment:
1. Dividends received (from listed and unlisted shares).
2. Increase/decrease in fair value of listed share investments. An increase and de-
crease in the fair value of unlisted investments shall only be disclosed here if the
unlisted investment was designated at fair value through profit or loss. If it is not
the case, any fair value adjustment in unlisted shares must be disclosed in other
comprehensive income.
Chapter 1: Introduction to the preparation and presentation of financial statements 55
3. Depending on the type of ownership of the entity, income tax expense can or
cannot be part of the statement of profit or loss and other comprehensive income.
Example Traders CC (name of reporting entity)
Statement of financial position as at 31 December 20.1
(Name of component of financial statements) + (Period covered by this component) (Presentation currency)
Note R R
20.1 20.0
ASSETS
Non-current assets (Classified according to the criteria set
out in IAS 1: 66)
Property, plant and equipment
Fixed deposit 7
Unlisted share investment 7
Current assets (Classified according to the criteria set out
in IAS 1: 66)
Inventories
Trade and other receivables1 7
Prepayments
Callable fixed deposit 7
Listed share investment held 7
Cash and cash equivalents 7
Current tax receivable
Total assets
EQUITY AND LIABILITIES
Total equity (Classified according to the specific criteria
of the entity. Refer to IAS 1: 79 and 80)
Members’ contributions
Retained earnings
Other components of equity
Total liabilities
Non-current liabilities (Classified according to the criteria
set out in IAS 1: 69)
Long-term borrowings 10
Comment:
For accounting at an introductory level: The test for being “non-current” or “current” as
laid down in IAS 1: 66 and IAS 1: 69 will apply when deciding how financial assets and
financial liabilities will be classified and disclosed.
56 About Financial Accounting: Volume 2
Example Traders CC
Statement of changes in equity for the year ended 31 December 20.1
Comment:
As the statement of changes in equity for each type of business ownership differs sub-
stantially, it will be shown when the financial statements of partnerships and close cor-
porations are addressed. The reader must refer to Volume 1 for the presentation of this
statement for sole traders. The minimum requirements of IAS 1: 106 must be adhered
to when preparing a statement of changes in equity.
Example Traders CC
Notes for the year ended 31 December 20.1
Comment:
Only the notes regarding to some of the accounting policies and financial assets and
liabilities are shown. Other notes will be discussed when the financial statements of
partnerships and close corporations are prepared.
Accounting policy
1. Basis of presentation
The annual financial statements have been prepared in accordance with Inter-
national Financial Reporting Standards (IFRS) appropriate to the business of the
entity and the Close Corporations Act 69 of 1984. The annual financial statements
have been prepared on the historical cost basis, modified for the fair valuation of
certain financial instruments, and incorporate the principal accounting policies set
out below. The financial statements are presented in South African Rand.
2. Summary of significant accounting policies
The annual financial statements incorporate the following significant accounting
policies which are consistent with those applied in previous years except where
otherwise stated.
2.1 Property, plant and equipment
Property, plant and equipment are initially recognised at cost price. No depre-
ciation is written off on land. Plant, equipment and vehicles are subsequently
measured at cost less accumulated depreciation and accumulated impair-
ment losses.
Depreciation on plant, equipment and vehicles are written off at a rate
deemed to be sufficient to reduce the carrying amount of the assets over their
estimated useful life to their estimated residual value. The depreciation rates
are as follows:
Plant: 2% per annum according to the straight-line method;
Equipment: 10% per annum according to the straight-line method;
Vehicles: 20% per annum according to the diminishing balance method.
Chapter 1: Introduction to the preparation and presentation of financial statements 57
4. Dividend income
R R
20.1 20.0
Listed share investments
Unlisted share investments
Total dividend income
5. Fair value adjustments
R R
20.1 20.0
Unlisted share investment designated as at fair value through
profit or loss
Listed investment held for trading
Net fair value adjustments
7. Financial assets
R R
20.1 20.0
Non-current financial assets
Fixed deposit at amortised cost: ABS Bank at 12% p.a.
callable at 31 December 20.4
Unlisted share investment designated at fair value through
profit or loss: 1 000 ordinary shares in CAAP (Pty) Ltd
(consideration R50 000)
Current financial assets
Trade and other receivables:
Trade receivables control
Allowance for credit losses [amount must be between ()]
Allowance for settlement discount granted [amount must be
between ()]
Callable fixed deposit: WILL Investment Ltd at 14% p.a.
callable at 30 June 20.2
Listed share investment held for trading at fair value through
profit or loss: 10 000 ordinary shares in ABB Limited (con-
sideration R12 000)
Cash and cash equivalents:
Bank
Petty cash
Chapter 1: Introduction to the preparation and presentation of financial statements 59
Comment:
1. Mortgage: If a fixed annual interest rate was negotiated, the word “equal” must be
inserted before the words “monthly instalments”.
2. The cross reference to note “xx” will be a reference to the note pertaining to prop-
erty, plant and equipment. This will be illustrated in Chapter 2.
3. A “bank overdraft facility” does not represent a financial liability. It is only when the
entity uses the facility that an obligation arises to repay and thus a financial liability
is created.
4. Settlement discount granted is the actual discount granted to debtors who paid
their accounts within the required time frame. The allowance for settlement dis-
count granted is the amount of discount included in credit sales in the current
financial year. Because the debtor will only pay in the following financial year (and
will only then qualify for the discount if payment is timely) an allowance is created
in the current year to rectify the overstatement of sales. The entity must make an
objective estimation of the amount of settlement discount that debtors might take
up based on their past payment history and journalise the estimation as follows: dr
sales and cr allowance for settlement discount granted.
1.7.2 Calculations
Calculations are indicated by an encircled figure, for example “c”. Where there is
reference to another calculation within a calculation, such a calculation is indicated as
“n”. Calculations between brackets do not form part of the journal or ledger entries or
60 About Financial Accounting: Volume 2
the disclosures in the financial statements and are used to illustrate the calculation of
the amount(s) disclosed.
1.8 Summary
In this chapter, the reader was introduced to the preparation and presentation of
general purpose financial statements of an entity, using the Conceptual Framework
and IAS 1 as points of reference. The Conceptual Framework consists of a group of
interrelated objectives and theoretical principles that serve as a frame of reference for
Financial Accounting. The main purpose of the Conceptual Framework is to assist the
IASB to develop IFRS, to assist preparers to develop consistent accounting policies
and to assist all parties to understand and interpret IFRS.
The objective of financial statements is to report on the financial position and financial
performance in such a way that the information it provides will be useful to a wide
variety of users who rely on the information in the financial statements to make eco-
nomic decisions.
When preparing financial statements, the preparer ensures that transactions are rec-
ognised when they occur and that these transactions are recorded in the financial
statements of the period to which they relate, and that the entity will continue its oper-
ations in the foreseeable future.
In order to provide useful information, financial statements must have the following
fundamental qualitative characteristics, namely relevance and faithful representation.
The financial statements should also comply with the enhancing qualitative character-
istics of comparability, verifiability, timeliness and understandability. In practice, how-
ever, the constraints of timeliness and costliness impact heavily on these
characteristics, to such an extent that the preparer of financial statements must some-
times balance or trade off the characteristics against each other in order to meet the
objectives of financial statements.
The information in financial statements is grouped into elements that make up the
financial statements. These elements are further grouped into those that pertain to the
financial position (assets, liabilities and equity) and those that pertain to financial per-
formance (income and expenses). Before these elements are accounted for, they must
first comply with the recognition criteria and thereafter measured using an applicable
measurement basis as described in this chapter. The recognised and measured elem-
ents can thereafter be presented and disclosed in financial statements according to
IFRS.
IFRS refers to the “International Financial Reporting Standards”, of which IAS (Interna-
tional Accounting Standards) forms a major part.
IAS 1 deals with the presentation of financial statements and uses the Conceptual
Framework as its point of reference. The main objective of IAS 1 is to prescribe the
62 About Financial Accounting: Volume 2
basis for the preparation of general purpose financial statements to ensure compar-
ability both with the entity’s financial statements of previous periods and with the finan-
cial statements of other entities. Financial statements can be described as a structured
representation of the financial position, financial performance and cash flows of an
entity that is useful to a wide range of users in making economic decisions.
When preparing the financial statements of an entity, the preparer must ensure that the
overall considerations, as required by IAS 1, are adhered to. These considerations are:
l Financial statements must present the financial position, financial performance and
cash flows of an entity fairly in accordance with the requirements of IFRS.
l Financial statements must be prepared on a going-concern basis.
l Financial statements must be prepared using the accrual basis of accounting.
l The presentation and classification of items in the financial statements must be
consistent with those of previous periods.
l Each material class of similar items must be presented separately. Items of a dis-
similar nature must be presented separately if they are material, and items that
cannot be allocated to a specific class must also be shown separately if they are
material.
l Offsetting of assets, liabilities, income and expenses is normally not allowed.
l Financial statements should be prepared annually, information must be presented
consistently and comparative information of previous periods must be disclosed.
According to IAS 1, a complete set of financial statements consists of the following
components:
l a statement of financial position;
l a statement of profit or loss and other comprehensive income;
l a statement of changes in equity;
l a statement of cash flows; and
l notes, comprising a summary of significant accounting policies and other explana-
tory notes.
Each component of the financial statements must be identified by providing it with a
name of the reporting entity, the specific name of the component being prepared, the
statement of financial position date or period covered by the specific financial state-
ment and the presentation currency.
When preparing a statement of financial position, all assets must be classified as
either current or non-current assets and all liabilities must be classified as either cur-
rent or non-current liabilities. For the purpose of this volume, equity will be equal to the
net assets (assets minus liabilities). When preparing a statement of profit or loss and
other comprehensive income, expenses for the purpose of this volume are classified
according to their function as part of cost of sales or as part of the cost of distribution
or administrative activities.
IAS 1 is also very specific as to which items should be presented on the face of each
of the components of the financial statements, and those which can be disclosed
Chapter 1: Introduction to the preparation and presentation of financial statements 63
either on the face of the particular component or in the notes to the financial state-
ments. This requirement of IAS 1 must be complied with.
In addition to the Conceptual Framework and IAS 1, the reader was also introduced to
financial instruments as discussed in IAS 32, IFRS 7 and IFRS 9. According to IAS 32,
financial instruments can be classified as financial assets and/or financial liabilities.
The consequence of this is that in preparing financial statements, assets and liabilities
will have to be further divided into being of a financial or non-financial nature and pre-
sented accordingly in the financial statements. The concept of fair value, contract,
transaction costs, and the classification, recognition and measurement of financial in-
struments, were also discussed.
CHAPTER 2
Establishment and financial statements
of a partnership
Contents
Page
Overview of the establishment and financial statements of a partnership ............. 66
2.1 Introduction ................................................................................................... 67
2.2 Reasons for the formation of partnerships .................................................... 68
2.2.1 Increasing the amount of capital in the business ............................ 68
2.2.2 Eliminating competition ................................................................... 68
2.2.3 Uniting capital and technical expertise ........................................... 68
2.2.4 Retaining skills and technical expertise .......................................... 68
2.3 Legal position of a partner ............................................................................ 68
2.4 Establishment of a partnership ..................................................................... 69
2.4.1 Action............................................................................................... 69
2.4.2 Agreement ....................................................................................... 69
2.5 The partnership agreement .......................................................................... 69
2.6 Dissolution of a partnership .......................................................................... 70
2.7 Accounting procedures and specialised accounts...................................... 70
2.7.1 Recording of equity ......................................................................... 71
2.7.1.1 Capital accounts ............................................................. 71
2.7.1.2 Current accounts ............................................................. 72
2.7.1.3 Drawings accounts ......................................................... 72
2.7.2 Loan accounts ................................................................................. 72
2.7.3 The appropriation account .............................................................. 73
2.7.4 Recording of salaries and bonuses paid or payable to
partners ........................................................................................... 73
2.8 Financial statements of a partnership........................................................... 81
2.9 Summary ....................................................................................................... 97
65
66 About Financial Accounting: Volume 2
Partnership
• Mutual agreement
• Passage of time
• Changes in partners
Dissolution
• Insolvency
• Unilateral action of a partner
• Unlawful acts by partners
Capital accounts
Equity Current accounts
Drawings accounts
Loans Loan to or from partner – terms of
repayment will determine if it is non-
current or current liability/non-current
or current asset
Appropriation of profit or loss Appropriation account
Salaries and bonuses paid or Recorded according to the legal
payable to partners approach
Chapter 2: Establishment and financial statements of a partnership 67
2.1 Introduction
STUDY OBJECTIVES
In Volume 1, the sole proprietor as a form of business ownership was discussed. The
main feature of a sole proprietor is that the entity belongs to one person only. All deci-
sions regarding the business are taken by the owner, and all the profits or losses
accrue to him. The owner is personally liable for all the obligations of the entity and he
is the sole owner and disposer of the assets of the business.
Due to the limitations (financial and managerial) of a sole trader, it is common practice
for two or more persons to start a business. If these entrepreneurs do not want to get
involved in the complicated juridical proceedings required to start a company or close
corporation, they will find it more convenient to form a partnership. This form of busi-
ness entity, which is suitable for small to medium-sized businesses, is frequently found
among the professions, for example engineers, architects, accountants, medical doc-
tors and lawyers.
By definition, a “partnership” can be described as a legal relationship created by an
agreement between two or more natural persons. In terms of this agreement, each
person (called a “partner”) contributes either cash, merchandise, property, plant,
equipment or expertise to the entity for the purpose of conducting a lawful business
and making a profit, which is then divided amongst the partners in a pre-arranged ratio
or according to common law principles (if no pre-arranged ratio exists).
Although the partnership agreement creates a legal relationship between the partners,
the partnership itself is not a legal entity. The property of an entity which is not a legal
entity, also known as a “non-incorporated entity”, belongs to the owner(s) of the entity
and the owner(s) is personally liable for the entity’s obligations. All legal actions of
such an entity are conducted through its owner(s). Sole proprietorships and partner-
ships are the most common forms of entities without legal status.
An entity with legal status, which is an incorporated entity, on the other hand, may own
property, incur debts and execute all other legal actions in its own right as if it were a
natural person. Companies and close corporations fall into this category.
68 About Financial Accounting: Volume 2
2.4.1 Action
It is possible to establish a partnership by tacit agreement. This implies that if the actions
(conduct) of two or more people are such that it gives rise to the assumption that the
people are in partnership, a partnership is automatically established between them.
2.4.2 Agreement
A partnership is established when people agree to form a partnership. There is no indi-
cation in the law that the agreement to enter into a partnership should be in writing and
a verbal agreement is therefore sufficient. The partners should agree on the general
terms in a partnership agreement, namely contributions in money, goods and/or labour,
the intention to generate profit, and an agreement on how this profit should be distrib-
uted between the partners.
l salaries and bonuses payable to partners for services rendered to the partnership;
l provisions in respect of withdrawals by the partners;
l provisions for the retirement, admission and death of the partners;
l procedures for settling any disputes between the partners;
l provisions with regard to life insurance policies for partners, the treatment of insur-
ance premiums and the proceeds of such policies; and
l provisions with regard to the valuation of assets and in particular the valuation of
goodwill and the treatment thereof in the accounting records of the partnership.
least once a year (usually at the end of the financial year), the partnership must pre-
pare a full set of financial statements as explained in Chapter 1 paragraph 1.4.3.
Although the accounting procedures of a partnership are very similar to those of a sole
proprietor, there are certain special ledger accounts and procedures which are unique
to a partnership. Before the use of these accounts is illustrated, it is important to note
the two different approaches in preparing partnership accounts.
The first approach is called the “entity approach” towards accounting for partnerships.
The entity approach treats the partners and the partnership as separate accounting
entities. When applying this approach, the interest on capital and partners’ salaries are
treated as expenses in the calculation of profit/loss in the statement of profit or loss
and other comprehensive income of the partnership. The capital invested by the part-
ners is regarded as finance from a separate accounting entity (the partner) and the
related interest is treated as finance costs in the same way as the interest on any other
liability. Following the same argument, salaries and bonuses that are paid or payable
to partners during the financial year for services rendered to the partnership are re-
garded as expenses incurred in the production of the income of the partnership. These
salaries and bonuses should be disclosed in the statement of profit or loss and other
comprehensive income as operating expenses similar to salaries paid to employees.
The second approach is the “legal approach” towards accounting for partnerships.
The partners and the partnership are treated as the same legal entity. The law does
not recognise the partnership as an entity distinct from the partners and the partners
can therefore not be debtors and/or creditors of the partnership. The partners are the
owners of the partnership and cannot employ themselves. Following this argument,
salaries and bonuses are an appropriation of the profit of the partnership and not an
operating expense. Interest on capital, according to this argument, is a distribution of
profits to the partners and not a finance cost to the partnership.
In this volume, the legal approach to accounting for partnerships is adopted. From a
taxation point of view, it does not really matter which approach is followed, as each
partner will end up with the same taxable income received from the partnership, on
which he will be taxed in his personal capacity.
of the loan. Interest payable on such a loan is regarded as a finance cost, and is
disclosed as such in the statement of profit or loss and other comprehensive income.
On the other hand, a partnership can also lend money to a partner. Depending on the
terms of repayment of the loan, it is either reflected as a non-current asset or as a
current asset in the statement of financial position. The interest receivable on such a
loan is disclosed under “other income” in the statement of profit or loss and other com-
prehensive income.
l Interest on capital;
l Salary: A Apple;
l Salary: P Pie;
l Trading account;
l Profit or loss account; and
l Appropriation account.
All ledger accounts must be balanced/closed off on 28 February 20.6. Folio ref-
erences are not required and dates in the general journal and ledger accounts
can be ignored.
Solution:
(a) Applepie Furniture and Fittings
General journal
Debit Credit
R R
Bank (R100 000 + R40 000) 140 000
Capital: A Apple 100 000
Capital: P Pie 40 000
Cash capital contributions deposited
Vehicles 60 000
Office equipment 50 000
Capital: P Pie 110 000
Recording of non-cash capital contributions
Drawings: A Apple 45 000
Drawings: P Pie 45 000
Bank 90 000
Cash withdrawal of salaries by partners
Drawings: A Apple 4 000
Drawings: P Pie 6 000
Purchases 10 000
Merchandise withdrawn by partners
Purchases 110 000
Bank 110 000
Recording of cash purchases
Bank 400 000
Sales 400 000
Recording of cash sales
Salaries 60 000
Bank 60 000
Recording of salaries paid to employees
Rental expenses 36 000
Bank 36 000
Recording of rent paid
continued
76 About Financial Accounting: Volume 2
Debit Credit
R R
Sundry operating expenses 40 000
Bank 40 000
Recording of operating expenses paid
Bank 20 000
Long-term loan: A Apple 20 000
Loan acquired from A Apple
Office equipment 20 000
Bank 20 000
New office equipment purchased for cash
Interest on long-term loan: A Apple (R20 000 × 14% × 6/12) 1 400
Interest payable 1 400
Recording of interest payable on long-term loan
Depreciation c 18 000
Accumulated depreciation: Office equipment 6 000
Accumulated depreciation: Vehicles 12 000
Provision for depreciation: Office equipment at 10% per
annum according to the straight-line method and vehicles at
20% per annum according to the diminishing balance method
Salary: A Apple 60 000
Salary: P Pie 60 000
Current account: A Apple 60 000
Current account: P Pie 60 000
Recording of salaries payable to partners
Interest on capital d 25 000
Current account: A Apple 10 000
Current account: P Pie 15 000
Recording of interest on capital
Trading account 100 000
Purchases (R110 000 – R10 000) 100 000
Closing transfer
Sales 400 000
Inventory 15 000
Trading account 415 000
Closing transfer
Trading account (R415 000 – R100 000) 315 000
Profit or loss account 315 000
Closing transfer of gross profit
Profit or loss account 155 400
Salaries 60 000
Rental expenses 36 000
Sundry operating expenses 40 000
Depreciation 18 000
Interest on long-term loan: A Apple 1 400
Transfer of expenses to profit or loss account
continued
Chapter 2: Establishment and financial statements of a partnership 77
Debit Credit
R R
Profit or loss account (R315 000 – R155 400) 159 600
Appropriation account 159 600
Closing transfer of profit for year
Current account: A Apple 49 000
Current account: P Pie 51 000
Drawings: A Apple (R45 000 + R4 000) 49 000
Drawings: P Pie (R45 000 + R6 000) 51 000
Closing transfer of drawings to current accounts
Appropriation account 25 000
Interest on capital 25 000
Closing transfer of interest on capital
Appropriation account 120 000
Salary: A Apple 60 000
Salary: P Pie 60 000
Transfer of salaries to partners
Appropriation account e 14 600
Current account: A Apple 5 840
Current account: P Pie 8 760
Appropriation of available profit for the year
Comment:
No interest was calculated on the current accounts as there were no opening balances
on these accounts because trading only commenced during the financial year.
(b) Applepie Furniture and Fittings
General ledger
Dr Capital: A Apple Cr
R
Bank 100 000
Dr Capital: P Pie Cr
R R
Balance c/d 150 000 Bank 40 000
Vehicles 60 000
Office equip-
ment 50 000
150 000 150 000
Balance b/d 150 000
continued
78 About Financial Accounting: Volume 2
Dr Drawings: A Apple Cr
R R
Bank 45 000 Current
Purchases 4 000 account:
A Apple 49 000
49 000 49 000
Dr Drawings: P Pie Cr
R R
Bank 45 000 Current
Purchases 6 000 account:
P Pie 51 000
51 000 51 000
continued
Chapter 2: Establishment and financial statements of a partnership 79
Dr Bank Cr
R R
Capital: Drawings:
A Apple 100 000 A Apple 45 000
Capital: P Pie 40 000 Drawings: P Pie 45 000
Sales 400 000 Purchases 110 000
Loan: A Apple 20 000 Salaries 60 000
Rental
expenses 36 000
Sundry
operating
expenses 40 000
Office equip-
ment 20 000
Balance c/d 204 000
560 000 560 000
Balance b/d 204 000
Dr Interest on capital Cr
R R
Current Appropriation
account: account 25 000
A Apple 10 000
Current
account:
P Pie 15 000
25 000 25 000
Dr Salary: A Apple Cr
R R
Current Appropriation
account: account 60 000
A Apple 60 000
Dr Salary: P Pie Cr
R R
Current Appropriation
account: account 60 000
P Pie 60 000
continued
80 About Financial Accounting: Volume 2
Dr Trading account Cr
R R
Purchases 100 000 Inventory 15 000
Profit or loss Sales 400 000
account 315 000
415 000 415 000
Dr Appropriation account Cr
R R
Interest on Profit or loss
capital 25 000 account 159 600
Salary: A Apple 60 000
Salary: P Pie 60 000
Current
account:
A Apple 5 840
Current
account:
P Pie 8 760
159 600 159 600
Chapter 2: Establishment and financial statements of a partnership 81
Calculations:
c Depreciation R
Depreciation on office equipment: 6 000
R50 000 × 10% 5 000
R20 000 × 10% × 6/12 1 000
Depreciation on vehicles: 12 000
R60 000 × 20% 12 000
Total depreciation 18 000
d Interest on capital R
A Apple 10 000
R100 000 × 10/100 10 000
P Pie 15 000
R150 000 × 10/100 15 000
Total interest on capital 25 000
e Appropriation of profit
Because the partnership agreement does not stipulate the appropriation of profits/
losses, common law principles apply and the profit/loss for the year must be shared
in the same ratio as their capital contributions (refer to paragraphs 2.5 and 2.7.4).
A Apple : P Pie
100 000 :150 000
10 :15
2 :3
R
A Apple’s share: R14 600 × 2/5 5 840
P Pie’s share: R14 600 × 3/5 8 760
14 600
Vanilla Traders
Pre-adjustment trial balance as at 31 December 20.1
Debit Credit
R R
Capital: A Van (1 January 20.1) 100 000
Capital: E Nilla (1 January 20.1) 150 000
Current account: A Van (1 January 20.1) 7 000
Current account: E Nilla (1 January 20.1) 9 000
Drawings: A Van 58 140
Drawings: E Nilla 70 860
Mortgage 120 000
Long-term loan: A Van 30 000
Trade payables control 59 000
Bank 11 000
Land and buildings (at cost) 500 000
Equipment (at cost) 70 000
Vehicles (at cost) 80 000
Accumulated depreciation: Equipment (1 January 20.1) 21 000
Accumulated depreciation: Vehicles (1 January 20.1) 39 040
Allowance for credit losses 600
Inventory 7 500
Trade receivables control 18 000
Petty cash 350
Sales 595 000
Cost of sales 195 990
Advertising 7 400
Bank charges 2 300
Telephone expenses 9 800
Water and electricity 12 100
Salaries 80 400
Insurance 4 000
Delivery expenses 3 900
Credit losses 500
Interest on bank overdraft 600
Stationery consumed 6 300
Settlement discount received 500
1 135 140 1 135 140
Additional information:
Abstract from the terms of the partnership agreement:
1. Interest on capital will be calculated at a rate of 10% per annum on the opening
balances of the capital accounts and at a rate of 8% per annum on the opening
Chapter 2: Establishment and financial statements of a partnership 83
balances of the current accounts. The interest on capital and current accounts
must be capitalised to the current accounts of the partners.
2. Interest will be charged at a rate of 5% per annum on the balance of the drawings
accounts at the end of each month. The interest must be capitalised against the
current accounts of the partners.
3. A Van is entitled to an annual salary of R60 000 and E Nilla is entitled to an annual
salary of R80 000.
4. The partners will share profits and losses in the following ratio: A Van, 1/3 and
E Nilla, 2/3.
Year-end adjustments:
1. An outstanding debt of R300 is irrecoverable and must be written off.
2. The allowance for credit losses must be adjusted to R708.
3. Depreciation must be provided as follows:
Equipment: 10% per annum according to the straight-line method; and
Vehicles: 20% per annum according to the diminishing balance method.
4. The terms of the mortgage provide for interest on the loan to be calculated at a
rate of 15% per annum on the outstanding amount of the loan at the end of the
financial year. Interest is payable in the first week of January of the following year.
During the 20.2 financial year, the partnership will start repaying the loan at an
amount of R20 000 per annum payable on 2 January of every year until the loan is
fully paid. The loan is secured by a mortgage over land and buildings and was
originally granted to the partnership by Capital Bank Limited on 2 January 20.0.
5. A Van granted an unsecured loan to the partnership on 1 September 20.1. Ac-
cording to the terms of the loan agreement, interest at 9% per annum will be
charged and is payable in January of every year. The total amount of the loan will
be repaid in full on 30 June 20.5.
6. Advertising expenses include an amount of R400 which was prepaid for January
20.2.
7. The amount paid for water and electricity excludes an amount of R2 300 still pay-
able for December 20.1.
8. Account for the appropriation of salaries according to the partnership agreement.
During the year, the following cash salaries were withdrawn by the partners:
A Van, R47 140; and
E Nilla, R62 860.
9. Interest calculated on the partners’ drawings accounts, as per the partnership
agreement, amounted to R230 for A Van and R145 for E Nilla for the current finan-
cial year. The interest was not yet recorded in the books of the partnership at the
end of the financial year.
10. Provisions to comply with the terms of the partnership agreement must still be
made.
84 About Financial Accounting: Volume 2
Required:
Prepare the following in respect of Vanilla Traders to comply with the requirements of
International Financial Reporting Standards appropriate to the business of the partner-
ship:
(a) Statement of profit or loss and other comprehensive income for the year ended
31 December 20.1;
(b) Statement of changes in equity for the year ended 31 December 20.1;
(c) Statement of financial position as at 31 December 20.1;
(d) Notes for the year ended 31 December 20.1.
Comparative figures can be ignored. Where necessary, amounts must be rounded off
to the nearest Rand.
Solution:
(a) Vanilla Traders
Statement of profit or loss and other comprehensive income for the year ended
31 December 20.1
Note R
Revenue 3 595 000
Cost of sales R(195 990 – 500) (195 490)
Gross profit 399 510
Distribution, administrative and other expenses (144 200)
Advertisingc 7 000
Bank charges 2 300
Telephone expenses 9 800
Water and electricityd 14 400
Salaries 80 400
Insurance 4 000
Delivery expenses 3 900
Credit lossese 908
Stationery consumed 6 300
Depreciationf 4 15 192
Finance costsg (19 500)
Interest on long-term loan: A Van 900
Interest on mortgage 18 000
Interest on bank overdraft 600
Debt instruments that are classified as current assets or current liabilities are
measured at the undiscounted amount of the cash expected to be received
or paid, unless the arrangement effectively constitutes a financing transaction.
2.3 Inventories
Inventories are initially measured at cost and subsequently valued at the
lower of cost or net realisable value. Cost is calculated using the first-in, first-
out method. Net realisable value is the estimated selling price in the ordinary
course of business less any costs of completion and disposal.
2.4 Revenue
Revenue is measured at the fair value of the consideration received or receiv-
able. Revenue represents the transfer of promised goods to customers in an
amount that reflects the consideration to which the entity expects to be enti-
tled to in exchange for those goods. Revenue from the sale of goods consists
of the total net invoiced sales excluding value added tax and settlement dis-
count granted. Revenue is recognised when performance obligations are
satisfied.
3. Revenue
R
Sale of goods 595 000
The partnership has pledged land and building with a carrying amount of R500 000
(20.0: R500 000) as security for the mortgage obtained from Capital Bank Ltd.
Please note:
The question did not provide sufficient detail to split the land and buildings col-
umn between land and a separate column for buildings as you will see in other
examples. This is especially necessary if buildings are depreciated or land was
revalued.
88 About Financial Accounting: Volume 2
5. Financial assets
6. Financial liabilities
Calculations:
R
c Advertising
R(7 400 – 400) 7 000
d Water and electricity
R(12 100 + 2 300) 14 400
Chapter 2: Establishment and financial statements of a partnership 89
g Finance costs
Interest on long-term loan R30 000 × 4/12 × 9/100 900
Interest on mortgage R120 000 × 15% 18 000
Interest on bank overdraft 600
Total finance costs 19 500
h Interest on capital
R(100 000 + 150 000) × 10% 25 000
Required:
Prepare the following in respect of Vanilla Traders to comply with the requirements of
International Financial Reporting Standards appropriate to the business of the partner-
ship:
(a) Statement of profit or loss and other comprehensive income for the year ended
31 December 20.1;
(b) Statement of changes in equity for the year ended 31 December 20.1.
Notes to the financial statements and comparative figures are not required.
Solution:
(a) Vanilla Traders
Statement of profit or loss and other comprehensive income for the
year ended 31 December 20.1
Note R
Revenue 335 500
Cost of sales (195 990 – 500) (195 490)
Gross profit 140 010
Distribution, administrative and other expenses (144 200)
Advertising 7 000
Bank charges 2 300
Telephone expenses 9 800
Water and electricity 14 400
Salaries 80 400
Insurance 4 000
Delivery expenses 3 900
Credit losses 908
Stationery consumed 6 300
Depreciation 15 192
Finance costs (19 500)
Interest on long-term loan: A Van 900
Interest on mortgage 18 000
Interest on bank overdraft 600
Calculation:
c Partner’s share in loss R
A Van: 1/3 × R188 475 62 825
E Nilla: 2/3 × R188 475 125 650
Total loss 188 475
92 About Financial Accounting: Volume 2
Example 2.4
The following information relates to the partnership S & W Patio Furniture with partners
S Snow and W Wolf:
S & W Patio Furniture
Pre-adjustment trial balance as at 28 February 20.8
Debit Credit
R R
Capital: S Snow (1 March 20.7) 200 000
Capital: W Wolf (1 March 20.7) 100 000
Current account: S Snow (1 March 20.7) 12 000
Current account: W Wolf (1 March 20.7) 19 000
Drawings: S Snow 24 800
Drawings: W Wolf 30 000
Mortgage 180 000
Long-term loan: S Snow 97 000
Trade payables control 79 000
Bank 9 000
Bank savings account 12 000
Land and buildings (at cost) 600 000
Equipment (at cost) 250 000
Vehicles (at cost) 320 000
Accumulated depreciation: Equipment (1 March 20.7) 75 000
Accumulated depreciation: Vehicles (1 March 20.7) 115 200
Inventory 49 500
Petty cash 500
Cash sales 1 193 840
Cost of sales 369 250
Advertising 27 800
Bank charges 12 900
Telephone expenses 19 300
Cell phone expenses 12 000
Water and electricity 31 700
Salaries and commissions 248 000
Insurance 9 000
Delivery expenses (on merchandise sold) 15 700
Cleaning materials used 7 090
Settlement discount received 1 500
2 060 540 2 060 540
Additional information:
S & W Patio Furniture sells merchandise on a cash basis only.
Abstract from the terms of the partnership agreement:
1. Interest on the opening balances of the capital accounts will be calculated at a per
annum rate of twice the average prime lending rate,* as determined by the SA
Reserve Bank. During the financial year the prime lending rate was as follows: first
quarter of the financial year; 6.0%; second quarter; 5.5%; third quarter: 5.0% and
Chapter 2: Establishment and financial statements of a partnership 93
fourth quarter; 4.5%. Interest is calculated at a rate of 8.0% per annum on the
opening balances of the current accounts. The interest on capital and current
accounts must be capitalised to the current accounts of the partners.
2. Interest will be charged at a rate of 10% per annum on the balance of the drawings
accounts at the end of each month. The interest must be capitalised against the
current accounts of the partners.
3. S Snow is entitled to an annual salary of R75 000 and W Wolf is entitled to an
annual salary of R65 000.
4. The partners share profits and losses equally.
Year-end adjustments:
1. Depreciation must be provided as follows:
Equipment: 15% per annum according to the straight-line method; and
Vehicles: 20% per annum according to the diminishing balance method.
2. The terms of the mortgage provide for interest on the loan to be calculated at a
rate of 10% per annum on the outstanding amount of the loan at the end of the
financial year. Interest is payable in the first week of March of the following year.
On 5 March 20.8, the partnership must repay an amount of R35 000 of the loan.
The loan is secured by a mortgage over land and buildings and was granted to the
partnership by Bond Bank Limited on 1 March 20.6. The balance of the loan is
repayable in full in March 20.15.
3. S Snow granted an unsecured loan to the partnership on 1 September 20.7.
According to the terms of the loan agreement, interest at 12% per annum will be
charged and is payable in March of every year. An amount equal to 40% of the
loan is repayable on 1 September 20.8. The remaining balance of this loan is
repayable in full in September 20.10.
4. Advertising expenses exclude an amount of R1 200 which is still payable for the
current financial year.
5. The amount paid for water and electricity includes an amount of R3 000 paid for
March 20.8.
6. Cell phone expenses incurred by the partners are paid for by the partnership due
to the fact that the partners, Snow and Wolf, use their cell phones mainly for busi-
ness purposes. The amount payable for February 20.8 towards the cell phone ex-
penses of Snow is R1 000 and towards the cell phone expenses of Wolf, R700 and
must still be provided for.
7. An amount of R26 000 for commission to sales representatives for February 20.8
still has to be accounted for.
8. Account for the appropriation of salaries according to the partnership agreement.
During the year, the following cash salaries were withdrawn by the partners:
S Snow, R14 900 and
W Wolf, R23 100.
9. Interest calculated on the partners’ drawings accounts, as per the partnership
agreement, amounted to R1 490 for Snow and R2 500 for Wolf for the current finan-
cial year and must still be recorded.
94 About Financial Accounting: Volume 2
Note R
Revenue 1 193 840
Cost of sales R(369 250 – 1 500) (367 750)
Gross profit 826 090
Distribution, administrative and other expenses (487 850)
Advertisingc 29 000
Bank charges 12 900
Telephone expenses 19 300
Water and electricityd 28 700
Salaries and commissionse 274 000
Insurance 9 000
Delivery expenses 15 700
Cell phone expensesf 13 700
Cleaning materials used 7 090
Depreciationg 3 78 460
Finance costsh (23 820)
Interest on long-term loan: S Snow 5 820
Interest on mortgage 18 000
Note R
ASSETS
Non-current assets 901 340
Property, plant and equipment 3 901 340
Current assets 74 000
Inventories 49 500
Prepayments 3 000
Cash and cash equivalents R(9 000 + 12 000 + 500) 21 500
The partnership has pledged land and building with a carrying amount of R600 000
(20.7: R600 000) as security for the mortgage obtained from Bond Bank Ltd.
Calculations:
R
c Advertising
R(27 800 + 1 200) 29 000
d Water and electricity
R(31 700 - 3 000) 28 700
e Salaries and commissions
R(248 000 + 26 000) 274 000
f Cell phone expenses
R (12 000 + 1 000 + 700) 13 700
g Depreciation on equipment (straight-line method)
R250 000 × 15% 37 500
Depreciation on vehicles (diminishing balance method):
R(320 000 – 115 200) × 20% 40 960
Total depreciation 78 460
h Finance costs
Interest on long-term loan from Snow R97 000 × 6/12 × 12% 5 820
Interest on mortgage R180 000 × 10% 18 000
Total finance costs 23 820
Chapter 2: Establishment and financial statements of a partnership 97
i Interest on capital
Calculation of average prime lending rate:
6 + 5,5 + 5 + 4,5 = 21/4 = 5,25 × 2 = 10,5%
Interest on capital: Snow R200 000 × 10,5% 21 000
Interest on capital: Wolf R100 000 × 10,5% 10 500
Total interest on capital 31 500
j Interest on current accounts
Interest income: S Snow (R12 000 x 8%) 960
Interest expense: W Wolf (R19 000 x 8%) 1 520
k Partner’s share of profit
S Snow: R146 350 × 1/2 73 175
W Wolf: R146 350 × 1/2 73 175
l Trade and other payables
Trade payables control 79 000
Advertising payable 1 200
Cell phone expenditures payable 1 700
Interest on mortgage payable 18 000
Interest on long-term loan payable 5 820
Commissions payable 26 000
Total 131 720
2.9 Summary
In this chapter, the formation of the partnership as a form of business ownership was
introduced. Partnerships are formed for many reasons, the main reason being to attract
more capital and expertise in a business, as an unlimited number of natural persons
can constitute a partnership. A partnership can be formed by way of action or by an
agreement that should preferably be in writing.
The relationship between partners and between partners and the partnership are noted
in the partnership agreement. The necessity for such a document lies in the fact that a
partnership is not a legal entity and the partners are responsible for all actions of the
partnership. There is no specific act which deals with partnerships and for disputes
which cannot be resolved by the partners themselves, common law principles will
apply.
Because a partnership implies multiple ownership, adjustments to the basic accounting
system, introduced in the sole proprietor, are necessary to cope with this demand of
multiple ownership. Except for the fact that the capital contribution of each partner
must be separately recorded, accounts must also be opened to record the drawings of
each partner as well as the current accounts to record transactions between each
partner and the partnership. A special account, the appropriation account, is also
needed to record the apportionment of profits and losses amongst the partners.
Profits/losses are shared amongst the partners according to the terms of the partner-
ship agreement. If the partnership agreement is silent on the appropriation of profits/
98 About Financial Accounting: Volume 2
losses, it must be apportioned in the ratio of the respective capital contributions of the
partners. If, however, these contributions are not specified, the profits/losses must be
shared equally.
The format of the financial statements of a partnership is the same as that of a sole
proprietor. It is only the statement of changes in equity and the statement of financial
position that reflect slight changes due to multiple ownership. Strictly speaking, the
statement of cash flows also forms part of the financial statements, but this will be dis-
cussed in detail in Chapter 7. Chapters 3 and 4 deal with further aspects of partner-
ships.
CHAPTER 3
Changes in the ownership structure of
partnerships
Contents
Page
Overview of the changes in the ownership structure of partnerships .................... 100
3.1 Introduction ................................................................................................... 101
3.2 Valuation adjustments ................................................................................... 103
3.2.1 Recording valuation adjustments in the books of an existing
partnership ...................................................................................... 103
3.2.2 Reversing valuation adjustments in the books of a new
partnership ...................................................................................... 107
3.3 Goodwill ........................................................................................................ 109
3.3.1 Description of goodwill .................................................................... 109
3.3.2 Calculation of goodwill acquired ..................................................... 110
3.3.3 Initial recognition of goodwill acquired............................................ 111
3.4 The calculation of new profit-sharing ratios .................................................. 111
3.4.1 Calculation of a new profit-sharing ratio on the
admission of a partner ..................................................................... 111
3.4.2 Calculation of a new profit-sharing ratio on the
retirement or death of a partner....................................................... 113
3.4.3 Calculation of a new profit-sharing ratio on the concurrent
admission and retirement of a partner ............................................ 114
3.5 Recording a change in ownership structure by way of a personal
transaction .................................................................................................... 115
3.6 Recording a change in ownership structure by way of a transaction with
the partnership .............................................................................................. 120
3.6.1 Accounting procedure based on the legal perspective.................. 121
3.6.2 Accounting procedure based on the going-concern
perspective ...................................................................................... 140
3.7 Abridged case studies ................................................................................. 154
3.8 Summary ....................................................................................................... 160
99
100 About Financial Accounting: Volume 2
Legal Going-concern
perspective perspective
Chapter 3: Changes in the ownership structure of partnerships 101
3.1 Introduction
STUDY OBJECTIVES
ASSETS R
Non-current assets 200 000
Property, plant and equipment 200 000
Current assets 160 000
Inventories 58 000
Trade and other receivables (Trade receivables control) 52 000
Cash and cash equivalents 50 000
Additional information:
1. In the above statement, the balances of the capital accounts of Andrews and
Bevan were R180 000 and R120 000 respectively.
2. Andrews and Bevan decided to record the following valuations in preparation of
the admission of Collins:
– Property, plant and equipment: Included in the property, plant and equipment
of R200 000 is land to the amount of R20 000. The fair value of the land is
R32 000.
– Trade receivables control: An allowance for credit losses to the amount of
R5 200 must be created.
Chapter 3: Changes in the ownership structure of partnerships 105
Required:
(a) Record the valuation adjustments in the general journal of Andrews & Bevan Part-
ners on 28 February 20.3 in preparation of the admission of Collins by way of a
valuation account.
(b) Prepare the valuation account (properly closed off) as well as the land and the
capital accounts in the general ledger of Andrews & Bevan Partners, after the
above journal entries were posted to the appropriate general ledger accounts.
Solution:
(a) Andrews & Bevan Partners
General journal
Debit Credit
20.3 R R
Feb 28 Land 12 000
Valuation account R(32 000 – 20 000) 12 000
Adjustment of the balance of the land account accord-
ing to the valuation thereof in preparation of the change
in the ownership structure of the partnership
Valuation account 5 200
Allowance for credit losses 5 200
Creation of an allowance for credit losses in prepar-
ation of the change in the ownership structure of the
partnership
Valuation account R(12 000 – 5 200) 6 800
Capital: Andrews (R6 800 × 3/5) 4 080
Capital: Bevan (R6 800 × 2/5) 2 720
Closing off the balancing amount in the valuation
account to the capital accounts of Andrews and Bevan
according to their profit-sharing ratio
Comments:
l In the examples of this chapter, with exception of Example 3.14, non-current
assets are disclosed in the books of the partnerships without indicating whether
they are at cost price, carrying or valued amounts. The reason for this is that the
legal and going-concern perspectives complicate these disclosures. Since the
objective of this chapter is to discuss basic guidelines, such detailed disclosure is
omitted.
l The valuation adjustments, which in this example are recorded in the first two
journal entries, can be combined into a single journal entry because the valuation
adjustments are recorded by applying the valuation account as the contra
account. In such a combined journal entry, the net amount pertaining to the adjust-
ments of the land and the allowance for credit losses, namely R6 800 (R12 000 –
R5 200), will be disclosed as the amount that must be posted to the valuation
account. In this example, the following combined journal entry could have been
prepared:
106 About Financial Accounting: Volume 2
Dr Land Cr
20.3 R
Feb 28 Balance b/d 20 000
Valuation account 12 000
32 000
Dr Capital: Andrews Cr
20.3 R
Feb 28 Balance b/d 180 000
Valuation account 4 080
184 080
Dr Capital: Bevan Cr
20.3 R
Feb 28 Balance b/d 120 000
Valuation account 2 720
122 720
Chapter 3: Changes in the ownership structure of partnerships 107
Solution:
(a) Andrews & Bevan Partners
General journal
Debit Credit
20.3 R R
Mar 1 Valuation account 12 000
Land 12 000
Reversal of the valuation adjustment that was re-
corded in respect of land
Allowance for credit losses 5 200
Valuation account 5 200
Reversal of the allowance for credit losses that was
created
Capital: Andrews (R6 800 × 3/6) 3 400
Capital: Bevan (R6 800 × 2/6) 2 267*
Capital: Collins (R6 800 × 1/6) 1 133*
Valuation account 6 800
Closing off the balancing amount in the valuation
account to the capital accounts of Andrews, Bevan
and Collins according to their profit-sharing ratio
* Rounded off to the nearest Rand.
(b) Andrews & Bevan Partners
General ledger
Dr Valuation account Cr
20.3 R 20.3 R
Feb 28 Allowance for credit Feb 28 Land 12 000
losses 5 200
Capital: Andrews 4 080
Capital: Bevan 2 720
12 000 12 000
Mar 1 Land 12 000 Mar 1 Allowance for credit
losses 5 200
Capital: Andrews 3 400
Capital: Bevan 2 267
Capital: Collins 1 133
12 000 12 000
Dr Land Cr
20.3 R 20.3 R
Feb 28 Balance b/d 20 000 Feb 28 Balance c/d 32 000
Valuation account 12 000
32 000 32 000
Mar 1 Balance b/d 32 000 Mar 1 Valuation account 12 000
Balancing amount 20 000
continued
Chapter 3: Changes in the ownership structure of partnerships 109
Dr Capital: Andrews Cr
20.3 R 20.3 R
Feb 28 Balance c/d 184 080 Feb 28 Balance b/d 180 000
Valuation account 4 080
184 080 184 080
Mar 1 Valuation account 3 400 Mar 1 Balance b/d 184 080
Balancing amount 180 680
Dr Capital: Bevan Cr
20.3 R 20.3 R
Feb 28 Balance c/d 122 720 Feb 28 Balance b/d 120 000
Valuation account 2 720
122 720 122 720
Mar 1 Valuation account 2 267 Mar 1 Balance b/d 122 720
Balancing amount 120 453
Dr Capital: Collins Cr
20.3 R 20.3 R
Mar 1 Valuation account 1 133 Mar 1 Bank 90 000
Balancing amount 88 867
Comment:
In this example, the books of the dissolved partnership were continued to be used by
the new partnership. The entries that were made in the above accounts on 28 Febru-
ary 20.3 pertain to the dissolved partnership, and the entries made on 1 March 20.3
pertain to the new partnership. Note that the accounts that were carried forward by the
dissolved partnership were balanced on 28 February 20.3, since this was the financial
year-end of the partnership, and not because of the change that took place in its own-
ership structure. If Collins was admitted during the financial year, it would have been
unnecessary to balance these accounts. Since 1 March 20.3 is the formation date of
the new partnership, the above accounts are not balanced on this date. Therefore,
balancing amounts were disclosed.
3.3 Goodwill
When the books of an existing partnership are prepared for a change in its ownership
structure, goodwill is usually determined and, if significant, included in the disclosure
of the fair value of its net assets. Past financial performance indicators, such as the
total comprehensive income in respect of previous financial periods, are ordinarily used
to determine goodwill. A discussion on the calculation of goodwill by means of past
performance indicators falls outside the scope of this chapter.
attached to those factors that enable a business to increase its turnover beyond the
industry norm.
Appendix A of IFRS 3 defines goodwill as “an asset representing the future economic
benefits arising from other assets that are not capable of being individually identified
and separately recognised.” IFRS distinguishes between two types of goodwill, namely
goodwill acquired (in IFRS 3) and internally generated goodwill (in IAS 38). According
to these Standards, goodwill acquired is recognised as an intangible asset (an intan-
gible asset is an identifiable non-monetary asset without physical substance), but in-
ternally generated goodwill is not. In this chapter, only goodwill acquired is dealt with.
(The capital contribution of the new partner multiplied by the inverse of the partner’s share
in the equity of the new partnership)
minus
the equity of the new partnership (on the date of formation, prior to the recording of goodwill
acquired)
equals
goodwill acquired
Comment:
Note that “The capital contribution of the new partner multiplied by the inverse of this
partner’s share in the equity of the new partnership” is equal to the equity (or the fair
value of the net assets) of the entire new partnership.
For example, if a new partner purchased a 1/4 share of the equity of a new partnership
for R15 000, the equity of the entire new partnership is equal to R60 000 (R15 000 × 4/1
(the inverse of 1/4 is 4/1)). The illustration below clarifies the calculation by showing that
four quarters (which is equal to a whole: 4/4 = 1) of R15 000 each is equal to R60 000.
respectively. (The total of the individual profit-sharing portions of Da Silva and Ehlers is
5 (2 + 3 = 5)). This means that the individual previous profit-sharing ratio of Da Silva
was 2/5, and that of Ehlers, 3/5.
The calculation of the new profit-sharing ratios of Da Silva and Ehlers can be formulat-
ed as follows:
Ratio according
Individual
to which the new
previous Profit-sharing ratio
minus times partner’s profit
profit-sharing of new partner
share is
ratio
relinquished
Da Silva 2/5 – (1/5 × 2/5)
According to the above, the new profit-sharing ratios of Da Silva and Ehlers are:
Da Silva = 2/5 – (1/5 × 2/5) = 2/5 – 2/25* = 10/25* – 2/25 = 8/25
* The denominators of 2/5 and 2/25 are not equal. Before the subtraction, the ratio with the smaller denom-
inator, i.e. 2/5, is adjusted to have the same denominator as 2/25:
2×5 10
=
5×5 25
By applying the formula given in Example 3.3 in tabular format, the profit-sharing ratio
of Da Silva, Ehlers and Frasier is calculated as follows:
Da Silva = 2/5 – (1/5 × 1/2) = 2/5 – 1/10 = 4/10 – 1/10 = 3/10
Ehlers = 3/5 – (1/5 × 1/2) = 3/5 – 1/10 = 6/10 – 1/10 = 5/10
Frasier’s profit share is given as 1/5 = 2/10. The profit-sharing ratio of Da Silva, Ehlers
and Frasier is thus 3:5:2 respectively.
Example 3.5 Calculation of a new profit-sharing ratio where the previous
partners relinquished a profit share to a new partner according to
a ratio other than a previous profit-sharing or an equal ratio
Da Silva and Ehlers were in a partnership with a profit-sharing ratio of 2:3 respectively.
They formed a new partnership by admitting Frasier. Frasier obtained a 1/5 share in the
profits/losses of the new partnership. Da Silva and Ehlers agreed to relinquish the 1/5
share to Frasier according to a ratio of 1:2 respectively.
Required:
Calculate the profit-sharing ratio of the partners of the new partnership (that is of
Da Silva, Ehlers and Frasier).
Solution:
Da Silva and Ehlers agreed to relinquish Frasier’s profit share according to the ratio of
1:2 respectively. In other words, Da Silva agreed to relinquish 1/3 of Frasier’s 1/5 profit
share, and Ehlers agreed to relinquish 2/3 of Frasier’s 1/5 profit share.
Da Silva = 2/5 – (1/5 × 1/3) = 2/5 – 1/15 = 6/15 – 1/15 = 5/15
Ehlers = 3/5 – (1/5 × 2/3) = 3/5 – 2/15 = 9/15 – 2/15 = 7/15
Frasier’s profit share was given as 1/5 = 3/15. The profit-sharing ratio of Da Silva, Ehlers
and Frasier is 5:7:3 respectively.
Solution:
When a partner is admitted to a partnership, the existing partners each relinquish a
portion of their profit share. When a partner retires or dies, the remaining partners each
take over a portion of the retired or deceased partner’s profit share.
The formula used in the above examples can also be applied to calculate a new profit-
sharing ratio on the death or retirement of a partner. The only difference is that the
retired or deceased partner’s profit share that is taken over by the remaining partners
is added to their profit shares.
Individual
Ratio according to
previous Profit-sharing ratio
plus times which profit share
profit-sharing of deceased partner
is taken over
ratio
Murray 5/10 + (1/10 × 5/9)
Murray = 5/10 + (1/10 × 5/9) = 5/10 + 5/90 = 45/90 + 5/90 = 50/90 = 5/9
Smith = 4/10 + (1/10 × 4/9) = 4/10 + 4/90 = 36/90 + 4/90 = 40/90 = 4/9
The profit-sharing ratio of Murray and Smith is 5:4 respectively.
Comment:
From the above solution, it can be noted that when a partner’s profit share was taken
over by the remaining partners according to the profit-sharing ratio which existed
between the remaining partners, the new profit-sharing ratio of the remaining partners
is the same as the ratio according to which the profit share was taken over. In this ex-
ample, the ratio according to which Murray and Smith took over Louw’s profit share
(see the last column in the above formula as shown in tabular format) was 5:4 respect-
ively. Since this ratio is the same as the ratio that previously existed between Murray
and Smith, (5:4:1 for Murray, Smith and Louw respectively, but 5:4 when considering
only Murray and Smith) the new profit-sharing ratio remains the same.
Required:
Calculate the profit-sharing ratio of the partners of the new partnership (that is of
Thava, Thuli and Eunice).
Solution:
Pinky relinquished her entire profit share to Thava, Thuli and Eunice. Therefore, Pinky’s
entire profit share must be subtracted from her existing profit share. Thava and Thuli
agreed to each take over a portion of Pinky’s profit share. These portions must thus be
added to the profit shares of Thava and Thuli. Eunice was admitted as a new partner,
and therefore her portion of Pinky’s profit share cannot be added to a previous profit
share.
Ratio
Portion of according to
Individual
Profit-sharing Pinky’s profit which the
previous
plus ratio of retired times share taken times portion of the
profit-
partner over by Thava profit share is
sharing ratio
and Thuli taken over
(equally)
Thava 2/5 + [(2/5 × 1/2) × 1/2]
Thava = 2/5 + [(2/5 × 1/2) × 1/2] = 2/5 + 2/20 = 2/5 + 1/10 = 4/10 + 1/10 = 5/10
Thuli = 1/5 + [(2/5 × 1/2) × 1/2] = 1/5 + 2/20 = 1/5 + 1/10 = 2/10 + 1/10 = 3/10
Eunice = Half of Pinky’s profit share = 1/2 × 2/5 = 2/10
[Pinky = 2/5 – 2/5 = 0]
The profit-sharing ratio of Thava, Thuli and Eunice is 5:3:2 respectively.
ratio of Zack, Black and Jack will be 2:2:1 respectively. If two or more partners sell
their entire interest directly to one new partner, the profit-sharing ratio of the new part-
nership will change, since the number of partners in the partnership has changed. For
example, if Zack, Mack and Jack are in a partnership, sharing profits and losses in the
ratio of 2:2:1 respectively, and Mack and Jack decide to sell their entire interest dir-
ectly to Black, Black will obtain a total interest in the profit share of 2/5 + 1/5 = 3/5. The
profit-sharing ratio of Zack and Black will be 2:3 respectively.
Example 3.8 Recording the admission of a partner who purchased an interest
from one partner by way of a personal transaction
Fisher and Green were in a partnership and had a profit-sharing ratio of 2:3 respect-
ively. The partnership traded as Fisher & Green Partners. On 31 December 20.3, the
financial year-end of the partnership, the books of the partnership were closed off,
where after the credit balances of the current accounts of Fisher and Green amounted
to R12 500 and R15 000 respectively, and the credit balances on the capital accounts
of Fisher and Green amounted to R40 000 and R60 000 respectively.
On 1 January 20.4, with the approval of Fisher, Green personally sold half of the bal-
ances on his capital and current accounts in the partnership to Hudson for a cash
amount of R43 125. Hudson paid the R43 125 into the personal bank account of
Green. The new partnership continued trading under the name of Fisher & Green Part-
ners, and the accounting records of the dissolved partnership were continued to be
used by the new partnership.
Required:
(a) Prepare the journal entry in the general journal of Fisher & Green Partners on
1 January 20.4 to record the transfer of the portion of the interest that was sold by
Green to Hudson.
(b) Calculate the profit-sharing ratio of Fisher, Green and Hudson.
(c) Prepare the capital and current accounts of Fisher, Green and Hudson in the
general ledger of Fisher & Green Partners on 1 January 20.4, after the above jour-
nal entry was posted to the general ledger.
Solution:
(a) Fisher & Green Partners
General journal
Debit Credit
20.4 R R
Jan 1 Capital: Green (R60 000 × 1/2) 30 000
Current account: Green (R15 000 × 1/2) 7 500
Capital: Hudson 30 000
Current account: Hudson 7 500
Recording the purchase of half of Green’s in-
terest by Hudson by way of a personal trans-
action
Chapter 3: Changes in the ownership structure of partnerships 117
Comments:
l In this example, it can be concluded that Green determined that the fair value of
the partnership is greater than the recorded net assets. (Recall that recorded net
assets are equal to recorded equity.) He therefore charged more for half of the
balances on his capital and current accounts. (Hudson paid R43 125 into the per-
sonal bank account of Green, but only R30 000 and R7 500 respectively were trans-
ferred to a capital and current account in his name.) Since Hudson was admitted by
way of a personal transaction, the fair value of the partnership is not recorded in
the books of the partnership. Note that the excess of R5 625 (R43 125 – R37 500)
which Hudson paid is not forfeited by him, since he acquired a share in the fair
value of the net assets, which can be realised in the future.
l If the current account of Green had a debit balance in closing, Green’s current
account would have been credited and Hudson’s current account debited.
(b) Calculation of the profit-sharing ratio of Fisher, Green and Hudson
Fisher = 2/5 = 4/10
Green = 3/5 – (1/2 × 3/5) = 3/5 – 3/10 = 6/10 – 3/10 = 3/10
Hudson = 1/2 × 3/5 = 3/10
The profit-sharing ratio of Fisher, Green and Hudson is 4:3:3 respectively.
(c) Fisher & Green Partners
General ledger
Dr Capital: Fisher Cr
20.4 R
Jan 1 Balance b/d 40 000
Dr Capital: Green Cr
20.4 R 20.4 R
Jan 1 Capital: Hudson 30 000 Jan 1 Balance b/d 60 000
Dr Capital: Hudson Cr
20.4 R
Jan 1 Capital: Green 30 000
continued
118 About Financial Accounting: Volume 2
Comment:
The sum of the capital and current account balances of Fisher and Green prior to the
admission of Hudson is R127 500 (R40 000 + R60 000 + R12 500 + R15 000). This
amount is equal to the sum of the capital and current account balances of Fisher,
Green and Hudson (R40 000 + R30 000 + R30 000 + R12 500 + R7 500 + R7 500 =
R127 500), because Hudson purchased a portion of Green’s interest by way of a per-
sonal transaction and therefore did not make an additional contribution to the assets of
the partnership. There merely was an exchange in equity between Green and Hudson.
Example 3.9 Recording the admission of a new partner who purchased an
interest from more than one partner by way of a personal transaction
Fisher and Green were in a partnership, trading as Fisher & Green Partners, with a profit-
sharing ratio of 2:3 respectively. The financial year-end of Fisher & Green Partners is
31 December. On 31 December 20.3, after the books of Fisher & Green Partners were
closed off according to the accounting policy of the partnership, the following accounts
were recorded in the trial balance of Fisher & Green Partners:
R
Furniture and equipment 65 000
Vehicles 70 000
Trade receivables control 8 500
Bank (favourable) 19 000
Capital: Fisher 40 000
Capital: Green 60 000
Current account: Fisher (Cr) 12 500
Current account: Green (Cr) 15 000
Trade payables control 35 000
Fisher and Green decided to each sell a 1/3 share of their equity in Fisher & Green
Partners to Hudson in their personal capacity for a total cash amount of R48 875. On
1 January 20.4, Hudson deposited the amounts due to Fisher and Green into their
personal bank accounts. The new partnership continued to trade as Fisher & Green
Partners, and the books of the dissolved partnership were continued to be used by the
new partnership.
Required:
(a) Prepare the journal entry in the general journal of Fisher & Green Partners on
1 January 20.4 to record the change in the ownership structure of the partnership.
(b) Calculate the profit-sharing ratio of Fisher, Green and Hudson.
(c) Prepare the capital and current accounts of Fisher, Green and Hudson in the gen-
eral ledger of Fisher & Green Partners on 1 January 20.4, after the journal entry to
record the change in the ownership structure of the partnership was posted to the
general ledger.
Chapter 3: Changes in the ownership structure of partnerships 119
Solution:
(a) Fisher & Green Partners
General journal
Debit Credit
20.4 R R
Jan 1 Capital: Fisher (R40 000 × 1/3) 13 333*
Capital: Green (R60 000 × 1/3) 20 000
Current account: Fisher (R12 500 × 1/3) 4 167*
Current account: Green (R15 000 × 1/3) 5 000
Capital: Hudson R(13 333 + 20 000) 33 333
Current account: Hudson R(4 167 + 5 000) 9 167
Recording the purchase of 1/3 of Fisher’s and 1/3
of Green’s equity in Fisher & Green Partners by
Hudson by way of a personal transaction
* Rounded off to the nearest Rand.
Dr Capital: Green Cr
20.4 R 20.4 R
Jan 1 Capital: Hudson 20 000 Jan 1 Balance b/d 60 000
Dr Capital: Hudson Cr
20.4 R
Jan 1 Capital: Fisher 13 333
Capital: Green 20 000
continued
120 About Financial Accounting: Volume 2
the entries that pertain to the preparation of the change in its ownership structure
are made, where after the balances of the statement of financial position accounts
are brought down as the opening balances of the new partnership.
In this chapter, the new partnership trades under the same name as the previous
partnership, and all valuation adjustments and goodwill recorded in preparation of
the change in the ownership structure, are reversed.
A discrepancy in this approach is that the accounting transactions of two partner-
ships are recorded in one set of books. For this reason, it is recommended that if a
change in ownership structure took place during a financial year, the statement of
profit or loss and other comprehensive income in respect of that financial year dif-
ferentiates between the two partnerships. Example 3.14 illustrates the preparation
of such a statement.
Should a current account have a credit balance in closing, this amount is debited in
the current account and the relevant capital account is credited. Should a current
account have a debit balance in closing, this amount is credited in the current account
and the relevant capital account is debited.
Step 3: Apportion any revaluation surplus to the capital accounts of the partners
according to their profit-sharing ratio.
The balance of a revaluation surplus account is debited in the revaluation surplus
account and credited to the capital accounts of the existing partners (including to the
capital account of a retired/deceased partner) according to the profit-sharing ratio of
the partners.
Step 4: Record any valuation adjustments of recorded assets and liabilities in a valu-
ation account.
If necessary, refer to paragraph 3.2, where valuation adjustments are discussed.
Step 5: Record goodwill, initially acquired.
Goodwill is discussed in paragraph 3.3.
Step 6: Record the dissolution of the partnership.
l In the case of the admission of a partner, the accounts to be disclosed on the
statement of financial position are closed off to a transferral account.
l In the case of the retirement (or death) of a partner:
• the capital account (this chapter deals only with favourable capital accounts) of
the retired (or deceased) partner is closed off in the books of the existing part-
nership on the date of its dissolution. The balance of the capital account of the
retired (or deceased) partner can be settled on this date. For example, if a cap-
ital account is settled with a cash repayment, the capital account is debited with
the closing balance thereof, and the bank account of the partnership credited. If
the settlement of the capital account is postponed, the balance of the capital
account is closed off to a loan (or estate) account in the name of the retired (or
deceased) partner by debiting the capital account with the balance thereof, and
crediting a loan (or estate) account in the name of the retired (or deceased)
partner with this amount; and
• thereafter the accounts to be disclosed on the statement of financial position are
closed off to a transferral account.
l Accounting entries to be made in the books of the new partnership
Comment:
In this chapter, the following entries are made on the date of the formation of the new
partnership, which is the day after the existing partnership dissolved.
Step 7: Record the formation of the new partnership.
Record the assets, equity and liabilities that were contributed by the remaining part-
ners of the dissolved partnership. Since this step deals with the recording of capital
contributions, each asset and liability is apportioned according to the capital ratio of
the contributing partners, and not according to their profit-sharing ratio.
Chapter 3: Changes in the ownership structure of partnerships 123
In the case of the admission of a partner, the contribution of this partner is also re-
corded.
Step 8: Adjust the applicable capital account balances of the partners of the new
partnership to the same ratio as their profit-sharing ratio, if so decided by the partners
of the new partnership.
The calculation and recording of such adjustments are illustrated in Examples 3.10
and 3.11.
Example 3.10 The purchase of an interest in a partnership from the partnership
without recording valuation adjustments
Ismael and Julyan traded as Ismael & Julyan Partners, and they shared profits/losses
in the ratio of 2:3 respectively. They decided to admit Khoza as a partner as from
1 July 20.3. It was arranged that Khoza would pay R67 500 in cash for a 1/3 interest in
the net assets (equity) and a 1/3 interest in the profits/losses of the new partnership.
Ismael and Julyan agreed to each relinquish a portion of their interest in the profits/
losses of Ismael & Julyan Partners to Khoza according to their profit-sharing ratio of
2:3, respectively.
At 30 June 20.3, the books of Ismael & Julyan Partners were closed off, where after the
following preliminary statement of financial position was prepared:
Ismael & Julyan Partners
Statement of financial position as at 30 June 20.3
R
ASSETS
Non-current assets 95 000
Property, plant and equipment (Furniture and equipment) 95 000
Current assets 80 000
Inventories 22 000
Trade and other receivables (Trade receivables control) 28 000
Cash and cash equivalents (Bank) 30 000
The above balances of the capital and current accounts of Ismael and Julyan were
compiled as follows:
According to the accounting policy of Ismael and Julyan Partners, the property, plant
and equipment were recorded at historical cost and not at fair value. Credit losses
were not provided for. After the above statement of financial position was prepared,
Ismael and Julyan decided, in preparation for the admission of Khoza, to value the
property, plant and equipment and the debtors. An appraiser determined that the fair
values thereof were equal to the amounts at which these assets were disclosed. It was
decided that the books of Ismael & Julyan Partners would not be used by the new
partnership.
On 1 July 20.3, Khoza paid R67 500 into the bank account of the partnership, and the
new partnership started to trade as Ismael, Julyan & Khoza Partners. Ismael, Julyan
and Khoza decided to keep their capital account balances in the same ratio as their
profit-sharing ratio. Any refunds or contributions to the capital accounts must be made in
cash.
Required:
(a) Prepare the journal entries on 30 June 20.3 in the general journal of Ismael &
Julyan Partners to prepare for the admission of Khoza as a partner, and to record
the dissolution of Ismael & Julyan Partners. (Apply and indicate Steps 2 to 6 of the
accounting procedure based on the legal perspective.)
(b) Prepare the transferral account in the general ledger of Ismael & Julyan Partners
on 30 June 20.3, after the above journal entries were posted to the general ledger.
(c) Prepare the journal entries on 1 July 20.3 in the general journal of Ismael, Julyan &
Khoza Partners to record the formation of the new partnership and to give effect to
the decisions which pertain to the accounting policy of the new partnership, and/
or to the new partnership agreement. (Apply and indicate Steps 7 and 8 of the
accounting procedure based on the legal perspective.)
(d) Prepare the capital accounts of the partners in the general ledger of Ismael,
Julyan & Khoza Partners on 1 July 20.3, after the journal entries as required in (c)
were posted to the relevant general ledger accounts.
Chapter 3: Changes in the ownership structure of partnerships 125
Solution:
(a) Journal entries to prepare for the admission of Khoza as a partner, and to
record the dissolution of Ismael & Julyan Partners
Step 2: Close the balances of the current accounts of Ismael and Julyan off to their
capital accounts.
Ismael & Julyan Partners
General journal
Debit Credit
20.3 R R
Jun 30 Current account: Ismael 28 100
Current account: Julyan 8 400
Capital: Ismael 28 100
Capital: Julyan 8 400
Closing off the balances of the current accounts
of Ismael and Julyan to their capital accounts
Comment:
After the above journal entry is posted to the general ledger, the credit balances of the
capital accounts of Ismael and Julyan amount to:
R
Capital: Ismael R(39 400 + 28 100) 67 500
Capital: Julyan R(59 100 + 8 400) 67 500
Step 3: Apportion any revaluation surplus to the capital accounts of Ismael and Julyan
according to their profit-sharing ratio.
There is no revaluation surplus, therefore this step is not applicable.
Step 4: Record any valuation adjustments in a valuation account.
Since the fair value and the disclosed amounts of the assets on the statement of finan-
cial position are equal, no valuation adjustments must be recorded.
Step 5: Record goodwill, initially acquired.
Firstly, the amount of goodwill must be calculated. According to the formula given in
paragraph 3.3.2, the goodwill acquired is calculated as follows:
(The capital contribution of the new partner multiplied by the inverse of the partner’s share
in the equity of the new partnership)
minus
the equity of the new partnership (on the date of formation, prior to the recording of goodwill
acquired)
equals
goodwill acquired
(R67 500 × 3) – R(67 500 + 67 500 + 67 500) = R(202 500 – 202 500) = nil
No goodwill was acquired; therefore, no journal entry is made in this regard.
126 About Financial Accounting: Volume 2
(c) Journal entries to record the formation of Ismael, Julyan & Khoza Partners,
and to give effect to any further decisions pertaining to the accounting policy
of the new partnership and/or to the new partnership agreement
Step 7: Record the formation of Ismael, Julyan & Khoza Partners.
Ismael, Julyan & Khoza Partners
General journal
Debit Credit
20.3 R R
Jul 1 Furniture and equipment (R95 000 × 1/2*) 47 500
Inventory (R22 000 × 1/2) 11 000
Trade receivables control (R28 000 × 1/2) 14 000
Bank (R30 000 × 1/2) 15 000
Trade payables control (R40 000 × 1/2) 20 000
Capital: Ismael 67 500
Recording the capital contribution of Ismael
Furniture and equipment (R95 000 × 1/2) 47 500
Inventory (R22 000 × 1/2) 11 000
Trade receivables control (R28 000 × 1/2) 14 000
Bank (R30 000 × 1/2) 15 000
Trade payables control (R40 000 × 1/2) 20 000
Capital: Julyan 67 500
Recording the capital contribution of Julyan
Bank 67 500
Capital: Khoza 67 500
Recording the cash capital contribution of Khoza
* The contributions of Ismael and Julyan are apportioned according to their capital ratio. With
reference to the second journal entry of Step 6, their capital accounts are R67 500 each;
R135 000 in total. The capital ratio of Ismael and Julyan is thus 1:1 (R67 500 / R135 000 = 1/2).
Step 8: Adjust the capital account balances of the partners to be in the same ratio as
their profit-sharing ratio, if so decided by Ismael, Julyan and Khoza.
Ismael, Julyan & Khoza Partners
General journal
Debit Credit
20.3 R R
Jul 1 Capital: Ismael 13 500c
Bank 13 500
Recording the cash repayment to Ismael so as
to bring the capital account ratio in the same
ratio as the profit-sharing ratio
Bank 13 500c
Capital: Julyan 13 500
Recording the contribution of Julyan so as to
bring the capital account ratio in the same ratio
as the profit-sharing ratio
128 About Financial Accounting: Volume 2
Calculation:
c Amount to be adjusted in the capital account balances of Ismael and Julyan
The sum of the capital contributions of Ismael, Julyan and Khoza is R202 500
(R67 500 + R67 500 + R67 500). Note that in the case of an admission, the sum of
the capital contributions can also be calculated by multiplying the contribution of
the new partner with the inverse of his share in the net assets (equity) of the new
partnership (R67 500 × 3 = R202 500). This amount must be apportioned accord-
ing to the profit-sharing ratio of the partners of the new partnership to calculate
what the capital account balances of the partners must be so that their capital ra-
tio is equal to their profit-sharing ratio:
R
Capital: Ismael R202 500 × /15n =
4 54 000
Capital: Julyan R202 500 × 6/15n = 81 000
Capital: Khoza R202 500 × 5/15n = 67 500
202 500
Should any of the recorded capital account balances in the general ledger of
Ismael, Julyan and Khoza differ from the amounts as calculated above, the capital
account balances must be adjusted.
Difference between the recorded and calculated capital account balances:
The balances of Ismael and Julyan differ. The recorded capital account balance
of Ismael must be decreased by refunding R13 500 to him. The recorded capital
account balance of Julyan must be increased by receiving a cash contribution of
R13 500 from him.
Calculation:
n The profit-sharing ratio of Ismael, Julyan and Khoza
Ismael = 2/5 – (1/3 × 2/5) = 2/5 – 2/15 = 6/15 – 2/15 = 4/15
Julyan = 3/5 – (1/3 × 3/5) = 3/5 – 3/15 = 9/15 – 3/15 = 6/15
Khoza = 1/3 [or (1/3 × 2/5) + (1/3 × 3/5) = 2/15 + 3/15] = 5/15
The profit-sharing ratio of Ismael, Julyan and Khoza is 4:6:5 respectively.
Chapter 3: Changes in the ownership structure of partnerships 129
Dr Capital: Julyan Cr
20.3 R 20.3 R
Jul 1 Trade payables Jul 1 Furniture and
control 20 000 equipment 47 500
Balancing amount 81 000 Inventory 11 000
Trade receivables
control 14 000
Bank R(15 000 + 28 500
13 500)
Dr Capital: Khoza Cr
20.3 R
Jul 1 Bank 67 500
Calculation:
c Goodwill
R(75 000 × 3) – R(67 500* + 67 500* + 75 000) = R(225 000 – 210 000) = R15 000
* Refer to the comment after the application of Step 2 in the solution to Example 3.10.
Comment:
After the journal entries in respect of Steps 2 and 5 are posted to the general ledger,
the credit balances of the capital accounts of Ismael and Julyan amount to:
R
Capital: Ismael Step 2: R(39 000 73 500
39 400 + 28 100 = 67 500); Step 5: R(67 500 + 6 000)
Capital: Julyan Step 2: R(59 000 76 500
59 100 + 8 400 = 67 500); Step 5: R(67 500 + 9 000)
(c) Journal entries to record the formation of Ismael, Julyan & Khoza Partners,
and to give effect to any further decisions pertaining to the accounting policy
of the new partnership and/or to the new partnership agreement
Step 7: Record the formation of Ismael, Julyan & Khoza Partners.
Ismael, Julyan & Khoza Partners
General journal
Debit Credit
20.3 R R
Jul 1 Furniture and equipment 46 550
(R95 000 × 73 500/150 000)
Goodwill (R15 000 × 73 500/150 000) 7 350
Inventory (R22 000 × 73 500/150 000) 10 780
Trade receivables control 13 720
(R28 000 × 73 500/150 000)
Bank (R30 000 × 73 500/150 000) 14 700
Trade payables control 19 600
(R40 000 × 73 500/150 000)
Capital: Ismael 73 500
Recording the capital contribution of Ismael
Furniture and equipment 48 450
(R95 000 × 76 500/150 000)
Goodwill (R15 000 × 76 500/150 000) 7 650
Inventory (R22 000 × 76 500/150 000) 11 220
Trade receivables control 14 280
(R28 000 × 76 500/150 000)
Bank (R30 000 × 76 500/150 000) 15 300
Trade payables control 20 400
(R40 000 × 76 500/150 000)
Capital: Julyan 76 500
Recording the capital contribution of Julyan
Bank 75 000
Capital: Khoza 75 000
Recording the cash capital contribution of
Khoza
Step 8: Adjust the capital account balances of the partners to be in the same ratio as
their profit-sharing ratio, if so decided by Ismael, Julyan and Khoza.
Ismael, Julyan & Khoza Partners
General journal
Debit Credit
20.3 R R
Jul 1 Capital: Ismael 13 500c
Bank 13 500
Recording the cash repayment to Ismael so as
to bring the capital account ratio in the same
ratio as the profit-sharing ratio
continued
132 About Financial Accounting: Volume 2
Debit Credit
20.3 R R
Jul 1 Bank 13 500c
Capital: Julyan 13 500
Recording the contribution of Julyan so as to
bring the capital account ratio in the same ratio
as the profit-sharing ratio
Calculation:
c Amount to be adjusted in the capital account balances of Ismael and Julyan
The sum of the capital contributions of Ismael, Julyan and Khoza is R225 000
[(R73 500 + R76 500 + R75 000) or (R75 000 × 3)]. This amount must be appor-
tioned according to the profit-sharing ratio of the partners of the new partnership
to calculate what the capital account balances of the partners must be so that
their capital ratio is equal to their profit-sharing ratio:
R
Capital: Ismael R225 000 × 4/15n = 60 000
Capital: Julyan R225 000 × 6/15n = 90 000
Capital: Khoza R225 000 × 5/15n = 75 000
225 000
Should any of the recorded capital account balances in the general ledger of
Ismael, Julyan and Khoza differ from the amounts as calculated above, the capital
account balances must be adjusted.
Difference between the recorded and calculated capital account balances:
The balances of Ismael and Julyan differ. The recorded capital account balance
of Ismael must be decreased by refunding R13 500 to him. The recorded capital
account balance of Julyan must be increased by receiving a cash contribution of
R13 500 from him. This adjustment is the same as the adjustment that was calcu-
lated in Step 8 of the solution to Example 3.10. The reason for this is that the
goodwill was contributed to the partnership according to the capital ratio of the
partners of the new partnership.
Calculation:
n The profit-sharing ratio of Ismael, Julyan and Khoza
Ismael = 2/5 – (1/3 × 2/5) = 2/5 – 2/15 = 6/15 – 2/15 = 4/15
Julyan = 3/5 – (1/3 × 3/5) = 3/5 – 3/15 = 9/15 – 3/15 = 6/15
Khoza = 1/3 [or (1/3 × 2/5) + (1/3 × 3/5) = 2/15 + 3/15] = 5/15
The profit-sharing ratio of Ismael, Julyan and Khoza is 4:6:5 respectively.
Chapter 3: Changes in the ownership structure of partnerships 133
Dr Capital: Julyan Cr
20.3 R 20.3 R
Jul 1 Trade payables Jul 1 Furniture and
control 20 400 equipment 48 450
Balancing amount 90 000 Goodwill 7 650
Inventory 11 220
Trade receivables
control 14 280
Bank R(15 300 + 28 800
13 500)
Dr Capital: Khoza Cr
20.3 R
Jul 1 Bank 75 000
R
ASSETS
Non-current assets 200 000
Property, plant and equipment 200 000
The above balances of the capital and current accounts of Lock, Stock and Barrel
were compiled as follows:
The property, plant and equipment of Lock, Stock & Barrel Traders were not recorded
at fair value; the inventory was recorded at cost price, and no credit losses were pro-
vided for. In preparation of the dissolution of Lock, Stock & Barrel Traders, the follow-
ing valuations/decisions were made:
l land, R90 000 (the property, plant and equipment as disclosed in the above state-
ment of financial position consist of land at cost price, R30 000, buildings at carry-
ing amount, R150 000, and furniture and equipment at carrying amount, R20 000);
l inventory, R46 000 (net realisable value); and
l an allowance for credit losses to the amount of R1 500 must be created.
On 1 July 20.4, Jock’s capital contribution of R80 125 was paid into the bank account
of the partnership. The partners of the new partnership, namely Lock, Stock and Jock,
Chapter 3: Changes in the ownership structure of partnerships 135
decided to record the formation of their partnership from the legal perspective, trading
as Lock, Stock & Jock Traders, and opened a new set of books for the partnership.
Required:
(a) Prepare the journal entries in the general journal of Lock, Stock & Barrel Traders
on 30 June 20.4 to prepare for and record the dissolution of the partnership.
(b) Prepare the journal entries in the general journal of Lock, Stock & Jock Traders on
1 July 20.4 to record the formation of the new partnership and to give effect to the
decisions of the partners of the new partnership.
(c) Prepare the statement of financial position of Lock, Stock & Jock Traders as at
1 July 20.4 according to the requirements of IFRS, appropriate to the business of
the partnership. Notes and comparative figures are not required.
Solution:
Comment:
This example does not require disclosing the steps of the accounting procedure
applied; they are nonetheless included for illustrative purposes.
(a) Lock, Stock & Barrel Traders
General journal
Step 1: Close off the books of the existing partnership and prepare a preliminary
statement of financial position.
According to the given information, the books were closed off and the statement of
financial position was prepared.
Step 2: Close off the balances of the current accounts to the capital accounts of the
partners.
Debit Credit
20.4 R R
Jun 30 Current account: Lock 9 000
Current account: Stock 5 400
Current account: Barrel 3 600
Capital: Lock 9 000
Capital: Stock 5 400
Capital: Barrel 3 600
Closing off the balances of the current ac-
counts of Lock, Stock and Barrel to their capital
accounts
Step 3: No revaluation surplus was given; therefore, this step is not applicable.
136 About Financial Accounting: Volume 2
Debit Credit
20.4 R R
Jun 30 Land R(90 000 – 30 000) 60 000
Inventory R(50 000 – 46 000) 4 000
Allowance for credit losses 1 500
Valuation account 54 500
Recording the valuation adjustments in prepar-
ation of the change in ownership structure
Valuation account 54 500
Capital: Lock (R54 500 × 5/10) 27 250
Capital: Stock (R54 500 × 3/10) 16 350
Capital: Barrel (R54 500 × 2/10) 10 900
Closing off the balancing amount of the valu-
ation account to the capital accounts of Lock,
Stock and Barrel according to their profit-
sharing ratio
Comment:
After the journal entries in respect of Steps 2 and 4 are posted to the general ledger,
the credit balances of the capital accounts of Lock, Stock and Barrel amount to:
R
Capital: Lock R(43 500 + 9 000 + 27 250) 79 750
Capital: Stock R(54 100 + 5 400 + 16 350) 75 850
Capital: Barrel R(54 400 + 3 600 + 10 900) 68 900
Step 5: Record goodwill, initially acquired.
Debit Credit
20.4 R R
Jun 30 Goodwill 4 650c
Capital: Lock (R4 650 × 5/10) 2 325
Capital: Stock (R4 650 × 3/10) 1 395
Capital: Barrel (R4 650 × 2/10) 930
Recording goodwill in preparation of the retire-
ment of Barrel and the admission of Jock
Calculation:
c Goodwill
R(80 125 × 3) – R(79 750* + 75 850* + 80 125) = R(240 375 – 235 725) = R4 650
* Refer to the comment after the application of Step 4.
Comment:
After the journal entries in respect of Steps 2, 4 and 5 are posted to the general
ledger, the credit balances of the capital accounts of Lock, Stock and Barrel
amount to:
Chapter 3: Changes in the ownership structure of partnerships 137
R
Capital: Lock Steps 2 and 4: R(43
43 500 + 9 000 + 27 250 = 79 750);
Step 5 R(79 750 + 2 325)
325 82 075
Capital: Stock Steps 2 and 4: R(54
54 100 + 5 400 + 16 350 = 75 850);
Step 5 R(75 850 + 1 395)
395 77 245
Capital: Barrel Steps 2 and 4: R(54
54 400 + 3 600 + 10 900 = 68 900);
Step 5 R(68 900 + 930)
930 69 830
Step 6: Record the dissolution of the partnership. (Record the settlement of Barrel’s
capital account and close off all accounts to a transferral account.)
Debit Credit
20.4 R R
Jun 30 Capital: Barrel R(54 400 + 3 600 + 10 900 + 930) 69 830
Bank 69 830
Recording the cash paid to Barrel to settle his
capital account
Transferral account 340 650
Land 90 000
Buildings 150 000
Furniture and equipment 20 000
Goodwill 4 650
Inventory 46 000
Trade receivables control 30 000
Closing off the balances of the asset accounts
to the transferral account to record the dissolu-
tion of the partnership
Capital: Lock R(43 500 + 9 000 + 27 250 + 2 325) 82 075
Capital: Stock R(54 100 + 5 400 + 16 350 + 1 395) 77 245
Mortgage 120 000
Trade payables control 10 000
Allowance for credit losses 1 500
Bank [overdraft R(69 830 – 20 000)] 49 830
Transferral account 340 650
Closing off the balances of the equity and
liability accounts to the transferral account to
record the dissolution of the partnership
138 About Financial Accounting: Volume 2
Comment:
Where necessary, the amounts in the above journal entries were rounded off to the
nearest Rand.
Step 8: Adjust the applicable capital account balances of the partners of the new
partnership to be in the same ratio as their profit-sharing ratio, if so decided by the
partners of the partnership.
Chapter 3: Changes in the ownership structure of partnerships 139
Since the ratio of the capital contribution of Jock (1/3 of the equity of the new partner-
ship) is not equal to his profit-sharing ratio (1/4 of the profits/losses of the new partner-
ship), it is concluded that the partners of the new partnership decided not to adjust
their capital account balances to be in the same ratio as their profit-sharing ratio.
Therefore, this step is not applied.
(c) Lock, Stock & Jock Traders
Statement of financial position as at 1 July 20.4
R
ASSETS
Non-current assets 264 650
Property, plant and equipmentc 260 000
Goodwilld 4 650
Calculations:
c Property, plant and equipment
R
Land 90 000
Buildings 150 000
Furniture and equipment 20 000
260 000
Refer to the journal entry of Step 6 for the amounts.
d Goodwill and Inventories
Refer to the journal entry of Step 6 for the amounts.
140 About Financial Accounting: Volume 2
off” means closing off the accounts according to the accounting policy and procedures
of the existing partnership as if administered at the end of a financial year/period.
Refer to the closing off procedure in paragraph 3.6.1, Step 1.) However, all the ac-
counts are balanced to prepare a pre-adjustment trial balance which serves as a start-
ing point in the recording of the fair value of the net assets of the existing partnership
in preparation of its change in ownership structure.
Since the business activities of the two partnerships are recorded as a single business
entity, the new partnership continues to use the books of the previous partnership.
Therefore, accounting entries that pertain to the previous and the new partnerships are
recorded in the same set of books, and reported on in the same set of financial state-
ments.
l If the change in the ownership structure takes place at the end of a financial
period
If a change in the ownership structure of a partnership takes place at the end of a
financial period, the books of the existing partnership are closed off and the financial
statements prepared accordingly. (In this regard, “closed off” means closing off the
accounts according to the accounting policy and procedures of the existing partner-
ship as if administered at the end of a financial year/period. Refer to the closing off
procedure in paragraph 3.6.1, Step 1.)
Since the business activities of the two partnerships are recorded as a single business
entity, the new partnership will continue to use the books (which at this stage will only
be the accounts to be disclosed on the statement of financial position) of the previous
partnership. The balances of these accounts are therefore not closed off to a trans-
ferral account (as was the case with the accounting procedure which was applied
according to the legal perspective), but brought down in the books as the opening
balances of the new partnership. Note that the current accounts of the existing part-
ners are not closed off to their capital accounts, as is the case with the accounting
procedure based on the legal perspective. (Refer to paragraph 3.6.1, Step 2.)
To simplify matters, Step 1 is not required and is presented as part of the given infor-
mation.
Step 2: Apportion (close off) the revaluation surplus to the capital accounts of the
partners according to the existing profit-sharing ratio.
There are various methods according to which a revaluation surplus can be dealt with
from a going-concern perspective. For example, the surplus account need not neces-
sarily be closed off. To simplify matters, a revaluation surplus account is closed off
when the going-concern perspective is applied.
Step 3: Record any valuation adjustments of the assets and liabilities in a valuation
account.
Valuation adjustments are discussed in paragraph 3.2; please refer to this paragraph if
necessary.
Step 4: Record goodwill, initially acquired.
Goodwill is discussed in paragraph 3.3; please refer to this paragraph if necessary.
142 About Financial Accounting: Volume 2
Comment:
Since the nominal accounts of the partnership were not closed off, the sum of the debit
balances and the sum of the credit balances of the accounts in the above list are
unequal.
After the above list of balances was prepared, an independent sworn appraiser made
the following valuations on 31 March 20.8 in preparation of Nell’s admission to the
partnership:
l land, R30 000;
l buildings, R60 000;
l furniture and equipment (increase in valuation of office paintings), R27 700;
l inventory, R12 600;
l trade receivables control, R7 200 (to provide for credit losses); and
l trade payables control, R10 225 (due to a settlement discount offer which Lamola
and Meyer intend to take up on 15 April 20.8).
144 About Financial Accounting: Volume 2
On 1 April 20.8, Nell paid R25 500 into the bank account of the partnership. The new
partnership continued to trade as Lamola & Meyer Partners. The partners of the new
partnership decided on the following:
l the revaluation surplus of R10 000 must be reinstated;
l the valuation adjustments that were recorded must be written back (the new part-
ners decided to forfeit the settlement discount that was offered);
l the goodwill that was recorded must be written back (reversed); and
l their capital ratio need not be the same as their profit-sharing ratio.
Required:
(a) Prepare the journal entries on 31 March 20.8 in the general journal of Lamola &
Meyer Partners to prepare for the admission of Nell as a partner. (Apply and indi-
cate Steps 2 to 4 of the accounting procedure based on the going-concern per-
spective.)
(b) Prepare the capital accounts of Lamola and Meyer in the general ledger of Lamola
& Meyer Partners on 31 March 20.8, properly balanced, after the journal entries as
required in (a) were posted to the relevant general ledger accounts.
(c) Prepare the journal entries on 1 April 20.8 in the general journal of Lamola & Meyer
Partners to record the admission of Nell and to give effect to the decisions which
pertain to the accounting policy and/or the new partnership agreement. (Apply and
indicate Steps 5 to 8 of the accounting procedure based on the going-concern
perspective.)
(d) Prepare the valuation account and the capital accounts of Lamola, Meyer and Nell
in the general ledger of Lamola & Meyer Partners on 1 April 20.8, after the journal
entries as required in (c) were posted to the relevant general ledger accounts.
(For illustrative purposes, disclose these accounts as from 31 March 20.8.)
Solution:
Comment:
Since the partners of the new partnership decided:
l not to close off the books of the dissolved partnership;
l to reinstate the revaluation surplus, to reverse all the valuation adjustments and the
goodwill that was created in preparation of the change in the ownership structure
of the partnership; and
l to continue to trade under the same name as the dissolved partnership,
it is clear that the change in the ownership structure of the partnership must be re-
corded from the going-concern perspective.
Chapter 3: Changes in the ownership structure of partnerships 145
Debit Credit
20.8 R R
Mar 31 Revaluation surplus 10 000
Capital: Lamola (R10 000 × 3/5) 6 000
Capital: Meyer (R10 000 × 2/5) 4 000
Revaluation surplus apportioned to the capital
accounts of Lamola and Meyer according to
their profit-sharing ratio
Debit Credit
20.8 R R
Mar 31 Furniture and equipment R(27 700 – 13 000) 14 700
Allowance for settlement discount received 500
R(10 725 – 10 225)
Inventory R(13 500 – 12 600) 900
Allowance for credit losses R(9 000 – 7 200) 1 800
Valuation account 12 500
Recording the valuation adjustments in prepar-
ation of the change in ownership structure
Valuation account 12 500
Capital: Lamola (R12 500 × 3/5) 7 500
Capital: Meyer (R12 500 × 2/5) 5 000
Closing off the balancing amount of the valu-
ation account to the capital accounts of Lamola
and Meyer according to their profit-sharing ratio
Comment:
After the journal entries in respect of Steps 2 and 3 are posted to the general ledger:
l the credit balances of the capital accounts of Lamola and Meyer amount to:
R
Capital: Lamola R(36 000 + 6 000 + 7 500) 49 500
Capital: Meyer R(27 000 + 4 000 + 5 000) 36 000
l the equity (in this example, the sum of the capital and the current account balanc-
es) of Lamola and Meyer are:
R
Equity: Lamola R(49 500 + 8 100) 57 600
Equity: Meyer R(36 000 + 5 400) 41 400
146 About Financial Accounting: Volume 2
Debit Credit
20.8 R R
Mar 31 Goodwill 3 000c
Capital: Lamola (R3 000 × 3/5) 1 800
Capital: Meyer (R3 000 × 2/5) 1 200
Recording goodwill in preparation of the admit-
tance of Nell
Calculation:
c Goodwill
R(25 500 × 5) – R(57 600* + 41 400* + 25 500) = R(127 500 – 124 500) = R3 000
* Refer to the comment after the application of Step 3.
Dr Capital: Meyer Cr
20.8 R 20.8 R
Mar 31 Balance c/d 37 200 Mar 31 Balance b/d 27 000
Revaluation surplus 4 000
Valuation account 5 000
Goodwill 1 200
37 200 37 200
Debit Credit
20.8 R R
Apr 1 Bank 25 500
Capital: Nell 25 500
Recording the cash capital contribution of Nell
Chapter 3: Changes in the ownership structure of partnerships 147
Step 6: Reinstate the revaluation surplus that was closed off in preparation of the
change in ownership.
Debit Credit
20.8 R R
Apr 1 Capital: Lamola (R10 000 × 9/20c) 4 500
Capital: Meyer (R10 000 × 7/20c) 3 500
Capital: Nell (R10 000 × 4/20c) 2 000
Revaluation surplus 10 000
Revaluation surplus reinstated to the capital
accounts of Lamola, Meyer and Nell according
to their profit-sharing ratio
Calculation:
c The profit-sharing ratio of Lamola, Meyer and Nell
Lamola = 3/5 – (1/5 × 3/4) = 3/5 – 3/20 = 12/20 – 3/20 = 9/20
Meyer = 2/5 – (1/5 × 1/4) = 2/5 – 1/20 = 8/20 – 1/20 = 7/20
Nell = 1/5 = 4/20
The profit-sharing ratio of Lamola, Meyer and Nell is 9:7:4 respectively.
Step 7: Write back the valuation adjustments that were recorded in the books of the
partnership.
Debit Credit
20.8 R R
Apr 1 Inventory 900
Allowance for credit losses 1 800
Valuation account 12 500
Furniture and equipment 14 700
Allowance for settlement discount received 500
Writing back the valuation adjustments
Capital: Lamola (R12 500 × 9/20) 5 625
Capital: Meyer (R12 500 × 7/20) 4 375
Capital: Nell (R12 500 × 4/20) 2 500
Valuation account 12 500
Closing off the balancing amount of the valuation
account to the capital accounts of the new part-
ners according to the new profit-sharing ratio
Dr Valuation account Cr
20.8 R 20.8 R
Apr 1 Furniture and Apr 1 Inventory 900
equipment 14 700 Allowance for credit
Allowance for losses 1 800
settlement discount Capital: Lamola 5 625
received 500 Capital: Meyer 4 375
Capital: Nell 2 500
15 200 15 200
Comment:
The entries on 31 March 20.8 pertain to the entries made in the books of the dissolved
partnership, and the entries on 1 April 20.8 pertain to the new partnership.
Dr Capital: Lamola Cr
20.8 R 20.8 R
Mar 31 Balance c/d 51 300 Mar 31 Balance b/d 36 000
Revaluation surplus 6 000
Valuation account 7 500
Goodwill 1 800
51 300 51 300
Apr 1 Revaluation surplus 4 500 Apr 1 Balance b/d 51 300
Valuation account 5 625
Goodwill 1 350
Balancing amount 39 825
Chapter 3: Changes in the ownership structure of partnerships 149
Dr Capital: Meyer Cr
20.8 R 20.8 R
Mar 31 Balance c/d 37 200 Mar 31 Balance b/d 27 000
Revaluation surplus 4 000
Valuation account 5 000
Goodwill 1 200
37 200 37 200
Apr 1 Revaluation surplus 3 500 Apr 1 Balance b/d 37 200
Valuation account 4 375
Goodwill 1 050
Balancing amount 28 275
Dr Capital: Nell Cr
20.8 R 20.8 R
Apr 1 Revaluation surplus 2 000 Apr 1 Bank 25 500
Valuation account 2 500
Goodwill 600
Balancing amount 20 400
Comment:
1 April 20.8 is the formation date of the new partnership. The capital accounts will thus
not be balanced at this stage.
150 About Financial Accounting: Volume 2
Additional information:
1. On 30 June 20.8, the inventory on hand was R12 800.
2. Included in the salaries and wages is an amount of R3 000 paid as a salary to Nell
for the financial year.
3. The credit losses were recorded on 1 March 20.8.
4. On 1 April 20.8, a rental agreement for storage space was entered into by the part-
nership with Rent-a-Space CC. The rental fee payable by Lamola & Meyer Partners
amounted to R240 per month.
Chapter 3: Changes in the ownership structure of partnerships 151
5. On 30 June 20.8 the partners of the new partnership decided to create an allow-
ance for credit losses to the amount of R960.
6. Depreciation for the financial year on furniture and equipment, namely R1 300, and
on the vehicle, namely R400, must still be recorded.
7. Interest on the long-term loan is charged at 12% per annum. The loan was ob-
tained on 1 July 20.6 from Loyale Bank. The interest was paid on 1 July 20.7 and
1 January 20.8.
8. Interest on the average balance of each of the capital accounts over the financial
year is payable at 12% per annum. Lamola and Meyer made no capital contribu-
tions or capital withdrawals during the financial year. Interest on the opening bal-
ances of the current accounts are payable at 10% per annum.
Required:
Prepare the statement of profit or loss and other comprehensive income of Lamola &
Meyer Partners for the year ended 30 June 20.8 according to the requirements of
IFRS, appropriate to the business of the partnership. Disclose two additional columns
on the statement to differentiate between the statements of the new and the dissolved
partnerships by apportioning the balances of the relevant items of Lamola & Meyer
Partners between these two partnerships. Notes and comparative figures are not re-
quired. (Unless otherwise indicated, all the items must be apportioned to the dissolved
and the new partnership on a time-proportionate basis.)
152 About Financial Accounting: Volume 2
Solution:
(a) Lamola & Meyer Partners
Statement of profit or loss and other comprehensive income for the
year ended 30 June 20.8
Additional columns
Lamola New Dissolved
& Meyer partner- partnership
Partners ship
(1/07/20.7 – (1/4/20.8 – (1/07/20.7 –
30/06/20.8) 30/06/20.8) 31/03/20.8)
R R R
Revenue R(270 600 – 17 508) 253 092 63 273 189 819
Cost of sales (87 832) (21 958) (65 874)
Inventory (1 July 20.7) 13 500 12 975 c 13 500
Purchases R(88 860 – 1 728) 87 132 21 783 65 349
100 632 34 758 78 849
Inventory (30 June 20.8) (12 800) (12 800) (12 975) c
Comments:
l The calculations after the entries (first column) pertain to the whole financial year.
l The items that were apportioned on a time-proportionate basis were apportioned
according to the ratios of 3/12 (from 1 April 20.8 to 30 June 20.8; which is equal to
three months) and 9/12 (from 1 July 20.7 to 31 March 20.8; which is equal to nine
months). For example, the cost of sales was apportioned as follows:
1 April 20.8 – 30 June 20.8: R87 832 × 3/12 = R21 958
1 July 20.7 – 31 March 20.8: R87 832 × 9/12 = R65 874
Chapter 3: Changes in the ownership structure of partnerships 153
l Recall that income and expenses which pertain to the partners of a partnership are
disclosed in the appropriation account. Therefore, the R3 000 included in the sal-
aries and wages had to be subtracted because it pertains to the salary of a part-
ner, which is disclosed in the statement of changes in equity for the financial year/
period. Likewise, the interest on the capital and current accounts of the partners
are not disclosed in the statement of profit or loss and other comprehensive in-
come, but in the statement of changes in equity.
l The statement does not comply to all IFRS requirements, as the partnership does
not disclose all assets and liabilities at fair value.
Calculations:
c Inventory (31 March 20.8/1 April 20.8)
The opening and closing balances of the inventory for the financial year were
given as R13 500 and R12 800 respectively. The cost of sales and the purchases
are calculated on a time-proportionate basis. Therefore, the closing balance of the
inventory on 31 March 20.8 is calculated as follows: [Inventory (1 July 20.7) + Pur-
chases] – Cost of sales R(78 849 – 65 874) = R12 975.
d Credit losses
l 1 July 20.7 – 31 March 20.8:
The given information states that R1 600 was recorded as credit losses on
1 March 20.8. This amount therefore pertains to the above period.
l 1 April 20.8 – 30 June 20.8:
The given information states that an allowance for credit losses to the amount of
R960 was created on 30 June 20.8. Since the R960 is based on the debtors as at
30 June 20.8, the entire amount is disclosed in the above period.
e Rental expense
l 1 July 20.7 – 31 March 20.8:
Since the rental contract was entered into on 1 April 20.8, the rental expense does
not pertain to Lamola and Meyer.
l 1 April 20.8 – 30 June 20.8:
The rental agreement was entered into for a period of three months, at R240 per
month. Therefore, the rental expense that incurred is equal to R240 × 3 = R720.
R480 of this amount was paid and R240 is accrued.
f Depreciation
l 1 July 20.7 – 31 March 20.8:
Since the vehicle was purchased on 1 June 20.8, the depreciation in respect of
the vehicle does not pertain to the above period.
Appropriation of the depreciation on the furniture and equipment:
R1 300 × 9/12 = R975
154 About Financial Accounting: Volume 2
continued
Chapter 3: Changes in the ownership structure of partnerships 155
R
EQUITY AND LIABILITIES
Total equity 684 875
Capital 648 000
Current accounts 14 375
Other components of equity (Revaluation surplus) 22 500
Total liabilities 43 750
Current liabilities 43 750
Trade and other payables 43 750
On 1 March 20.4 Puppet deposited R178 000 into the bank account of the partnership
for a 20% share in the net assets (equity), and a 10% interest in the profits/losses of the
partnership between Punch, Judy and Puppet. Punch and Judy ventured into this new
partnership with the same profit-sharing ratio as they had before 1 March 20.4, and
relinquished the 10% interest of Puppet according to this ratio on this date.
Required:
(a) In preparation of the recording of the admission of Puppet, prepare the journal
entry (narrative excluded) to account for the valuation of the equipment.
(b) In preparation of the recording of the admission of Puppet, calculate the goodwill
acquired.
(c) Calculate the profit-sharing ratio of Punch, Judy and Puppet, respectively.
(d) On which date does the application of the profit-sharing ratio between Punch,
Judy and Puppet take effect?
(e) After the admission of Puppet is recorded, according to the going-concern per-
spective, prepare the journal entries (narratives excluded) to:
(i) record the reinstatement of the revaluation surplus of R22 500.
(ii) record the reversal of the valuation adjustment of the equipment (of R15 000).
156 About Financial Accounting: Volume 2
Solution:
(a) Your Puppet Show
General journal
Debit Credit
20.4 R R
Feb 28 Equipment 15 000
Valuation account 15 000
(b) Formula:
(The capital contribution of the new partner multiplied by the inverse of the partner’s
share in the equity of the new partnership)
minus
the equity of the new partnership (on the date of formation, prior to the recording of
goodwill acquired)
equals
goodwill acquired
Comment:
A valuation account is used in this chapter to record and reverse valuation adjust-
ments. The balance of the valuation account is closed off to the capital accounts of the
partners concerned according to their profit-sharing ratio.
Case study 2: Recording a change in the ownership structure of a partnership
upon the retirement of a partner at financial year-end by transact-
ing with the partnership
Jade, Jock and Joan were in a partnership until 31 July 20.4, the financial year-end of
the partnership, and the last date in partnership for Jade as her retirement took effect
as from 1 August 20.4. Jade, Jock and Joan traded as The Golden Oldies and shared
profits/losses in the ratio of 3:2:1 respectively.
Jock and Joan decided to continue with the activities of the partnership as from
1 August 20.4, trading as The Young Ones. It was agreed that the capital account of
Jade be settled by two equal monthly cash instalments, payable on 31 July 20.4 and
30 August 20.4 by the partnership.
On 31 July 20.4, prior to recording any valuation adjustments and the settlement of
Jade’s capital account as per agreement, the books of The Golden Oldies were closed
off, and the following preliminary statement of financial position prepared:
The Golden Oldies
Statement of financial position as at 31 July 20.4
R
ASSETS
Non-current assets 240 000
Property, plant and equipment 240 000
Current assets 120 000
Inventories 60 000
Trade and other receivables (Trade receivables control) 36 000
Cash and cash equivalents (Bank) 24 000
The above balances of the capital and current accounts were compiled as follows:
On 31 July 20.4, after the preparation of the above statement of financial position, the
following occurred:
l Included in the property, plant and equipment in the above statement of financial
position, is land at a cost price of R216 000. In preparation of the dissolution of The
Golden Oldies, the land was valued by an independent sworn appraiser at
R540 000. The net realisable value of the inventory was valued by the appraiser as
R55 200.
l As per agreement, a repayment was made to Jade towards settling her capital
account.
As from 1 August 20.4, Jock and Joan calculated the new profit-sharing ratio between
them by using the ratio existing between them prior to 1 August 20.4 (2/6:1/6 respect-
ively), and adjusting it by taking over Jade’s profit share equally.
Required:
(a) In preparation of the dissolution of The Golden Oldies on 31 July 20.4, according
to the legal perspective,
(i) calculate the balances of the capital accounts of the partners after the
balances of their current accounts were closed off thereto.
(ii) prepare the journal entry (narrative excluded) to close off the balance of the
valuation account to the capital accounts of the partners.
(iii) which accounts and amount are involved to record the payment made to
Jade on 31 July 20.4.
(iv) prepare the journal entry (narrative excluded) to close off the balance of
Jade’s capital account after the payment in (iii) above was recorded.
(b) Concerning The Young Ones, calculate the profit-sharing ratio of Jock and Joan,
respectively.
Solution:
(a) (i) Jade: R(43 200 – 5 800) = R37 400, credit
Jock: R(59 520 + 14 780) = R74 300, credit
Joan: R(61 680 + 12 620) = R74 300, credit
Chapter 3: Changes in the ownership structure of partnerships 159
(b) Jock = 2/6 + (3/6 × 1/2) = 2/6 + 3/12 = 4/12 + 3/12 = 7/12
Joan = 1/6 + (3/6 × 1/2) = 1/6 + 3/12 = 2/12 + 3/12 = 5/12
The new profit-sharing ratio of Jock and Joan is 7:5 respectively.
160 About Financial Accounting: Volume 2
3.8 Summary
Goal of chapter
To discuss and illustrate the recording of changes in the ownership structure of
partnerships due to the admission, retirement or death of a partner.
Description of change in ownership structure
A change in the ownership structure of a partnership is regarded as a change in the
contractual relationship between the partners of a partnership which affects the
profit-sharing ratio of the partners.
When a change in the ownership structure of a partnership occurs, the partnership
dissolves, irrespective of whether the business activities of the partnership are con-
tinued.
Ownership and management of a partnership
Since a partnership is not an independent legal entity, the ownership of a partner-
ship is vested in the partners, and not in the partnership. Therefore, the activities of
a partnership fall under the jurisdiction of common law. More specifically, the part-
ners of a partnership manage the partnership by means of a partnership agree-
ment.
Selling price of a partnership
The selling price of a partnership is usually determined by the fair value of its net
assets (equity). The fair value of the net assets of a partnership is not necessarily
reflected in the accounting records thereof.
Valuation adjustments
If the fair value of an asset or liability is not reflected in the accounting records, the
selling price of a partnership is determined by making appropriate valuation
adjustments.
Goodwill acquired
Goodwill can be ascribed to the sound reputation of a business and represents the
value attached to those factors that enables a business to increase its turnover
beyond the expected industry norm.
Goodwill is acquired or internally generated.
In this chapter, goodwill acquired is calculated as follows:
(The capital contribution of the new partner multiplied by the inverse of the partner’s share
in the equity of the new partnership)
minus
the equity of the new partnership (on the date of formation, prior to the recording of goodwill
acquired)
equals
goodwill acquired
continued
Chapter 3: Changes in the ownership structure of partnerships 161
Contents
Page
Overview of the liquidation of a partnership ........................................................... 164
4.1 Introduction ................................................................................................... 165
4.2 Liquidation methods ..................................................................................... 165
4.3 The liquidation account ................................................................................ 166
4.4 Accounting procedure to record the simultaneous liquidation of a
partnership .................................................................................................... 168
4.4.1 Profit on liquidation .......................................................................... 170
4.4.2 Loss on liquidation........................................................................... 175
4.5 Accounting procedure to record the piecemeal liquidation
of a partnership ............................................................................................. 183
4.5.1 Calculation of interim repayments according to the
surplus-capital method .................................................................... 184
4.5.2 Calculation of interim repayments according to the
loss-absorption-capacity method .................................................... 191
4.6 Summary ....................................................................................................... 220
163
164 About Financial Accounting: Volume 2
4.1 Introduction
STUDY OBJECTIVES
then typically liquidated under duress at less favourable amounts, due to the short
period available for the liquidation. Another factor that impedes a simultaneous liquid-
ation is debtors who are unwilling or unable to pay their debts over a shortened time
span.
In contrast to a simultaneous liquidation, a piecemeal liquidation occurs when a part-
nership continues with its business activities, but on a steadily decreasing scale. Here-
by an opportunity is created to liquidate the partnership at a more favourable amount
than would otherwise be the case with a simultaneous liquidation.
The difference between the credit entry of R15 000 and the debit entry of R13 500
in the liquidation account reflects a settlement discount received of R1 500. These
two examples are shown in the following liquidation account:
Dr Liquidation account Cr
R R
Vehicles* 20 000 Bank* 18 000
Bank** 13 500 Trade payables control** 15 000
Balancing amount 500
If an asset was recorded at the carrying amount thereof, the liquidation account is
debited and the asset account credited with the closing balance of the asset
account.
If an asset was recorded at cost (for example, land), the liquidation account is
debited and the asset account credited with the closing balance of the asset
account. Any contra-asset account (for example, accumulated depreciation) must
be closed off to the liquidation account by debiting the contra-asset account and
crediting the liquidation account with the closing balance of the contra-asset
account.
l Record the liquidation of the assets.
When an asset is sold for cash, the bank account is debited and the liquidation
account is credited with the selling price (cash amount) of the asset on the date of
the liquidation.
Should a partner take over an asset, the amount at which the asset is taken over is
debited in the partner’s capital account and credited in the liquidation account.
l Record income received.
Income received, for example, services rendered for cash, is debited in the bank
account and credited in the liquidation account on the date that the transaction
occurs.
l Record the payment of liquidation expenses.
Usually, the settlement of a liquidation expense has preference over the settlement
of all other expenses. The liquidation account is debited, and the bank account
credited with the amount paid on the date of payment.
l Record the payments of any liabilities.
The settlement of a liability is recorded by debiting the liquidation account and
crediting the bank account with the amount paid.
l Record the payments of any further expenses as they arise.
Any further expenses paid are recorded by debiting the liquidation account and
crediting the bank account on the date of payment.
l Close off the balance of the liquidation account to the capital accounts of the
partners according to their profit-sharing ratio.
After all the entries in the liquidation account have been made, the balancing
amount of the liquidation account represents the net profit/loss made on the liquid-
ation of the partnership.
If a profit was made, the liquidation account is debited with the profit, and the
capital accounts of the partners credited according to their profit-sharing ratio.
If a loss was made, the capital accounts are debited according to their profit-
sharing ratio and the liquidation account is credited.
Step 4: Record the settlement (once-off repayments) of the capital accounts of the
partners.
At this stage of the liquidation process, only the bank account and the capital accounts
of the solvent partners have balances in the books of the partnership. The balance of
170 About Financial Accounting: Volume 2
the bank account will be equal to the sum of the capital account balances. The capital
account balances indicate the liability of the partnership towards each partner. To
record the settlement of the capital accounts, the balances of the capital accounts,
which are not necessarily in the profit-sharing ratio of the partners, are debited and the
bank account of the partnership credited. After the settlement of the capital accounts
has been recorded, the liquidation of the partnership is complete, and the partnership
ceases to exist.
Extract of the note regarding the property, plant and equipment for the year ended
31 July 20.5:
Furniture
and Vehicle Total
fittings
R R R
Carrying amount at 31 July 20.5 40 000 50 000 90 000
Cost 60 000 80 000 140 000
Accumulated depreciation (20 000) (30 000) (50 000)
On 1 August 20.5, the furniture and fittings were sold for R60 200 cash. The vehicle
was taken over by Pascoe at a mutually agreed value of R48 000. The inventory was
sold for R70 000 cash. The debtors settled their debts in full by paying R38 000 to the
partnership. All the creditors were paid and a settlement discount of R2 300 was re-
ceived. R39 000 was repaid in respect of the long-term loan. The liquidation expenses
amounted to R15 000.
Required:
(a) Prepare the general journal of Trio Traders on 1 August 20.5 to record the liquid-
ation of the partnership by applying the steps given in paragraph 4.4. Indicate the
number of the step according to which each journal entry is recorded.
(b) Prepare the liquidation, bank and capital accounts on 1 August 20.5 in the gen-
eral ledger of Trio Traders.
Solution:
(a) Trio Traders
General journal
Step 1:
Debit Credit
20.5 R R
Aug 1 Current account: Pascoe 12 000
Current account: Cannon 8 500
Capital: Fradley 13 000
Capital: Pascoe 12 000
Capital: Cannon 8 500
Current account: Fradley 13 000
Closing off the balances of the current ac-
counts to the capital accounts
172 About Financial Accounting: Volume 2
Step 2:
Debit Credit
20.5 R R
Aug 1 Capital: Pascoe (R27 000 × 1/3) 9 000
Capital: Cannon (R27 000 × 1/3) 9 000
Capital: Fradley (R27 000 × 1/3) 9 000
Goodwill 27 000
Closing off the goodwill to the capital ac-
counts according to the profit-sharing ratio of
the partners
Step 3:
Debit Credit
20.5 R R
Aug 1 Liquidation account 240 000
Furniture and fittings at cost 60 000
Vehicle at cost 80 000
Inventory 60 000
Trade receivables control 40 000
Closing off the assets to be liquidated to the
liquidation account
20.5
Aug 1 Accumulated depreciation: Furniture
and fittings 20 000
Accumulated depreciation: Vehicle 30 000
Liquidation account 50 000
Closing off the accumulated depreciation
accounts to the liquidation account
20.5
Aug 1 Long-term loan 39 000
Trade payables control 31 000
Liquidation account 70 000
Closing off the liability accounts to the liquid-
ation account
20.5
Aug 1 Bank R(60 200 + 70 000 + 38 000) 168 200
Liquidation account 168 200
Recording of the cash received for the assets
sold
20.5
Aug 1 Capital: Pascoe 48 000
Liquidation account 48 000
Recording of the vehicle taken over by Pascoe
continued
Chapter 4: The liquidation of a partnership 173
Debit Credit
20.5 R R
Aug 1 Liquidation account R[15 000 + 39 000 + 82 700
(31 000 – 2 300)]
Bank 82 700
Recording the payments of the liquidation ex-
penses, long-term loan and creditors
20.5
Aug 1 Liquidation account 13 500c
Capital: Pascoe (R13 500 × 1/3) 4 500
Capital: Cannon (R13 500 × 1/3) 4 500
Capital: Fradley (R13 500 × 1/3) 4 500
Closing off the balancing figure of the liquid-
ation account to the capital accounts accord-
ing to the profit-sharing ratio of the partners
Calculation:
c Balancing amount of liquidation account
Credit entries:
R(50 000 + 70 000 + 168 200 + 48 000) = R336 200
Debit entries:
R(240 000 + 82 700) = R322 700
Balancing amount:
R(336 200 – 322 700) = R13 500 = Net profit on liquidation
Step 4:
Debit Credit
20.5 R R
Aug 1 Capital: Pascoe 29 500c
Capital: Cannon 54 000d
Capital: Fradley 10 000e
Bank 93 500
Settlement of the closing balances of the cap-
ital accounts
Calculations:
c Closing balance of Pascoe’s capital account
R(70 000 + 12 000 – 9 000 – 48 000 + 4 500) = R29 500
d Closing balance of Cannon’s capital account
R(50 000 + 8 500 – 9 000 + 4 500) = R54 000
e Closing balance of Fradley’s capital account
R(27 500 – 13 000 – 9 000 + 4 500) = R10 000
174 About Financial Accounting: Volume 2
Comment:
The cash payments and cash receipts are disclosed separately for explanatory pur-
poses. It is also correct to disclose the cash payments as a single amount of R82 700
[R(15 000 + 39 000 + 28 700)], and the cash receipts as a single amount of R168 200
[R(60 200 + 70 000 + 38 000)].
Dr Bank Cr
20.5 R 20.5 R
Aug 1 Balance b/d 8 000 Aug 1 Liquidation account 15 000
Liquidation account 60 200 (Liquidation
(Furniture and expenses)
fittings sold) Liquidation account 39 000
Liquidation account 70 000 (Long-term loan
(Inventory sold) repaid)
Liquidation account 38 000 Liquidation account 28 700
(Debtors payments (Creditors paid)
received) Capital: Pascoe 29 500
Capital: Cannon 54 000
Capital: Fradley 10 000
176 200 176 200
continued
Chapter 4: The liquidation of a partnership 175
Dr Capital: Pascoe Cr
20.5 R 20.5 R
Aug 1 Goodwill 9 000 Aug 1 Balance b/d 70 000
Liquidation account 48 000 Current account:
Bank 29 500 Pascoe 12 000
Liquidation account 4 500
86 500 86 500
Dr Capital: Cannon Cr
20.5 R 20.5 R
Aug 1 Goodwill 9 000 Aug 1 Balance b/d 50 000
Bank 54 000 Current account:
Cannon 8 500
Liquidation account 4 500
63 000 63 000
Dr Capital: Fradley Cr
20.5 R 20.5 R
Aug 1 Current account: Aug 1 Balance b/d 27 500
Fradley 13 000 Liquidation account 4 500
Goodwill 9 000
Bank 10 000
32 000 32 000
The abridged statement of financial position as at 31 July 20.5, the financial year-end
of Trio Traders, was as follows:
Trio Traders
Statement of financial position as at 31 July 20.5
R
ASSETS
Non-current assets 117 000
Property, plant and equipment 90 000
Goodwill 27 000
Current assets 108 000
Inventories 60 000
Trade and other receivables (Trade receivables control) 40 000
Cash and cash equivalents (Bank) 8 000
The capital and current account balances of each partner at 31 July 20.5:
Pascoe Cannon Fradley
R R R
Capital account 70 000 50 000 27 500
Current account 12 000 8 500 (13 000)
Total 82 000 58 500 14 500
Extract from the note regarding the property, plant and equipment for the year ended
31 July 20.5:
Furniture and Vehicle Total
fittings
R R R
Carrying amount at 31 July 20.5 40 000 50 000 90 000
Cost 60 000 80 000 140 000
Accumulated depreciation (20 000) (30 000) (50 000)
Chapter 4: The liquidation of a partnership 177
On 1 August 20.5, the furniture and fittings were sold for R42 000 cash. The vehicle
was taken over by Pascoe at a mutually agreed value of R48 000. The inventory was
sold for R30 000 cash. The debtors settled their debts in full by paying R35 000 to the
partnership. All the creditors were paid and a settlement discount of R2 300 was
received. R39 000 was repaid in respect of the long-term loan. The liquidation ex-
penses amounted to R15 000.
All the partners have sufficient personal funds to settle any deficits on their capital
accounts.
Required:
Prepare the liquidation, bank and capital accounts in the general ledger of Trio Traders
on 1 August 20.5.
Solution:
Trio Traders
General ledger
Dr Liquidation account Cr
20.5 R 20.5 R
Aug 1 Furniture and Aug 1 Accumulated
fittings at cost 60 000 depreciation:
Vehicle at cost 80 000 Furniture and
Inventory 60 000 fittings 20 000
Trade receivables Accumulated
control 40 000 depreciation:
Bank 15 000 Vehicle 30 000
(Liquidation Long-term loan 39 000
expenses) Trade payables
Bank 39 000 control 31 000
(Long-term loan Bank 42 000
repaid) (Furniture and
Bank 28 700 fittings sold)
(Creditors paid) Bank 30 000
(Inventory sold)
Bank 35 000
(Debtors
payments
received)
Capital: Pascoe 48 000
Capital: Pascoec 15 900
Capital: Cannonc 15 900
Capital: Fradleyc 15 900
322 700 322 700
Calculation:
c Appropriation of loss on liquidation
The balancing amount of the liquidation account, prior to the appropriation of the
loss, amounts to R47 700.
178 About Financial Accounting: Volume 2
Debit entries:
R(60 000 + 80 000 + 60 000 + 40 000 + 15 000 + 39 000 + 28 700) = R322 700
Credit entries:
R(20 000 + 30 000 + 39 000 + 31 000 + 42 000 + 30 000 + 35 000 + 48 000) =
R275 000
Balancing amount:
R(322 700 – 275 000) = R47 700
Pascoe: R47 700 × 1/3 = R15 900
Cannon: R47 700 × 1/3 = R15 900
Fradley: R47 700 × 1/3 = R15 900
Dr Bank Cr
20.5 R 20.5 R
Aug 1 Balance b/d 8 000 Aug 1 Liquidation account 15 000
Liquidation account 42 000 (Liquidation
(Furniture and expenses)
fittings sold) Liquidation account 39 000
Liquidation account 30 000 (Long-term loan
(Inventory sold) repaid)
Liquidation account 35 000 Liquidation account 28 700
(Debtors pay- (Creditors paid)
ments received) Capital: Pascoe** 9 100
Capital: Fradley* 10 400 Capital: Cannon** 33 600
125 400 125 400
Dr Capital: Pascoe Cr
20.5 R 20.5 R
Aug 1 Goodwill 9 000 Aug 1 Balance b/d 70 000
Liquidation account 48 000 Current account:
Liquidation account 15 900 Pascoe 12 000
Bank* 9 100
82 000 82 000
* Balancing entry
Dr Capital: Cannon Cr
20.5 R 20.5 R
Aug 1 Goodwill 9 000 Aug 1 Balance b/d 50 000
Liquidation account 15 900 Current account:
Bank* 33 600 Cannon 8 500
58 500 58 500
continued
Chapter 4: The liquidation of a partnership 179
Dr Capital: Fradley Cr
20.5 R 20.5 R
Aug 1 Current account: Aug 1 Balance b/d 27 500
Fradley 13 000 Bank* 10 400
Goodwill 9 000
Liquidation account 15 900
37 900 37 900
* Fradley paid R10 400 from his personal funds into the bank account of the partnership to clear the deficit
on his capital account.
Should a partner be insolvent and therefore unable to pay the final deficit on his capital
account, the remaining solvent partners must bear the deficit. The settlement of dis-
putes regarding the apportionment of deficits can be resolved by means of court
rulings, such as the Garner versus Murray rule, which was constituted in England
during 1903.
Essentially, the Garner versus Murray rule stipulates that in the absence of a prior
agreement, the (actual) final deficit on an insolvent partner’s capital account should be
paid in cash by the solvent partners according to their “last agreed” capital account
balances, and not according to their profit-sharing ratio, as was the case prior to the
ruling. All partnerships that operate under English jurisdiction must follow the Garner
versus Murray rule.
A major problem with the application of the Garner versus Murray rule is the ambiguity
thereof concerning the determination of the last agreed capital account balances. The
date of the last agreed capital account balances is indicated in the rule as the date of
the previous statement of financial position. It is, however, unclear whether this “previ-
ous” statement pertains, for example, to the previous financial year-end, or to the date
immediately prior to the liquidation. To avoid applying the Garner versus Murray rule,
the method according to which the final capital deficits of insolvent partners must be
apportioned can be stipulated in a partnership agreement.
It is not the objective to deliver a detailed discussion on the Garner versus Murray rule
in this chapter, but rather to illustrate that should the rule be applied, the remaining
solvent partners must bear the final capital deficit of an insolvent partner according to
their capital ratio, and not according to their profit-sharing ratio. In this chapter, last
agreed capitals are interpreted as being the balances on the capital accounts of the
partners immediately prior to the liquidation of the partnership. These balances are
determined after the balances of the drawings, the current accounts, the goodwill and
the revaluation surplus accounts were closed off to the capital accounts.
Example 4.3 Simultaneous liquidation of a partnership with a net loss on
liquidation where all the partners do not have sufficient personal
funds to settle the final deficits on their capital accounts
Use the same information as in Example 4.2, with the exception that Fradley is insolv-
ent and unable to repay any amount of his final capital deficit to the partnership.
180 About Financial Accounting: Volume 2
Required:
(a) Prepare the bank and capital account entries in the general ledger of Trio Traders
on 1 August 20.5. Apply the Garner versus Murray rule to clear the final capital
deficit of Fradley.
(b) Prepare the bank and capital accounts in the general ledger of Trio Traders on
1 August 20.5. Apportion Fradley’s final capital deficit to the remaining solvent
partners (Pascoe and Cannon) according to their profit-sharing ratio.
Solution:
(a) Trio Traders
General ledger
Dr Bank Cr
20.5 R 20.5 R
Aug 1 Balance b/d 8 000 Aug 1 Liquidation account 15 000
Liquidation account 42 000 (Liquidation
(Furniture and expenses)
fittings) Liquidation account 39 000
Liquidation account 30 000 (Long-term loan
(Inventory sold) repaid)
Liquidation account 35 000 Liquidation account 28 700
(Debtors pay- (Creditors paid)
ments received) Capital: Pascoe* 2 860
Capital: Cannon* 29 440
115 000 115 000
* The closing balance of the bank account is used to settle Pascoe’s and Cannon’s capital accounts.
Dr Capital: Pascoe Cr
20.5 R 20.5 R
Aug 1 Goodwill 9 000 Aug 1 Balance b/d 70 000
Liquidation account 48 000 Current account:
Liquidation account 15 900 Pascoe 12 000
Capital: Fradleyc 6 240
Bank* 2 860
82 000 82 000
* Due to 60% (3/5) of Fradley’s capital deficit closed off to Pascoe’s capital account, the balance of Pas-
coe’s capital account decreased. Thus, instead of receiving R6 240 in cash from Pascoe in respect of
Fradley’s deficit and paying R9 100 to Pascoe to settle his capital account, a net amount of R2 860
(R9 100 – R6 240) was paid to Pascoe by the partnership.
Calculation:
c Portion of Fradley’s final capital deficit to be settled by Pascoe
To apportion the final capital deficit of Fradley, the balance of Pascoe’s capital
account is calculated as the balance of his capital account on 31 July 20.5
(immediately prior to the liquidation), after the balances of the accounts that stand
directly to the capital accounts of the partners were closed off to their capital
accounts. Thus, the balance of Pascoe’s capital account is calculated as the
Chapter 4: The liquidation of a partnership 181
opening balance of his capital account plus his current account balance minus
his portion of the goodwill, which is R73 000 [R(70 000 + 12 000 – 9 000)].
Likewise, Cannon’s capital account balance is calculated as R49 500 [(R(50 000 +
8 500 – 9 000). The total of the capital account balances of Pascoe and Cannon is
R122 500 [R73 000 (Pascoe) + R49 500 (Cannon)]. Therefore, the capital ratio of
Pascoe and Cannon, immediately prior to the liquidation of the partnership, is
73 000/122 500:49 500/122 500, respectively. Stated in its simplest form, this ratio
equals 3/5:2/5 [60%:40% (rounded off to the nearest Rand) = 6/10:4/10 = 3/5:2/5].
The capital ratio of Pascoe and Cannon is thus 3:2, respectively.
The portion of Fradley’s capital deficit that must be settled by Pascoe is calcu-
lated as follows:
R10 400* × 3/5 = R6 240
* Fradley’s capital deficit is R10 400 (R37 900 – R27 500).
Dr Capital: Cannon Cr
20.5 R 20.5 R
Aug 1 Goodwill 9 000 Aug 1 Balance b/d 50 000
Liquidation account 15 900 Current account:
Capital: Fradleyc 4 160 Cannon 8 500
Bank* 29 440
58 500 58 500
* Due to 40% (2/5) of Fradley’s capital deficit closed off to Cannon’s capital account, the balance of
Cannon’s capital account decreased. Thus, instead of receiving R4 160 in cash from Cannon in respect
of Fradley’s deficit, and paying R33 600 to Cannon to settle his capital account, the partnership paid a
net amount of R29 440 (R33 600 – R4 160) to Cannon.
Calculation:
c Portion of Fradley’s capital deficit to be settled by Cannon
R10 400* × 2/5 = R4 160
* Fradley’s capital deficit is R10 400 (R37 900 – R27 500).
Dr Capital: Fradley Cr
20.5 R 20.5 R
Aug 1 Current account: Aug 1 Balance b/d 27 500
Fradley 13 000 Capital: Pascoe* 6 240
Goodwill 9 000 Capital: Cannon* 4 160
Liquidation account 15 900
37 900 37 900
Comment:
The apportionment of Fradley’s capital deficit does not influence the preparation of the
liquidation account. Under the circumstances given in Example 4.3, the preparation of
the liquidation account will be the same as the preparation of the liquidation account in
Example 4.2.
182 About Financial Accounting: Volume 2
* The closing balance of the bank account (R32 300) is used to settle the final balances on the capital
accounts of Pascoe and Cannon.
Dr Capital: Pascoe Cr
20.5 R 20.5 R
Aug 1 Goodwill 9 000 Aug 1 Balance b/d 70 000
Liquidation account 48 000 Current account:
Liquidation account 15 900 Pascoe 12 000
Capital: Fradleyc 5 200
Bank* 3 900
82 000 82 000
* Balancing entry, which is the settlement of Pascoe’s capital account by the partnership.
Calculation:
c Portion of Fradley’s capital deficit to be settled by Pascoe
The profit-sharing ratio of Pascoe, Cannon and Fradley is given as 1:1:1. The profit-
sharing ratio of Pascoe and Cannon is thus 1:1. Therefore, the portion of Fradley’s
capital deficit that must be settled by Pascoe is calculated as follows:
R10 400 × 1/2 = R5 200.
Dr Capital: Cannon Cr
20.5 R 20.5 R
Aug 1 Goodwill 9 000 Aug 1 Balance b/d 50 000
Liquidation account 15 900 Current account:
Capital: Fradleyc 5 200 Cannon 8 500
Bank* 28 400
58 500 58 500
* Balancing entry; which is the settlement of Cannon’s capital account by the partnership.
Chapter 4: The liquidation of a partnership 183
Calculation:
c Portion of Fradley’s capital deficit to be settled by Cannon
The profit-sharing ratio of Pascoe, Cannon and Fradley was given as 1:1:1. The
profit-sharing ratio of Pascoe and Cannon is thus 1:1. Therefore, the portion of
Fradley’s capital deficit that must be settled by Cannon is calculated as follows:
R10 400 × 1/2 = R5 200.
Dr Capital: Fradley Cr
20.5 R 20.5 R
Aug 1 Current account: Aug 1 Balance b/d 27 500
Fradley 13 000 Capital: Pascoe* 5 200
Goodwill 9 000 Capital: Cannon* 5 200
Liquidation account 15 900
37 900 37 900
* The closing balance of Fradley’s capital account (a deficit of R10 400) is closed off to Pascoe’s and
Cannon’s capital accounts according to their profit-sharing ratio (1:1); R(5 200 + 5 200) = R10 400.
There is a risk involved when making arbitrary interim repayments, since assets can
thereafter be liquidated at a loss, which may result in final capital deficits. If a partner
with a final capital deficit is declared insolvent, the remaining solvent partners must
bear the deficit whilst the insolvent partner could already have prematurely received
interim repayments. Although legal steps can be taken against an insolvent partner to
recover his/her capital deficit, it must be considered that legal procedures are costly
and time-consuming, and that there is uncertainty as to whether the court ruling will be
in favour of the plaintiffs (that is the remaining solvent partners).
Apart from the risk mentioned above, it is also impractical to make interim repayments
to partners, only to require of them to repay it to the partnership at a later date. Interim
repayments should thus be made to partners when it is certain that in the future it will
not be required of a partner to make any repayment of an interim distribution that was
received.
Two methods can be applied to calculate the interim repayments to partners so that they
will not be required to in future repay these distributions to the partnership, namely the
surplus-capital and the loss-absorption-capacity methods. The application of these
methods is discussed in paragraphs 4.5.1 and 4.5.2. The answers of these methods
are always the same.
Step 4: Record the settlement (final repayment) of the capital accounts of the part-
ners.
Tom Dick
Profit-sharing ratio = 2/3 Profit-sharing ratio = 1/3
Item Capital account Capital account
Dr Cr Dr Cr
R R R R
Balance 3 000 2 500
R6 000 (loss) 4 000c 2 000c
Balance 1 000 500
Chapter 4: The liquidation of a partnership 185
Calculation:
c Apportionment of the loss of R6 000 to Tom and Dick
Tom: R6 000 × 2/3 = R4 000
Dick: R6 000 × 1/3 = R2 000
From the above it is clear that although Tom had the largest capital account balance
prior to the apportionment of the loss (namely R3 000), his higher profit-sharing ratio of
2:3 caused the balance on his capital account to turn into a deficit after his share of
the R6 000 loss (namely R4 000) was recorded. Therefore, when the surplus-capital
method is applied within Step 3 of the accounting procedure for the piecemeal liquid-
ation of a partnership (refer to paragraph 4.5), interim cash repayments are calculated
by taking both the capital account balance and the profit-sharing ratio of a partner into
account. Hereby the making of prudent interim repayments is assured.
Two steps are applied to calculate the interim repayments that must be made to part-
ners according to the surplus-capital method, namely:
Step A: Determine the order of preference according to which interim repayments
must be made to the partners.
An order of preference is determined by the ability of a partner to absorb losses as
recorded in his/her capital account.
The ability to absorb a loss is determined by the capital per unit of profit share of a
partner. The capital per unit of profit share of a partner is calculated after the postings
regarding Steps 1 and 2 of the accounting procedure to record the piecemeal liquid-
ation of a partnership (refer to the steps in paragraph 4.5) have been made.
When an order of preference for interim repayments is determined according to the
surplus-capital method for the first time, the calculation is done on the date when the
piecemeal liquidation commences.
Except for interim repayments, any amounts entered into the capital accounts of the
partners according to a different ratio than their profit-sharing ratios (for example,
when an asset is taken over by a partner) will require that the order of preference be
recalculated. This is so because such entries change the capital per unit of profit
shares of the partners, which changes the order of preference that was initially deter-
mined. The recalculation of an order of preference is illustrated in Example 4.7.
The formula for calculating a capital per unit of profit share is:
Capital account balance divided by Unit of profit share
A unit of profit share is equal to the numerator of an individual profit-sharing ratio. For
example, the individual profit-sharing ratio of Tom is 2/3. Therefore, his unit of profit share
is 2. The individual profit-sharing ratio of Dick is 1/3. Therefore, his unit of profit share is
1. The capital per unit of profit shares of Tom and Dick is calculated as follows:
Partner Capital account balance Unit of profit Capital per
(after Steps 1 and 2) share unit of profit
(a) (b) (a)/(b) share
Dr Cr
R R R
Tom 3 000 2 3 000/2 1 500
Dick 2 500 1 2 500/1 2 500
186 About Financial Accounting: Volume 2
The higher the capital per unit of profit share of a partner, the higher the surplus cap-
ital of the partner, and the greater the possibility that such a partner will be able to
absorb future losses. Interim cash repayments are thus made to the partner(s) with the
highest capital per unit of profit share(s) until the capital per unit of profit shares of all
the partners are equal. (Bear in mind that a capital repayment decreases the balance
of a capital account, which in turn decreases the capital per unit of profit share of a
partner.)
Dick’s capital per unit of profit share, namely R2 500, is greater than that of Tom’s,
which is R1 500. Therefore, the capital account of Dick is less likely to turn into a deficit
if a loss should be apportioned thereto.
Dick thus, first and solely, has preference when interim repayments are made until his
capital per unit of profit share is equal to that of Tom’s. Once the capital per unit of
profit shares of Tom and Dick are equal, the capital ratio of the partners is equal to
their profit-sharing ratio. When the capital per unit of profit shares of partners are equal
and interim cash repayments must be made, the payments are calculated according
to the profit-sharing ratios of the partners, and the partners are paid out simultaneously.
By ranking the capital per unit of profit shares of the partners from the highest to the
lowest, the order of preference for the making of interim repayments to the partners is
determined. In the case of Tom and Dick, the order of preference is shown below:
Dick has the first order of preference, and Tom the second. This means that the sur-
plus capital of Dick must first and solely be paid to him before Tom can receive any
interim repayments. The calculation of the surplus capitals of partners is discussed in
Step B.
Step B: Calculate the surplus capitals of the partners to determine the amounts
repayable to them when cash for interim repayments becomes available.
The formula for the calculation of surplus capital is:
Capital account balance of the partner with the highest capital per unit of
profit share
minus
(the next highest capital per unit of profit share multiplied by
the unit of profit share of the partner with the highest capital per unit of profit
share)
In the discussion concerning Tom and Dick, it was determined that Dick has the high-
est capital per unit of profit share. Therefore, the surplus capital of Dick must be calcu-
lated and repaid first until his capital per unit of profit share is equal to that of Tom’s.
Chapter 4: The liquidation of a partnership 187
According to the above formula, the calculation of Dick’s surplus capital is as follows:
minus
After the surplus capital of R1 000 has been paid to Dick, the capital per unit of profit
shares of Tom and Dick will be equal:
Tom: R3 000/2 = R1 500
Dick: R(2 500 – 1 000) = R1 500; R1 500/1 = R1 500
All further interim repayments will thus be paid out simultaneously to Tom and Dick
according to their profit-sharing ratios of 2/3 and 1/3 respectively.
188 About Financial Accounting: Volume 2
Step B: Calculate the surplus capitals of the partners to determine the amounts
repayable to them when cash for interim repayments becomes available.
(i) The calculation of the surplus capital of Ex, which must be repaid first and solely
to him because he holds the first order of preference, is given in tabular format as
follows:
The surplus capital of Ex is R2 200, and it must be repaid first and solely to him.
Chapter 4: The liquidation of a partnership 189
After the interim repayment of R2 200 has been made to Ex and recorded in the books
of the partnership, the balance of the capital account of Ex is R7 500 (R9 700 –
R2 200).
The calculation of the capital per unit of profit shares of the partners after R2 200 has
been repaid to Ex is as follows:
The capital per unit of profit shares of Ex and Zed (R1 500) are now the highest and
equal. This is so because Ex and Zed, respectively, hold the first and second orders of
preference.
(ii) The calculation of the surplus capitals of Ex and Zed (which must be repaid simul-
taneously to them because they hold the first and second orders of preference) is
as follows:
The surplus capital of Ex is R3 250, and that of Zed, R650. After these interim repay-
ments have been made and recorded in the books of the partnership, the capital
account balance of Ex is R4 250 (R7 500 – R3 250) and that of Zed, R850 (R1 500 –
R650).
190 About Financial Accounting: Volume 2
At this stage, the capital per unit of profit shares of Ex, Why and Zed are calculated as
follows:
Since the capital per unit of profit shares of Ex, Why and Zed are now equal, all further
interim repayments must be made to them according to their profit-sharing ratios.
In line with the order of preference and the surplus capitals as determined above, the
distribution of the available cash of R6 800 as interim repayments between the part-
ners is summarised as follows:
Cash Repayments to
distributions
Ex Why Zed
R R R R
Available cash 6 800*
Interim repayment of the sur-
plus capital of Ex (first and
solely to him) (2 200) 2 200
Remaining cash 4 600
Interim repayments of the sur-
plus capitals of Ex and Zed
(simultaneously) (3 900) 3 250 650
Remaining cash 700
Interim repayments to Ex, Why
and Zed according to their
profit-sharing ratio of 5:4:1
(simultaneously) (700) 350c 280c 70c
Total Nil 5 800* 280* 720*
Calculation:
c Appropriation of R700 to Ex, Why and Zed according to their profit-sharing
ratios
Ex: R700 × 5/10 = R350
Why: R700 × 4/10 = R280
Zed: R700 × 1/10 = R70
Chapter 4: The liquidation of a partnership 191
Comment:
Steps B and D are omitted because they are not applicable.
Calculation:
c Appropriation of the unsold assets
Ex: R7 800 × 5/10 = R3 900
Why: R7 800 × 4/10 = R3 120
Zed: R7 800 × 1/10 = R780
The R6 800 that is available for an interim repayment is paid to the partners according
to their capital account balances, namely R5 800 to Ex, R280 to Why and R720 to Zed.
The total of the balances is equal to the available cash of R6 800 (R5 800 + R280 +
R720).
Comprehensive example 4.6 Piecemeal liquidation of a solvent partnership
Lola, Ruby and Maya were in a partnership, trading as Mayflower Creations; they
shared in the profits and losses of the partnership in the ratio of 5:3:2, respectively. On
30 June 20.3, a financial year-end of the partnership, the partners decided to dissolve
Chapter 4: The liquidation of a partnership 193
the partnership piecemeal during July and August. The budgeted liquidation expenses
amounted to R4 000. All the partners were able to settle any final deficits on their
capital accounts. The following liquidation procedure was applied:
The assets were sold for cash, with exception of those taken over by a partner. The
budgeted liquidation expenses had to be provided for and held in the bank account
until payment – which is immediately after all the assets have been liquidated. The
creditors were paid after the liquidation expenses were provided for in full. As further
cash became available, interim repayments were made to the partners in such a way
that no partner had to repay any interim repayment that was received.
On 1 July 20.3, the trial balance of the partnership was as follows:
Mayflower Creations
Trial balance as at 1 July 20.3
Debit Credit
R R
Capital: Lola 15 500
Capital: Ruby 16 200
Capital: Maya 8 300
Current account: Lola 4 500
Current account: Ruby 2 700
Current account: Maya 4 000
Revaluation surplus 6 000
Goodwill 5 000
Trade payables control 25 500
Bank 1 000
Land at valuation 8 500
Buildings at carrying amount 11 500
Furniture and equipment at carrying amount 30 400
Inventory 17 300
78 200 78 200
continued
194 About Financial Accounting: Volume 2
A settlement discount of R250 was received on the first payment to the creditors. On
16 August 20.3, the liquidation expenses, amounting to R2 800, were paid in full.
Required:
Comment:
For explanatory purposes, this example comprises individual entries according to the
steps presented in paragraph 4.5, concerning the accounting procedure for the piece-
meal liquidation of a partnership. Alternatively, the liquidation process can be recorded
without preparing the individual entries, as per the summarised solution given after the
solution to (m).
(a) Open the goodwill, the revaluation surplus, the current and the capital accounts in
the general ledger of Mayflower Creations. Enter the balances thereof on 1 July
20.3. Close the current accounts (Step 1), the goodwill account (Step 2), and the
revaluation surplus account (Step 2) off to the capital accounts of the partners on
this date. Calculate the balancing amounts of the capital accounts. (Do not bal-
ance the capital accounts, since they will be used throughout the recording of the
liquidation process.)
(b) Record the first liquidation of the assets and the first payment to the creditors
(Step 3) in the general ledger accounts of Mayflower Creations (after the given
opening balances of the accounts were entered). Prepare liquidation account A to
record the liquidation of the assets, and liquidation account B to record the pay-
ment to the creditors. Calculate the balancing amount of the bank account.
(c) Calculate whether there are funds available to make first interim repayments to the
partners on 18 July 20.3.
(d) Record the second liquidation of the assets (in liquidation account C) and the
settlement of any remaining debts (Step 3) in the general ledger accounts of May-
flower Creations. Proceed with the accounts that are open, and, if necessary, open
any further accounts with the given opening balances. Since no settlement dis-
count was received on the payment of the outstanding creditors, it is unnecessary
to record this transaction in a liquidation account. Balance the inventory and the
trade payables control accounts. Calculate the balancing amounts of the bank
and the capital accounts.
(e) Calculate whether there are funds available to make first interim repayments to the
partners on 1 August 20.3.
(f) Calculate the first interim repayments that must be made to the partners on
1 August 20.3 according to the loss-absorption-capacity method.
Chapter 4: The liquidation of a partnership 195
(g) Record the first interim repayments to the partners on 1 August 20.3 in the general
ledger accounts of Mayflower Creations (Step 3).
(h) Record the third liquidation of the assets (in liquidation account D) in the general
ledger accounts of Mayflower Creations (Step 3). Calculate the balancing amounts
of the furniture and equipment at carrying amount, the bank and capital accounts.
(i) Calculate the second interim repayments that must be made to the partners on
9 August 20.3 according to the loss-absorption-capacity method.
(j) Record the second interim repayments to the partners on 9 August 20.3 in the
general ledger accounts of Mayflower Creations (Step 3).
(k) Record the fourth liquidation of the assets (in liquidation account E) in the general
ledger accounts of Mayflower Creations (Step 3).
(l) Record the payment of the actual liquidation expenses in the general ledger of the
partnership (Step 3). Disclose the liquidation expenses in liquidation account F.
Calculate the balancing amounts of the bank and the capital accounts.
(m) Record the final payments to the partners (to close off the books of the partner-
ship – Step 4).
Solution:
Comment:
The shaded entries in the ledger accounts below indicate the entries per requirement,
from (a) to (m). The balancing amounts are indicated to ease calculations.
(a) Mayflower Creations
General ledger
Dr Goodwill Cr
20.3 R 20.3 R
Jul 1 Balance b/d 5 000 Jul 1 Capital: Lolac 2 500
Capital: Rubyc 1 500
Capital: Mayac 1 000
5 000 5 000
Dr Revaluation surplus Cr
20.3 R 20.3 R
Jul 1 Capital: Lolad 3 000 Jul 1 Balance b/d 6 000
Capital: Rubyd 1 800
Capital: Mayad 1 200
6 000 6 000
continued
196 About Financial Accounting: Volume 2
Dr Capital: Lola Cr
20.3 R 20.3 R
Jul 1 Current account: Jul 1 Balance b/d 15 500
Lola 4 500 Revaluation
Goodwillc 2 500 surplusd 3 000
Balancing amount 11 500
Dr Capital: Ruby Cr
20.3 R 20.3 R
Jul 1 Goodwillc 1 500 Jul 1 Balance b/d 16 200
Balancing amount 19 200 Current account:
Ruby 2 700
Revaluation
surplusd 1 800
Dr Capital: Maya Cr
20.3 R 20.3 R
Jul 1 Goodwillc 1 000 Jul 1 Balance b/d 8 300
Balancing amount 12 500 Current account:
Maya 4 000
Revaluation
surplusd 1 200
Calculations:
c Appropriation of goodwill to partners
Lola: R5 000 × 5/10 = R2 500
Ruby: R5 000 × 3/10 = R1 500
Maya: R5 000 × 2/10 = R1 000
d Appropriation of revaluation surplus to partners
Lola: R6 000 × 5/10 = R3 000
Ruby: R6 000 × 3/10 = R1 800
Maya: R6 000 × 2/10 = R1 200
Chapter 4: The liquidation of a partnership 197
Dr Inventory Cr
20.3 R 20.3 R
Jul 1 Balance b/d 17 300 Jul 18 Liquidation account:
A 11 000
* A single liquidation account can be used to record the entire liquidation of the partnership. In this ex-
ample, for exemplary purposes, separate liquidation accounts were specifically required to show how
each set of liquidation transactions are recorded. For simplicity purposes, in the summary of the solution
to this example (given after the solution to (m)), no liquidation account is disclosed because the bal-
ancing amounts of the liquidation accounts are closed off directly to the capital accounts of the partners.
continued
198 About Financial Accounting: Volume 2
Dr Bank Cr
20.3 R 20.3 R
Jul 1 Balance b/d 1 000 Jul 18 Liquidation account:
18 Liquidation account: Be 25 000
Ac 28 000 Balancing amount 4 000
Dr Capital: Lola Cr
20.3 R 20.3 R
Jul 1 Current account: Jul 1 Balance b/d 15 500
Lola 4 500 Revaluation surplus 3 000
Goodwill 2 500 18 Liquidation account:
18 Liquidation account: Bg 125
Ad 1 500
Dr Capital: Ruby Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 500 Jul 1 Balance b/d 16 200
18 Liquidation account: Current account:
Ad 900 Ruby 2 700
Revaluation surplus 1 800
18 Liquidation account:
Bg 75
Dr Capital: Maya Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 000 Jul 1 Balance b/d 8 300
18 Liquidation account: Current account:
Ad 600 Maya 4 000
Revaluation surplus 1 200
18 Liquidation account:
Bg 50
Calculations:
c Cash received during first liquidation of assets
R(8 500 + 6 500 + 13 000) = R28 000
d Apportionment of the net loss on the first liquidation of assets to partners
Lola: R3 000 × 5/10 = R1 500
Ruby: R3 000 × 3/10 = R900
Maya: R3 000 × 2/10 = R600
Chapter 4: The liquidation of a partnership 199
Dr Inventory Cr
20.3 R 20.3 R
Jul 1 Balance b/d 17 300 Jul 18 Liquidation account:
A 11 000
Aug 1 Liquidation account:
C 6 300
17 300 17 300
continued
200 About Financial Accounting: Volume 2
Dr Bank Cr
20.3 R 20.3 R
Jul 1 Balance b/d 1 000 Jul 18 Liquidation account:
Liquidation account: B 25 000
A 28 000 Aug 1 Trade payables
Aug 1 Liquidation account: control* 250
Cc 14 300 Balancing amount 18 050
* Payment of the final outstanding amount R(25 500 – 25 250) after the second liquidation of the assets.
* The amount of R25 250 includes the settlement discount received of R250.
** Payment of the final outstanding amount R(25 500 – 25 250) after the second liquidation of the assets.
Dr Capital: Lola Cr
20.3 R 20.3 R
Jul 1 Current account: Jul 1 Balance b/d 15 500
Lola 4 500 Revaluation surplus 3 000
Goodwill 2 500 18 Liquidation account:
18 Liquidation account: B 125
A 1 500
Aug 1 Liquidation account:
Cd 3 500
Balancing amount 6 625
Dr Capital: Ruby Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 500 Jul 1 Balance b/d 16 200
18 Liquidation account: Current account:
A 900 Ruby 2 700
Aug 1 Liquidation account: Revaluation surplus 1 800
Cd 2 100 18 Liquidation account:
Balancing amount 16 275 B 75
Dr Capital: Maya Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 000 Jul 1 Balance b/d 8 300
18 Liquidation account: Current account:
A 600 Maya 4 000
Aug 1 Liquidation account: Revaluation surplus 1 200
Cd 1 400 18 Liquidation account:
Balancing amount 10 550 B 50
Chapter 4: The liquidation of a partnership 201
Calculations:
c Cash received during second liquidation of assets
R(8 000 + 6 300) = R14 300
d Apportionment of the loss on liquidation of assets
Lola: R7 000 × 5/10 = R3 500
Ruby: R7 000 × 3/10 = R2 100
Maya: R7 000 × 2/10 = R1 400
(e) On 1 August 20.3, the bank account has a favourable balance of R18 050 (refer to
the solution in (d)), of which R4 000 must be set aside for the payment of the
budgeted liquidation expenses. Therefore, R14 050 (R18 050 – R4 000) is avail-
able.
(f)
Calculations:
c The amount of the unsold furniture and equipment that is assumed to be
worthless
As obtained from the given information in respect of the furniture and equipment
that was sold during the third and fourth liquidation: R(13 400 + 2 000) = R15 400;
or
refer to the solution for (d) – the balancing amount of the furniture and equipment
at carrying amount is R(30 400 – 15 000) = R15 400.
d The budgeted liquidation expenses apportioned to Lola, Ruby and Maya
Lola: R4 000 × 5/10 = R2 000
Ruby: R4 000 × 3/10 = R1 200
Maya: R4 000 × 2/10 = R800
202 About Financial Accounting: Volume 2
e The loss of the assumed worthless assets apportioned to Lola, Ruby and
Maya
Lola: R15 400 × 5/10 = R7 700
Ruby: R15 400 × 3/10 = R4 620
Maya: R15 400 × 2/10 = R3 080
f The anticipated capital deficit of Lola apportioned to Ruby and Maya
Ruby: R3 075 × 3/5 = R1 845
Maya: R3 075 × 2/5 = R1 230
Comment:
The anticipated balances on the capital accounts are merely the results of the cal-
culation that was done according to the loss-absorption-capacity method. The
final anticipated balances of the capital accounts of the partners (which is the re-
sult of Step D), indicate how the cash which is available for the repayments must
be paid out. Therefore, Ruby will receive R8 610 and Maya, R5 440. Lola’s capital
account has no final anticipated balance and she will thus not receive an interim
repayment at this stage.
(g) Mayflower Creations
General ledger
Dr Bank Cr
20.3 R 20.3 R
Jul 1 Balance b/d 1 000 Jul 18 Liquidation
18 Liquidation account: B 25 000
account: A 28 000 Aug 1 Trade payables
Aug 1 Liquidation control 250
account: C 14 300 Capital: Ruby* 8 610
Capital: Maya* 5 440
Dr Capital: Lola Cr
20.3 R 20.3 R
Jul 1 Current Jul 1 Balance b/d 15 500
account: Lola 4 500 Revaluation surplus 3 000
Goodwill 2 500 18 Liquidation
18 Liquidation account: B 125
account: A 1 500
Aug 1 Liquidation
account: C 3 500
continued
Chapter 4: The liquidation of a partnership 203
Dr Capital: Ruby Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 500 Jul 1 Balance b/d 16 200
18 Liquidation Current account:
account: A 900 Ruby 2 700
Aug 1 Liquidation Revaluation surplus 1 800
account: C 2 100 18 Liquidation
Bank* 8 610 account: B 75
* Calculated in the solution to (f).
Dr Capital: Maya Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 000 Jul 1 Balance b/d 8 300
18 Liquidation Current account:
account: A 600 Maya 4 000
Aug 1 Liquidation Revaluation surplus 1 200
account: C 1 400 18 Liquidation
Bank* 5 440 account: B 50
Dr Bank Cr
20.3 R 20.3 R
Jul 1 Balance b/d 1 000 Jul 18 Liquidation
18 Liquidation account: B 25 000
account: A 28 000 Aug 1 Trade payables
Aug 1 Liquidation control 250
account: C 14 300 Capital: Ruby 8 610
9 Liquidation Capital: Maya 5 440
account: D 12 000 Balancing amount 16 000
continued
204 About Financial Accounting: Volume 2
Dr Capital: Lola Cr
20.3 R 20.3 R
Jul 1 Current account: Jul 1 Balance b/d 15 500
Lola 4 500 Revaluation surplus 3 000
Goodwill 2 500 18 Liquidation
18 Liquidation account: B 125
account: A 1 500
Aug 1 Liquidation
account: C 3 500
9 Liquidation
account: Dc 700
Balancing amount 5 925
Dr Capital: Ruby Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 500 Jul 1 Balance b/d 16 200
18 Liquidation Current account:
account: A 900 Ruby 2 700
Aug 1 Liquidation Revaluation surplus 1 800
account: C 2 100 18 Liquidation
Bank 8 610 account: B 75
9 Liquidation
account: Dc 420
Balancing amount 7 245
Dr Capital: Maya Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 000 Jul 1 Balance b/d 8 300
18 Liquidation Current account:
account: A 600 Maya 4 000
Aug 1 Liquidation Revaluation surplus 1 200
account: C 1 400 18 Liquidation
Bank 5 440 account: B 50
9 Liquidation
account: Dc 280
Balancing amount 4 830
Calculation:
c Apportionment of the loss on the liquidation of the assets
Lola: R1 400 × 5/10 = R700
Ruby: R1 400 × 3/10 = R420
Maya: R1 400 × 2/10 = R280
Chapter 4: The liquidation of a partnership 205
(i)
Calculation:
c Apportionment of the remaining assets assumed to be worthless
Lola: R2 000 × 5/10 = R1 000
Ruby: R2 000 × 3/10 = R600
Maya: R2 000 × 2/10 = R400
(j) Mayflower Creations
General ledger
Dr Bank Cr
20.3 R 20.3 R
Jul 1 Balance b/d 1 000 Jul 18 Liquidation
18 Liquidation account: B 25 000
account: A 28 000 Aug 1 Trade payables
Aug 1 Liquidation control 250
account: C 14 300 Capital: Ruby 8 610
9 Liquidation Capital: Maya 5 440
account: D 12 000 9 Capital: Lola* 2 925
Capital: Ruby* 5 445
Capital: Maya* 3 630
* Calculated in the solution to (i).
Dr Capital: Lola Cr
20.3 R 20.3 R
Jul 1 Current account: Jul 1 Balance b/d 15 500
Lola 4 500 Revaluation surplus 3 000
Goodwill 2 500 18 Liquidation
18 Liquidation account: B 125
account: A 1 500
Aug 1 Liquidation
account: C 3 500
9 Liquidation
account: D 700
Bank* 2 925
* Calculated in the solution to (i).
continued
206 About Financial Accounting: Volume 2
Dr Capital: Ruby Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 500 Jul 1 Balance b/d 16 200
18 Liquidation Current account:
account: A 900 Ruby 2 700
Aug 1 Liquidation Revaluation surplus 1 800
account: C 2 100 18 Liquidation
Bank 8 610 account: B 75
9 Liquidation
account: D 420
Bank* 5 445
* Calculated in the solution to (i).
Dr Capital: Maya Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 000 Jul 1 Balance b/d 8 300
18 Liquidation Current account:
account: A 600 Maya 4 000
Aug 1 Liquidation Revaluation surplus 1 200
account: C 1 400 18 Liquidation
Bank 5 440 account: B 50
9 Liquidation
account: D 280
Bank* 3 630
* Calculated in the solution to (i).
continued
Chapter 4: The liquidation of a partnership 207
Dr Bank Cr
20.3 R 20.3 R
Jul 1 Balance b/d 1 000 Jul 18 Liquidation
18 Liquidation account: B 25 000
account: A 28 000 Aug 1 Trade payables
Aug 1 Liquidation control 250
account: C 14 300 Capital: Ruby 8 610
9 Liquidation Capital: Maya 5 440
account: D 12 000 9 Capital: Lola 2 925
16 Liquidation Capital: Ruby 5 445
account: E 1 000 Capital: Maya 3 630
Dr Capital: Lola Cr
20.3 R 20.3 R
Jul 1 Current account: Jul 1 Balance b/d 15 500
Lola 4 500 Revaluation surplus 3 000
Goodwill 2 500 18 Liquidation
18 Liquidation account: B 125
account: A 1 500
Aug 1 Liquidation
account: C 3 500
9 Liquidation
account: D 700
Bank 2 925
16 Liquidation
account: E 1 000
continued
208 About Financial Accounting: Volume 2
Dr Bank Cr
20.3 R 20.3 R
Jul 1 Balance b/d 1 000 Jul 18 Liquidation
18 Liquidation account: B 25 000
account: A 28 000 Aug 1 Trade payables
Aug 1 Liquidation control 250
account: C 14 300 Capital: Ruby 8 610
9 Liquidation Capital: Maya 5 440
account: D 12 000 9 Capital: Lola 2 925
16 Liquidation Capital: Ruby 5 445
account: E 1 000 Capital: Maya 3 630
16 Liquidation
account: F 2 800
Balancing amount 2 200
Dr Capital: Lola Cr
20.3 R 20.3 R
Jul 1 Current account: Jul 1 Balance b/d 15 500
Lola 4 500 Revaluation surplus 3 000
Goodwill 2 500 18 Liquidation
18 Liquidation account: B 125
account: A 1 500
Aug 1 Liquidation
account: C 3 500
9 Liquidation
account: D 700
Bank 2 925
16 Liquidation
account: E 1 000
Liquidation
account: Fc 1 400
Balancing amount 600
Dr Capital: Ruby Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 500 Jul 1 Balance b/d 16 200
18 Liquidation Current account:
account: A 900 Ruby 2 700
Aug 1 Liquidation Revaluation surplus 1 800
account: C 2 100 18 Liquidation
Bank 8 610 account: B 75
9 Liquidation
account: D 420
Bank 5 445
16 Liquidation
account: Fc 840
Balancing amount 960
continued
Chapter 4: The liquidation of a partnership 209
Dr Capital: Maya Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 000 Jul 1 Balance b/d 8 300
18 Liquidation Current account:
account: A 600 Maya 4 000
Aug 1 Liquidation Revaluation surplus 1 200
account: C 1 400 18 Liquidation
Bank 5 440 account: B 50
Liquidation
account: D 280
Bank 3 630
16 Liquidation
account: Fc 560
Balancing amount 640
Calculation:
c Apportionment of the liquidation expenses
Lola: R2 800 × 5/10 = R1 400
Ruby: R2 800 × 3/10 = R840
Maya: R2 800 × 2/10 = R560
(m) Mayflower Creations
General ledger
Dr Bank Cr
20.3 R 20.3 R
Jul 1 Balance b/d 1 000 Jul 18 Liquidation
18 Liquidation account: B 25 000
account: A 28 000 Aug 1 Trade payables
Aug 1 Liquidation control 250
account: C 14 300 Capital: Ruby 8 610
9 Liquidation Capital: Maya 5 440
account: D 12 000 9 Capital: Lola 2 925
Aug 16 Liquidation Capital: Ruby 5 445
account: E 1 000 Capital: Maya 3 630
16 Liquidation
account: F 2 800
Capital: Lola* 600
Capital: Ruby* 960
Capital: Maya* 640
56 300 56 300
* Remaining cash paid out according to the balancing amount of the bank account (R2 200) in the
solution to (l). R(600 + 960 + 640) = R2 200.
continued
210 About Financial Accounting: Volume 2
Dr Capital: Lola Cr
20.3 R 20.3 R
Jul 1 Current account: Jul 1 Balance b/d 15 500
Lola 4 500 Revaluation surplus 3 000
Goodwill 2 500 18 Liquidation
18 Liquidation account: B 125
account: A 1 500
Aug 1 Liquidation
account: C 3 500
9 Liquidation
account: D 700
Bank 2 925
16 Liquidation
account: E 1 000
Liquidation
account: F 1 400
Bank* 600
18 625 18 625
* Remaining cash paid out according to the balancing amount of Lola’s capital account in the solution to (l).
Dr Capital: Ruby Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 500 Jul 1 Balance b/d 16 200
18 Liquidation Current account:
account: A 900 Ruby 2 700
Aug 1 Liquidation Revaluation surplus 1 800
account: C 2 100 18 Liquidation
Bank 8 610 account: B 75
9 Liquidation
account: D 420
Bank 5 445
16 Liquidation
account: F 840
Bank* 960
20 775 20 775
* Remaining cash paid out according to the balancing amount of Ruby’s capital account in the solution to (l).
continued
Chapter 4: The liquidation of a partnership 211
Dr Capital: Maya Cr
20.3 R 20.3 R
Jul 1 Goodwill 1 000 Jul 1 Balance b/d 8 300
18 Liquidation Current account:
account: A 600 Maya 4 000
Aug 1 Liquidation Revaluation surplus 1 200
account: C 1 400 18 Liquidation
Bank 5 440 account: B 50
9 Liquidation
account: D 280
Bank 3 630
16 Liquidation
account: F 560
Bank* 640
13 550 13 550
* Remaining cash paid out according to the balancing figure of Maya’s capital account in the solution to (l).
The solution to the above example is summarised in columnar format (see below). In
this summary, credit balances and credit entries are disclosed in brackets, and the
liquidation accounts are not disclosed. Refer to the above solution for any calculations.
Mayflower Creations
General ledger in columnar format
Property,
plant Trade
Inven- Capital: Capital: Capital:
Date Transaction Bank and payables
tory Lola Ruby Maya
equip- control
ment
20.3 R R R R R R R
Jul 1 Balances 1 000 50 400 17 300 (25 500) (15 500) (16 200) (8 300)
Closed off:
Current
accounts* 4 500 (2 700) (4 000)
Goodwill* 2 500 1 500 1 000
Revaluation
surplus* (3 000) (1 800) (1 200)
Balances 1 000 50 400 17 300 (25 500) (11 500) (19 200) (12 500)
18 1st liquidation 28 000 (20 000) (11 000) 1 500 900 600
Payment to
creditors (25 000) 25 250 (125) (75) (50)
Balances 4 000 30 400 6 300 (250) (10 125) (18 375) (11 950)
continued
212 About Financial Accounting: Volume 2
Property,
plant Trade
Inven- Capital: Capital: Capital:
Date Transaction Bank and payables
tory Lola Ruby Maya
equip- control
ment
R R R R R R R
Balances
(carried for-
ward) 4 000 30 400 6 300 (250) (10 125) (18 375) (11 950)
20.3
Aug 1 2nd liquidation 14 300 (15 000) (6 300) 3 500 2 100 1 400
Payment to
creditors (250) 250
Balances 18 050 15 400 – – (6 625) (16 275) (10 550)
1st interim
repayments (14 050) 8 610 5 440
Balances 4 000 15 400 – – (6 625) (7 665) (5 110)
20.3
Aug 1 3rd liquidation 12 000 (13 400) 700 420 280
Balances 16 000 2 000 – – (5 925) (7 245) (4 830)
2nd interim
repayments (12 000) 2 925 5 445 3 630
Balances 4 000 2 000 – – (3 000) (1 800) (1 200)
16 4th liquidation 1 000 (2 000) 1 000
Balances 5 000 – – – (2 000) (1 800) (1 200)
Liquidation
expenses paid (2 800) 1 400 840 560
Balances 2 200 – – – (600) (960) (640)
Final
repayments (2 200) 600 960 640
Balances – – – – – – –
* Due to the limited number of columns available, the current, goodwill and revaluation surplus accounts
are not disclosed. Note how the balances of these accounts are apportioned to the capital accounts.
The partners decided to liquidate the partnership piecemeal as from 1 January 20.4,
and to repay the creditors in full with a once-off payment as soon as sufficient cash
becomes available from selling the assets. Bester, Gunter and Venter further decided
that, as cash becomes available, interim repayments will be made to them in such a
way that it would not be necessary to repay any of the interim repayments to the part-
nership at a later stage. The partners agreed that in the case of a final capital deficit of
an insolvent partner, the deficit will be borne according to the profit-sharing ratio of the
remaining solvent partner(s).
The assets of the partnership were liquidated as follows:
Date of Carrying
Asset Sales transaction
liquidation amount
R R
7 January 20.4 Furniture and equipment 12 800 10 400 (cash)
1 February 20.4 Furniture and equipment 5 000 5 000 (taken over by Venter)
20 February 20.4 Furniture and equipment 3 200 3 800 (cash)
Inventory 4 000 4 000 (cash)
3 March 20.4 Inventory 3 000 3 000 (cash)
No settlement discount was received on the payment of the creditors’ accounts, and at
3 March 20.4 Bester was declared insolvent. No cash is receivable from his insolvent
estate.
Required:
Record the liquidation transactions of Hillside Garden Centre in columnar format accord-
ing to the under-mentioned outlay. Disclose all credit balances and credit entries in
brackets. Use the surplus-capital method to calculate the interim repayments to the
partners. (To show that the results obtained when applying the surplus-capital method
are the same than the results obtained when applying the loss-absorption-capacity
method, the application of both methods are shown in the solution.)
214 About Financial Accounting: Volume 2
Outlay:
Hillside Garden Centre
General ledger
Furniture Trade
Inven- Capital: Capital: Capital:
Date Transaction Bank and payables
tory Bester Gunter Venter
equipment control
20.4 R R R R R R R
Jan 1 Balances 2 000 21 000 7 000 (11 000) (600) (8 400) (10 000)
Solution:
Hillside Garden Centre
General ledger in columnar format
Furniture Trade
Inven- Capital: Capital: Capital:
Date Transaction Bank and payables
tory Bester Gunter Venter
equipment control
20.4 R R R R R R R
Jan 1 Balances 2 000 21 000 7 000 (11 000) (600) (8 400) (10 000)
7 Liquidation 10 400 (12 800) 1 200c 800c 400c
Creditors (11 000) 11 000
Balances 1 400 8 200 7 000 – 600* (7 600) (9 600)
1st interim
repayment (1 400) 1 400d
20.4
Feb 1 Liquidation (5 000) 5 000
20 Liquidation 7 800e (3 200) (4 000) (300)f (200)f (100)f
Balances 7 800 – 3 000 – 300 (7 800) (3 300)
2nd interim
repayments (7 800) 5 600g 2 200g
Mar 3 Liquidation 3 000 – (3 000) –
Balances 3 000 – – – 300 (2 200) (1 100)
Deficit transfer (300) 200h 100h
Balances 3 000 – – – – (2 000) (1 000)
Final
repayments (3 000) 2 000** 1 000**
Balances – – – – – – –
* Bester’s capital account turned into a deficit, but Bester continues to share in the profits/losses of the
partnership until the liquidation process has been completed.
** The remaining cash in the bank is used to repay the final capital account balances of Gunter and Venter.
Calculations:
c Apportionment of the loss on the liquidation of the assets on 7 January 20.4
Loss: R(12 800 – 10 400) = R2 400
Bester: R2 400 × 3/6 = R1 200
Gunter: R2 400 × 2/6 = R800
Venter: R2 400 × 1/6 = R400
Chapter 4: The liquidation of a partnership 215
Step B: Calculate the surplus capitals of the partners to determine the amounts
repayable to them when cash for interim repayments becomes available.
Calculation of the surplus capital of Venter, which must be repaid first and solely to
him because he has the first order of preference:
Comment:
The same result for repayment (namely R1 400 to Venter) is obtained when calculating
the interim distribution according to the loss-absorption-capacity method:
C: Unsold
assets
subtracted (15 200) 7 600o 5 067o 2 533o
1 400 – 8 200 (2 533) (7 067)
D: Capital
deficits
subtracted:
Bester (8 200) 5 467p 2 733p
– 2 934 (4 334)
Gunter (2 934) 2 934
1 400 – – – (1 400)
Calculations:
n Total assets on 7 January 20.4
Furniture and equipment plus Inventory =
R(8 200 + 7 000) = R15 200
o Apportionment of the unsold assets
Bester: R15 200 × 3/6 = R7 600
Gunter: R15 200 × 2/6 = R5 067 (rounded off to the nearest Rand)
Venter: R15 200 × 1/6 = R2 533 (rounded off to the nearest Rand)
p Apportionment of the capital deficit of Bester to Gunter and Venter
Gunter: R8 200 × 2/3 = R5 467 (rounded off to the nearest Rand)
Venter: R8 200 × 1/3 = R2 733 (rounded off to the nearest Rand)
e Total amount of cash sales on 20 February 20.4
R(3 800 + 4 000) = R7 800
f Apportionment of the profit on the liquidation of the assets on
20 February 20.4
Profit: R(7 800 – 7 200) = R600
Bester: R600 × 3/6 = R300
Gunter: R600 × 2/6 = R200
Venter: R600 × 1/6 = R100
Chapter 4: The liquidation of a partnership 217
Step B: Calculate the surplus capitals of the partners to determine the amounts
repayable to them when cash for interim repayments becomes available.
(i) Calculation of the surplus capital of Gunter, which must be allotted first and
solely to him because he has the first order of preference:
Comment:
The same result for the repayment (namely R5 600 to Gunter and R2 200 to Venter) is
obtained when calculating the interim distribution according to the loss-absorption-
capacity method:
Calculations:
n Apportionment of the unsold assets (inventory)
Bester: R3 000 × 3/6 = R1 500
Gunter: R3 000 × 2/6 = R1 000
Venter: R3 000 × 1/6 = R500
o Apportionment of the capital deficit of Bester to Gunter and Venter
Gunter: R1 800 × 2/3 = R1 200
Venter: R1 800 × 1/3 = R600
h Apportionment of the actual final capital deficit of Bester, who is insolvent, to
Gunter and Venter
Gunter: R300 × 2/3 = R200
Venter: R300 × 1/3 = R100
Comment:
Should the Garner versus Murray rule have been applied, the actual final capital
deficit of Bester would have been apportioned to Gunter and Venter according to
their respective capital account balances on 1 January 20.4, namely R8 400 and
R10 000:
Gunter: R300 × 84/184 = R137 (rounded off to the nearest Rand)
Venter: R300 × 100/184 = R163 (rounded off to the nearest Rand)
4.6 Summary
In this chapter the term “liquidation” is described as a form of dissolution of a partner-
ship which results in the termination of the business activities thereof. From this per-
spective, the liquidation of a partnership can be caused by various factors, such as
the death or retirement of a partner, when a partnership is insolvent, or when a court
order for the liquidation of a partnership has been issued.
In general terms, a liquidation is associated with insolvency. To distinguish between
the liquidation of a solvent and an insolvent partnership, the liquidation of the latter is
Chapter 4: The liquidation of a partnership 221
the partnership at a later stage. Two methods according to which the calcu-
lation of an interim repayment can be made that complies with this condition,
are the surplus-capital and the loss-absorption-capacity methods. These
methods render the same results.
According to the surplus-capital method, the interim repayments are calcu-
lated in such a way that the capital per unit of profit shares of the partners will
eventually be equal. Equal capital per unit of profit shares indicate that the
capital ratio of the partners is equal to their profit-sharing ratio. The higher the
capital per unit of profit share of a partner, the higher the surplus capital of
the partner, and the greater the probability that such a partner will be able to
absorb future losses. Once the capital per unit of profit shares of the partners
are equal, interim cash repayments must be made to these partners accord-
ing to their profit-sharing ratio. When applying the surplus-capital method, the
undermentioned steps are followed to determine how the interim repayments
must be made:
Step A: Determine the order of preference according to which interim re-
payments must be made to the partners.
Step B: Calculate the surplus capitals of the partners to determine the
amounts repayable to them when cash for interim repayments be-
comes available.
When the surplus-capital method is applied, the order of preference is usually
calculated at the beginning of the piecemeal liquidation, and interim repay-
ments are made accordingly. With this method, the profits/losses that were
made during the liquidation process do not have to be determined to calcu-
late how the cash must be repaid to the partners. Should any transaction,
apart from an interim repayment, take place that changes the capital ratio
according to which the order of preference was calculated (such as when a
partner takes over an asset), the order of preference must be recalculated.
According to the loss-absorption-capacity method, the interim repayments of
the available cash to the partners are calculated by determining to what ex-
tent each of the balances of the capital accounts of the partners can absorb
the maximum anticipated loss during the liquidation of the partnership, by
apportioning such losses to the capital accounts according to the profit-
sharing ratio of the partners. The available cash is then repaid according to
these anticipated balances of the capital accounts. This calculation must be
repeated each time that cash becomes available for interim repayments.
The loss-absorption-capacity method entails the following:
Step A: Determine the actual general ledger account balances in the books
of the partnership on the date that cash becomes available for interim
repayments.
Chapter 4: The liquidation of a partnership 223
Contents
Page
Overview of close corporations .............................................................................. 227
5.1 Introduction ................................................................................................... 229
5.2 Attributes of a close corporation ................................................................... 230
5.3 Advantages of a close corporation............................................................... 231
5.4 Disadvantages of a close corporation .......................................................... 231
5.5 Prescribed forms of a close corporation ...................................................... 232
5.6 Name and registration number of a close corporation ................................. 233
5.7 Membership of a close corporation .............................................................. 234
5.7.1 Number of members........................................................................ 234
5.7.2 Membership requirements .............................................................. 234
5.7.3 Member’s interest ............................................................................ 234
5.8 Internal relations ........................................................................................... 236
5.8.1 The fiduciary relationship of members ............................................ 236
5.8.2 The liability of members in the case of negligent conduct .............. 237
5.8.3 The association agreement ............................................................. 237
5.8.4 Variable rules in respect of internal relations .................................. 237
5.8.5 Prohibition of loans and providing of security to members and
others by a close corporation .......................................................... 238
5.9 External relations .......................................................................................... 238
5.10 Joint liability of members and others for the debts of a close corporation... 239
5.11 The tax position of a close corporation and its members............................. 240
5.12 Accounting records and financial reporting ................................................. 241
5.12.1 Close Corporation Act requirements ............................................... 241
5.12.1.1 Keeping accounting records .......................................... 241
5.12.1.2 Financial year and financial statements .......................... 242
5.12.1.3 The accounting officer .................................................... 244
5.12.2 Companies Act Regulations applicable to close corporations ....... 246
5.12.2.1 Public interest score ........................................................ 246
5.12.2.2 Audit exemption .............................................................. 246
5.12.2.3 Audit requirement ............................................................ 247
5.12.2.4 Independent review ........................................................ 247
5.12.2.5 Trusts as members of close corporations ....................... 247
5.12.2.6 Financial Reporting Standards........................................ 248
225
226 About Financial Accounting: Volume 2
Page
5.12.3 Accounting procedures ................................................................... 248
5.12.3.1 Recording of the distribution of total comprehensive
income ............................................................................. 248
5.12.3.2 Preparation of financial statements ................................. 249
5.13 Deregistration of a close corporation ........................................................... 265
5.14 Summary ....................................................................................................... 265
Chapter 5: Close corporations 227
Accounting procedures:
• Distribution of total comprehensive income: Require liquidity and sol-
vency test to be met before any distribution is made to members
• Preparation of financial statements: Financial statements must provide
information about the financial performance and financial position in ac-
cordance with the provisions of the Close Corporations Act and Interna-
tional
Financial Reporting Standards (IFRS) or (IFRS for SMEs)
continued
228 About Financial Accounting: Volume 2
5.1 Introduction
STUDY OBJECTIVES
In the previous chapters, the partnership as a form of business entity was discussed. It
was mentioned that one of the disadvantages of a partnership is that it lacks inde-
pendent legal status as a business entity, thereby causing partners to be personally
liable for the obligations of the partnership, disallowing perpetual succession and
restricting the alternative resources of capital.
Close corporation, as a form of business ownership, was introduced in South African
commerce when the Close Corporations Act, 69 of 1984 (hereinafter referred to as the
Close Corporation Act) was passed by parliament. The purpose was to establish a
flexible form of business ownership to serve smaller businesses with the advantages of
simplified and inexpensive incorporation, separate legal existence, limited liability and
less onerous financial reporting requirements. Since the introduction of close corpor-
ations as a form of business ownership, small and medium size business entities have
enjoyed a combination of advantages similar to that of sole proprietorships, partnerships
and companies. The new Companies Act, 71 of 2008 (hereinafter referred to as the
Companies Act) came into effect on 1 May 2011 and introduced certain amendments
230 About Financial Accounting: Volume 2
A founding member of a close corporation obtains his member’s interest after an initial
contribution, as specified in the founding statement, has been made to the close
corporation.
A person who wants to become a member of a registered close corporation must
obtain a member’s interest by:
l purchasing it from one or more of the existing members, or from their deceased or
insolvent estates; or
l contributing to the close corporation, in which case the percentage of his interest
will be determined by an agreement between him and the existing members. This
contribution may consist of an amount of money, or of any property which is valued
at an agreed amount between the new member and the existing members.
The recording of the contributions made by the members to a close corporation is
illustrated in Example 5.1.
Example 5.1 Contributions made by members
J Botha and M Kent are the only members of Kenbo CC. According to the founding
statement of Kenbo CC, a member’s interest of 65% is allocated to Botha, and 35% to
Kent. The founding statement further indicates that Botha will contribute cash to the
amount of R65 000, and Kent will contribute office equipment to the value of R35 000
to the close corporation.
Required:
Record the contribution made by Botha and Kent in the general journal of Kenbo CC.
Solution:
Kenbo CC
General journal
Debit Credit
R R
Bank 65 000
Office equipment 35 000
Member’s contribution: J Botha 65 000
Member’s contribution: M Kent 35 000
Recording of members’ contributions to CC
This example illustrates that the members’ contributions to the close corporation are in
the same ratio as the member’s interest in the close corporation. However, such a
situation is not required by the Close Corporations Act.
Should a member become insolvent, the trustee of the insolvent estate may sell the
member’s interest under certain conditions to either the close corporation, the other
members of the close corporation, or to any other person who qualifies for member-
ship of a close corporation.
Subject to any other stipulation in the association agreement, the executor of the
estate of a deceased member must transfer the member’s interest of the deceased
member to a person who qualifies for membership of a close corporation in terms of
236 About Financial Accounting: Volume 2
the Close Corporations Act, and who is entitled thereto as legatee or heir or under a
redistribution agreement, only if the remaining member(s) of the close corporation
consent to such a transfer. If such consent is not given within 28 days after it was
requested by the executor, the executor must sell the interest, subject to certain condi-
tions, to the close corporation, or to any other remaining member(s), or to any other
person who qualifies for membership of a close corporation in terms of the Close
Corporations Act.
Other than the dispositions provided for in the Close Corporations Act in respect of an
insolvent or deceased member, or where a membership was ended by virtue of a
court order, a member may only dispose of his member’s interest or portion thereof in
accordance with the association agreement (if any) or with the consent of every other
member of the close corporation.
A close corporation may not acquire a member’s interest if it does not have any other
member(s). A close corporation may also not hold any acquired member’s interest.
Such interest must be added to the respective interests of the other members in pro-
portion to their existing interests or as they may otherwise agree upon. A close corpor-
ation may only buy a member’s interest if written consent was previously obtained from
each of the members, other than the member from whom the interest is acquired, and
if the solvency and liquidity requirements of the Close Corporations Act were adhered
to (refer to paragraph 5.2).
A close corporation may give financial assistance to any person for the purpose of
acquiring an interest in the close corporation, provided that the close corporation must
first obtain the written consent of every existing member for the specific assistance,
and that the close corporation meets the solvency and liquidity requirements of the
Close Corporations Act (refer to paragraph 5.2).
suffered, or for any economic benefit derived by the member, because such an act or
omission.
l a close corporation must indemnify every member for expenses incurred by him in
the ordinary and proper conduct of the business of the close corporation and with
regard to actions pertaining to the maintenance of the business or property of the
close corporation; and
l payments can be made by a close corporation to its members solely due to their
membership, provided that they are made at such amounts and at such times that
are agreed upon by the members from time to time. In addition, the close corpor-
ation must meet the solvency and liquidity requirements of the Close Corporations
Act when such payments are made. These payments must be made to the mem-
bers in proportion to their respective interests in the close corporation and exclude
payments made to members in the ordinary conduct of the business, such as sal-
aries and interest paid to the members or the repayment of loans that were granted
by the members.
5.10 Joint liability of members and others for the debts of a close
corporation
Under normal circumstances, the liability of a member towards the obligations of the
close corporation is limited to the extent that contributions were made by the member
to the close corporation. However, transgressions of certain provisions of the Close
Corporations Act may cause members to lose their protection of limited liability and
together with the close corporation, to become jointly and severally liable for the debts
of the close corporation. Such potential loss of limited liability provides a form of self-
regulation in so far as members are encouraged to adhere to set requirements in order
to maintain such protection.
According to Section 63 of the Close Corporations Act, the following persons, under
the following circumstances, may, together with a close corporation, be held jointly
and severally liable for certain debts of that close corporation (these debts are specified
in the Close Corporations Act, but fall outside the scope of this chapter. In the below
mentioned circumstances, the term “specified debts” is used in those cases where the
specifics, as mentioned in the Close Corporations Act, are too elaborate for the purpose
of this discussion):
l where a close corporation entered into a transaction with any other person, from
which a debt accrued for the close corporation, and such a person was unaware
that the transaction was made with a close corporation because the close corpor-
ation failed to subjoin the abbreviation CC in terms of the requirements of the Close
Corporations Act to its name. In such a case, any member who is responsible for,
or who authorised, or knowingly permitted the omission, is liable for the “specified
debts”;
l when a member fails to make his contribution as stipulated in the founding state-
ment, in which case he can be held liable for the “specified debts” of the close
corporation;
l where a juristic person (or a trustee of a trust inter vivos) purports to hold a mem-
ber’s interest in a close corporation, in contravention of any relevant provisions of
the Close Corporations Act, such a juristic person (or trustee) and any nominee
can be held liable for the “specified debts” of the close corporation;
l where a close corporation makes a payment in respect of the acquisition of a
member’s interest which does not comply with the requirements of the Close Cor-
porations Act, every person who is a member at the time of such payment and who
is aware of the making of such payment as well as a member or former member
who receives or received such payment, can be held liable for the “specified
debts” of the close corporation;
l where a close corporation gives financial assistance in respect of any acquisition
of a member’s interest which does not comply with the requirements of the Close
Corporations Act, every person who is a member at the time of giving such assist-
ance and who is aware of the giving of such assistance, and the person who
receives such assistance, can be held liable for the “specified debts” of the close
corporation;
l when an unauthorised person participates in the management of the close corpor-
ation, that person can be held liable for the “specified debts” of the close corpor-
ation; and
240 About Financial Accounting: Volume 2
l where the office of an accounting officer is vacant for a period of six months, any
person, who at any time during that period was a member of the close corporation
and aware of the vacancy, and who at the expiration of that period still is a mem-
ber, is liable for all the debts incurred by the close corporation while the position
was vacant. Such a member, if he still is a member, is also liable for every debt
incurred by the close corporation after the expiration of that period whilst the
vacancy continues.
If it at any time it appears that the business of the close corporation is being carried on
in a reckless manner, with gross negligence or with the intent to defraud, any person
who was knowingly a party to the conduct of the business of the close corporation in
such a manner, can be held personally liable for the debts as specified in terms of the
Close Corporations Act.
At the end of a financial period, the actual current income tax expense for the period is
recorded as follows:
General journal
Debit Credit
R R
Current income tax expense XXX
SARS (Income tax) XXX
Recording of the actual current income tax expense for the
financial period
Chapter 5: Close corporations 241
Comments:
l At the financial year-end, the current income tax expense account is closed off to
the appropriation account.
l After the two provisional payments and the current income tax expense were re-
corded in the SARS (current income tax) account, the account may have either a
debit or credit balance. A credit balance will indicate the final payment which must
be made to SARS. If the payment was not made before or on the date of the
applicable financial year-end, the credit balance will be disclosed under the
current liabilities of the balance sheet at the year-end as “Current Tax payable”. A
debit balance will indicate that the provisional tax payments that were made during
the financial period were greater than the actual income tax expense for this
period. At the financial year-end, a debit balance will be disclosed under the cur-
rent assets as “Current Tax receivable”.
Any distribution of total comprehensive income made by a close corporation to its
members is subject to a Dividend Tax, which is payable by the members of a close
corporation receiving the profit distributions. The discussion on the application of
Dividend Tax falls outside the scope of this chapter.
A member of a close corporation is regarded by the Income Tax Act as a shareholder
of a company. The Act also regards a member of a close corporation who is actively
involved in the affairs of the close corporation as a “director”. The provisions of the
Income Tax Act in respect of PAYE will be applicable to such a member as if he is an
employee. A member of a close corporation who is a resident of the Republic of South
Africa must register as a provisional taxpayer unless the Commissioner for South
African Revenue Service decides otherwise.
l statements of the annual stocktaking (inventory count) and records to enable the
value of the stock (inventory) to be determined at the financial year-end; and
l vouchers supporting the entries in the accounting records.
The terminology shown in brackets reflects the current terminology used in the field of
financial accounting whilst the Close Corporation Act (which is quoted) still reflects
previous terminology used.
The accounting records must be kept in such a manner that adequate precautions
against falsification is provided and that the identification of any falsification is facilitated.
If a close corporation fails to comply with the provisions of the Close Corporations Act
in respect of accounting records, every member thereof who is a party to such failure
or who failed to take all reasonable steps to ensure the compliance of the close cor-
poration with any of these provisions, shall be guilty of an offence. The members of a
close corporation may entrust the duty of ensuring that the close corporation complies
with the provisions of the Close Corporations Act in respect of accounting records to a
competent and reliable person, such as the appointed accounting officer.
5.12.1.2 Financial year and financial statements
A close corporation must specify the date on which its financial year will end in its
founding statement. This date may be changed to any other date by lodging an
amended founding statement with the Commissioner for registration. A close corporation
may not change the date of its financial year-end more than once in any financial year.
The members of a close corporation must ensure that the financial statements of the
close corporation are prepared within nine months after the end of every financial year
of the corporation, in respect of that financial year.
The Close Corporations Act requires that annual financial statements shall consist of a
statement of financial position and any notes thereto and a statement of profit or loss
and other comprehensive income or any similar financial statement where such form is
appropriate, any notes thereto, and a report from the accounting officer.
The Close Corporations Act also requires that the annual financial statements be in
conformity with IFRS, appropriate to the business of the corporation, and fairly present
the state of affairs of the close corporation at the financial year-end, as well as the
results of its operations for that year. Since “fair presentation” is specifically required
by the Close Corporations Act, it can be regarded as the underlying requirement when
the financial statements of a close corporation are prepared.
l The members of a corporation shall, within nine months after the end of every
financial year of the corporation, cause annual financial statements in respect of
that financial year to be made out in one of the official languages of the Republic.
l The annual financial statements of a close corporation:
• shall consist of:
– a statement of financial position and any notes thereon; and
– a statement of profit or loss and other comprehensive income or any similar
financial statement where such form is appropriate, and any notes thereon;
Chapter 5: Close corporations 243
l whether, at the time of the resignation or removal from office, the accounting officer
was aware of any matters pertaining to the financial affairs of the corporation which
contravened the provisions of the Close Corporations Act. If this is the case, the
accounting officer must submit the full particulars thereof in writing to the Commis-
sioner.
The Close Corporations Act stipulates that a new accounting officer should be appointed
within 28 days of the resignation of the existing accounting officer. If the office of an
accounting officer is vacant for a period of six months, any person who at any time
during that period was a member of the close corporation and aware of the vacancy
and who at the expiration of that period still is a member, is liable for all the debts
incurred by the close corporation while the position was vacant. Such a member, if he
still is a member, is also liable for every debt incurred by the close corporation after
the expiration of that period and whilst the vacancy continues.
(c) Right of access and remuneration
An accounting officer has the right of access to the accounting records and all the
books and documents of the close corporation. An accounting officer also has the
right to require such information and explanations which he deems necessary from
members for the performance of his duties as an accounting officer. The remuneration
of an accounting officer must be determined by agreement with the close corporation.
(d) Duties
An accounting officer must, not later than three months after completion of the financial
statements:
l determine whether the financial statements agree with the accounting records;
l review the appropriateness of the accounting policies which were represented to
the accounting officer as having been applied in the preparation of the financial
statements; and
l report to the close corporation on the above matters.
Should an accounting officer find any contravention of a provision of the Close Corpor-
ations Act, he must describe the nature of such contravention in his report, irrespective
of whether it is material or not.
An accounting officer must also state in his report if he is a member or employee of the
close corporation. Where the accounting officer is a firm of which a partner or employee
is a member or employee of the close corporation, the report of such accounting officer
must state that fact.
Should an accounting officer at any time know or have reason to believe that the close
corporation is not carrying on business or is not in operation and does not plan to
resume its business or operations within the foreseeable future, he should immediately
report such a situation to the Commissioner by registered post.
If an accounting officer, during the performance of his duties, finds that any change in
the relevant founding statement during a relevant financial year has not been regis-
tered, or that the financial statements indicate that the liabilities of the close corpora-
tion exceed its assets at the end of the financial year concerned, he must immediately
246 About Financial Accounting: Volume 2
report thereon to the Commissioner by registered post. The accounting officer shall
also report to the Commissioner by registered post if the financial statements incor-
rectly indicate that the assets of the close corporation exceed its liabilities at the end of
the financial year concerned.
interest score or activity test would require an audit. Should an audit of the close cor-
poration not be required in terms of the Regulations, the requirement is waived unless
the financial statements are internally (not independently) compiled.
An audit involves tests of controls and substantive procedures and provides an opin-
ion that has the highest level of assurance on an entity’s financial statements. An
independent review, on the other hand, involves only an enquiry and analytical pro-
cedures and provides limited assurance of an entity’s financial statements.
5.12.2.3 Audit requirement
The Regulations provide for both activity and size criteria to be used to determine
whether or not close corporations require audited financial statements.
The requirements for close corporations to have their financial statements audited are
as follows:
l if any close corporation in the ordinary course of its primary activities, holds assets
in a fiduciary capacity for persons who are not related to the close corporation,
and the aggregate value of such assets held at any time during the financial year
exceeds R5 million (activity test);
l if any close corporation has a public interest score in that financial year of
(i) 350 or more; or
(ii) at least 100 but less than 350, and its annual financial statements for that
year were internally compiled.
The activity test relates to the primary activities of the close corporation, not inci-
dental/resulting activities, and specifically states “in a fiduciary capacity”. For exam-
ple, assume a close corporation operates as an estate agency – the holding of funds
in trust is incidental to the primary business and not in a fiduciary capacity. The Com-
panies Act would thus not require an audit on this basis, but laws applicable to Estate
Agents might well require an audit.
Where the accounting officer is not related to the close corporation, an audit is not
required as the statements were not internally compiled as stated in (ii) above.
5.12.2.4 Independent review
As previously mentioned, if a close corporation obtains a PIS of 100 to 350, an audit is
required if the annual financial statements were internally compiled. However, should
the close corporation not require an audit in terms of the regulations, the requirement
for an independent review is not applicable as the new section 58(2A) states the
sections applicable to close corporations and the exemption in section 30(2A) is not
included. Close corporations are not scoped into the independent review requirement.
5.12.2.5 Trusts as members of close corporations
The Regulation requires close corporations to assess the specific circumstances
where a trust is a member of a close corporation. The trust deed must be evaluated to
confirm whether the trustees, benefactors and/or beneficiaries have a beneficial inter-
est in the close corporation and are members of the close corporation. Whichever
party/ies are deemed to have a direct or indirect interest in the close corporation
would need to be included in the computation of the public interest score.
248 About Financial Accounting: Volume 2
Accounting
Public Interest Score Financial Reporting Independent
Audit Officer’s
(PIS) Standard Review
Report
PIS 350 IFRS / IFRS for SMEs YES NO YES
PIS 100 and < 350 IFRS / IFRS for SMEs YES NO YES
and AFS internally
compiled
PIS 100 and < 350 IFRS / IFRS for SMEs NO NO YES
and AFS independently
compiled
PIS < 100 and AFS IFRS / IFRS for SMEs NO NO YES
independently compiled
PIS < 100 and AFS The Financial Reporting NO NO YES
internally compiled Standard as determined
by the close corporation
for as long as no specific
Financial Reporting Stand-
ard is prescribed
the distribution to members payable account is debited and the bank account credited
with the amount paid. These three journal entries are reflected below:
General journal
Debit Credit
R R
Distribution to members XXX
Distribution to members payable XXX
Recording of the provision for a distribution of total
comprehensive income to members
Retained earnings XXX
Distribution to members XXX
Closing off the distribution to members account to the retained
earnings account
Distribution to members payable XXX
Bank XXX
Recording of the payment of a distribution of total
comprehensive income to members
ments. The following information pertaining to Soccer Traders CC, for the year ended
28 February 20.2, is presented to you:
2. Additional information:
2.1 The depreciation on equipment for the year amounted to R41 250 and was
correctly accounted for in the records of the entity.
2.2 The land and buildings were purchased on 1 March 20.1 for R210 000 (land
R50 000 and buildings R160 000). There were no disposals of, or additions to
the land and buildings and equipment during the year.
2.3 The investment at Safa Bank was made on 1 May 20.0 for 24 months at 12%
interest per annum. The interest is receivable in cash, every six months, on
31 October and 30 April. Mr Arendse correctly accounted for the interest
received in the accounting records but left the close corporation before com-
pleting any interest provision.
2.4 The loan from Dean Fairman is unsecured and the first instalment of R15 000
is payable on 28 February 20.3.
Chapter 5: Close corporations 251
2.5 The current income tax for the year amounted to R50 570 and must still be
recorded.
2.6 A further profit distribution of R20 000 must be made to each member.
2.7 The long-term loan from UAE Bank was obtained on 1 March 20.0 at 15% in-
terest per annum and is secured by a first mortgage over land and buildings.
The capital amount of the loan is repayable in total on 28 February 20.9. In-
terest on the loan is payable in cash on 2 March every year until the loan is re-
paid but must still be accounted for.
2.8 The loan to Itumeleng Khume is unsecured, interest free and immediately
callable.
Required:
With regard to Soccer Traders CC, prepare:
(a) The statement of changes in net investment of members for the year ended
28 February 20.2.
(b) The statement of financial position as at 28 February 20.2.
(c) The following notes for the year ended 28 February 20.2:
(i) Property, plant and equipment
(ii) Financial assets
(iii) Financial liabilities.
Your solution must comply with the requirements of the Close Corporations Act, 69 of
1984, and the requirements of IFRS. Comparative figures are not required.
Solution:
(a) Soccer Traders CC
Statement of changes in net investment of members for the year ended
28 February 20.2
Members’ Loan Loan
Retained
contribu- from to
earnings Total
tions member member
R R R R R
Balances at 1 March 20.1 350 000 138 600 70 000 (120 000) 438 600
Total comprehensive income for
the year c115 810 115 810
Distribution to members d(120 000) (120 000)
Balances at 28 February 20.2 350 000 134 410 70 000 (120 000) 434 410
Calculations
c Total comprehensive income for the year
R
Profit before tax (before any applicable additional information) 169 380
Interest income R(4 000 + (12% × 50 000 × 4 /12)) 6 000
Interest paid R(60 000 × 15%) (9 000)
Profit before tax 166 380
Income tax expense (50 570)
Profit for the year/Total comprehensive income for the year 115 810
d Distribution to members
R(32 000 + 48 000 + 40 000) = R120 000
(b) Soccer Traders CC
Statement of financial position as at 28 February 20.2
Note R
ASSETS
Non-current assets 312 680
Property, plant and equipment 1 312 680
Current assets 410 190
Inventories R(140 500 + 6 200) 146 700
Trade and other receivables R(70 440 – 3 000 + 2 000 + 3 500) 2 72 940
Fixed deposit 2 50 000
Loan to member 2 120 000
Cash and cash equivalents 2 700
Taxation receivable R(70 420 – 50 570) 2 19 850
The land and buildings serve as security for the long-term loan (refer note 3).
(2) Financial assets
Current financial assets R
Trade and other receivables: 69 440
Trade receivables control 70 440
Allowance for credit losses (3 000)
Accrued income: Interest on fixed deposit 2 000
Loan to member: The loan is unsecured, interest free and callable 120 000
Fixed deposit: 50 000
The fixed deposit at Safa Bank was made at 1 May 20.0 for 24 months at
12% interest per annum.
Cash and cash equivalents 700
Petty cash 700
Comment:
Prepaid expense is excluded from financial assets because it represents a right to
receive a service (rent) and not cash.
(3) Financial liabilities
R
Non-current financial liabilities at amortised cost
Long-term borrowings: 115 000
The long-term loan was acquired from UAE Bank at 1 March 20.0 at an
interest rate of 15% per annum. The loan is secured by a first mortgage over
land and buildings (refer note 1) and is repayable on 28 February 20.9. 60 000
Loan from member: 55 000
The loan is unsecured, interest free and repayable in instalments of R15 000,
the first on 28 February 20.3
continued
254 About Financial Accounting: Volume 2
R
Current financial liabilities
Trade and other payables: 47 340
Trade payables control 31 540
Accrued expenses R(6 800 + 9 000) 15 800
Current portion of loan from a member at amortised cost 15 000
Financial liabilities at fair value through profit or loss: 61 120
Bank overdraft 21 120
Distribution to members payable 40 000
Crazehill Enterprises CC
Pre-adjustment trial balance as at 28 February 20.5
Debit Credit
R R
Member’s contribution: Y Craig 31 250
Member’s contribution: D Zeelie 31 250
Member’s contribution: S Hill 31 250
Loans to member: Y Craig 62 500
Loans to member: S Hill 87 500
Loan from member: D Zeelie (1 March 20.4) 37 500
Land at valuation 150 000
Buildings at cost 400 000
Equipment (at cost) 118 750
Accumulated depreciation: Equipment (1 March 20.4) 20 000
Mortgage 75 000
Trade receivables control 32 813
Trade payables control 31 188
Retained earnings (1 March 20.4) 446 912
Revaluation surplus (1 March 20.4) 20 000
Bank 5 125
Petty cash 250
Investment in Watsons Ltd at fair value 100 000
Inventory (1 March 20.4) 21 250
Allowance for credit losses 2 500
Sales 874 700
Purchases 300 000
Telephone expenses 11 750
Stationery consumed 4 937
Salaries (employees) 150 000
Salaries (members) 90 000
Remuneration: Accounting officer 17 500
Carriage on purchases 10 250
Credit losses 3 875
Settlement discount received 525
Carriage on sales 11 250
SARS (Current income tax) 23 075
Settlement discount granted 1 838
Interest income (on favourable bank balance) 288
Allowance for settlement discount granted (1 March 20.4) 300
1 602 663 1 602 663
Additional information:
1. Provision must still be made for depreciation on equipment at 20% per annum
according to the diminishing balance method. Included in the equipment at cost
account is a machine which was purchased on 1 September 20.4 for R18 750
cash, and immediately put to use. No other purchases or sales of equipment
occurred during the year.
2. Land and buildings consist of a shop and offices on Plot No. 40, situated in Menlyn,
and purchased on 4 July 20.2 at a cost of R480 000 (R130 000 land and R350 000
256 About Financial Accounting: Volume 2
14. The balance of the allowance for settlement discount granted account on 1 March
20.4 must be written back since the trade debtor to whom the discount offering
pertained did not settle his account as required. On 28 February 20.5 a trade deb-
tor who owes R3 400 was offered a 5% settlement discount, on condition that she
settles her account before 15 March 20.5. This offering must still be provided for.
15. Crazehill Enterprises CC was offered a discount of 4% on an amount of R1 300
owing to a supplier provided it pays the supplier before 15 March 20.5. At the
date of the transaction, the close corporation did not intend to take the settlement
discount offer. However, at year end and due to sufficient cash flow, the close
corporation decided to take advantage of this offer.
16. The current income tax in respect of the financial year amounted to R67 042 and
must still be recorded.
Required:
With regard to Crazehill Enterprises CC, prepare:
(a) The statement of profit or loss and other comprehensive income for the year
ended 28 February 20.5.
(b) The statement of changes in net investment of members for the year ended
28 February 20.5.
(c) The statement of financial position as at 28 February 20.5.
(d) The notes for the year ended 28 February 20.5.
Your solution must comply with the provisions of the Close Corporations Act, 69 of
1984, and the requirements of IFRS. Comparative figures are not required.
258 About Financial Accounting: Volume 2
Solution:
(a) Crazehill Enterprises CC
Statement of profit or loss and other comprehensive income for the
year ended 28 February 20.5
Note R
Revenuec 9 872 992
Cost of sales (319 236)
Inventory (1 March 20.4) 21 250
Purchasesd 299 423
Carriage on purchases R(10 250 + 938) 11 188
331 861
Inventory (28 February 20.5) (12 625)
610 294
Distribution, administrative and other expenses (323 115)
Credit lossesg 4 491
Carriage on sales R(11 250 + 312) 11 562
Salaries to employees 150 000
Salaries to members R(90 000 + 15 000) 3 105 000
Telephone expenses 11 750
Stationery consumed 4 937
Remuneration: Accounting officer 17 500
Depreciationh 2, 3 17 875
Finance costsi (21 000)
Interest on mortgage 6 13 500
Interest on loan from member 8 7 500
* Since the information is not applicable in this example, these items are included for illustrative purposes
only.
Comment:
In compliance with paragraph .81 of the Guide on Close Corporations, the members’
contributions and the movements that pertain thereto are not disclosed per member,
as is the case with partners in a partnership. The reason for this is that a close corpor-
ation is regarded as an independent legal entity. The ownership of the assets which
were contributed as capital by the members to the close corporation is therefore
vested in the close corporation, and not in the individual members thereof.
260 About Financial Accounting: Volume 2
The land and buildings consist of a shop and offices on Plot No. 40, Menlyn, pur-
chased on 4 July 20.2. The land was revalued during the year by a sworn apprais-
er. The land and buildings serve as security for the mortgage (refer to Note 6).
4. Financial assets
20.5
R
Trade and other receivables: 44 527
Trade receivables control 31 260
Allowance for credit losses (1 563)
Allowance for settlement discount granted (170)
Accrued income (dividends receivable) 15 000
Loans to members. 171 250
The loans are unsecured and carry interest at 15% per annum. The loans
are immediately callable.
Listed investment held for trading at fair value through profit or loss: 120 000
50 000 ordinary shares in Watsons Limited (consideration R90 000)
Cash and cash equivalents: 5 375
Bank 5 125
Petty cash 250
341 125
5. Loans to members
Y Craig S Hill Total
R R R
Balance at 1 March 20.4 62 500 62 500 125 000
Advances during the year – 25 000 25 000
Repayments during the year – – –
Interest capitalised 9 375 11 875 21 250
Balance at 28 February 20.5 71 875 99 375 171 250
Chapter 5: Close corporations 263
6. Financial liabilities
20.5
R
Non-current financial liabilities at amortised cost 120 000
Long-term borrowings: Mortgage 75 000
The mortgage was acquired from City Bank at 1 March 20.4 at an
interest rate of 18% per annum. The loan is repayable in five equal
instalments as from 1 January 20.8. The loan is secured by a first
mortgage over land and buildings (refer to Note 3)
Loans from members: 45 000
The loans from members are unsecured and carry interest
at 20% per annum. The loans are repayable in February 20.10
Current financial liabilities 135 886
Trade and other payables 68 386
Trade payables control 31 188
Allowance for settlement discount received (52)
Accrued expenses 37 250
Current portion of loans from members at amortised cost 67 500
255 886
9. Revenue
R
20.5
Sale of goods 874 700
Forfeited settlement discount written back 300
Settlement discount granted (1 838)
Allowance for settlement discount granted – 2.05 (170)
872 992
Calculations:
c Revenue R
Sales 874 700
Settlement discount granted [R1 838 + (R3 400 × 5%)] (2 008)
Allowance for settlement discount granted – 20.4 300
872 992
d Purchases
Purchases 300 000
Settlement discount received (R525 + R1 300 × 4%) (577)
299 423
e Dividend income
50 000 shares × R0,30 15 000
f Income (loans to members)
Y Craig
R62 500 × 15% 9 375
S Hill
R62 500 × 15% 9 375
R25 000 × 15% × 8/12 2 500
21 250
g Credit losses and allowance for credit losses
Allowance for credit losses: Opening balance (given) 2 500
Allowance for credit losses: Closing balance (given) (1 563)
Decrease in the allowance for credit losses 937
Calculation of credit losses:
Credit losses per trial balance 3 875
Additional amount written off 1 553
Decrease in allowance for credit losses (937)
Total 4 491
Chapter 5: Close corporations 265
h Depreciation: Equipment
R18 750 × 20% × 6/12 1 875
R(118 750 – 18 750 – 20 000) × 20% 16 000
Total 17 875
i Finance costs
Interest on mortgage (R75 000 × 18%) 13 500
Interest on loan from member: D Zeelie (R37 500 × 20%) 7 500
Total 21 000
j Trade and other receivables
Trade receivables control R(32 813 – 1 553) 31 260
Allowance for credit losses (1 563)
Allowance for settlement discount granted (170)
29 527
Accrued income (dividends receivable) 15 000
Total 44 527
k Trade and other payables
Trade payables control 31 188
Allowance for settlement discount received (52)
31 136
Accrued expenses: 37 250
Carriage on purchases 938
Carriage on sales 312
Interest on loan from member (R37 500 × 20%) 7 500
Salary: Hill 15 000
Interest on mortgage (R75 000 × 18%) 13 500
Total 68 386
l Interest income
Interest on loans to members (Refer to calculation f) 21 250
Interest on bank account 288
Total 21 538
l the Commissioner has reason to believe that a close corporation is not carrying on
business or is not in operation.
When the abovementioned period of 60 days has expired, and the Commissioner has
received no written reply from the close corporation to the effect that it is still carrying
on business or is in operation, the Commissioner may deregister the close corporation.
The Commissioner may also deregister the close corporation if a written statement,
signed by or on behalf of every member, has been received from the close corporation
to the effect that the close corporation has ceased to carry on its business or is not in
operation, and that the close corporation has no assets or liabilities.
When a close corporation is deregistered, the Commissioner cancels the registration
of its founding statement and gives notice thereof in the Government Gazette. The
date of deregistration will be the date on which the Government Gazette was pub-
lished.
Deregistration of a close corporation does not affect any liability of a member of the
close corporation, to the close corporation or to any other person. Such a liability may
be enforced as if the close corporation was still registered.
Should a close corporation be deregistered whilst having outstanding liabilities, the
members of the close corporation at the time of its deregistration shall be jointly and
severally liable for such liabilities.
5.14 Summary
In this chapter, the close corporation as a form of business entity was discussed.
Contrary to a sole proprietor and a partnership, a close corporation is an independent
juristic person which ensures that it does not cease to exist merely because of a
change in the ownership thereof, provided that such a change is in conformity with the
requirements of the Close Corporations Act. Since a close corporation is regarded as
a juristic person, it provides limited liability to its members. In addition, a close cor-
poration is, in comparison to a company, relatively simple to administer and the mem-
bers thereof are, in contrast to the shareholders of a limited company, in the position to
personally manage the close corporation.
The members of a close corporation are usually only natural persons, and the number
of members may never exceed ten. A close corporation must always have at least one
member. The above attributes of a close corporation suit the needs of a small busi-
ness entity which predominantly requires stability as a going concern, protection to its
owners in respect of the liabilities of the enterprise, relatively simple administration
and, to a certain extent, flexibility. These attributes apply specifically to a close cor-
poration, since neither a sole proprietor, nor a partnership or a company can meet all
of these needs. A close corporation also has disadvantages, for example, a member
can commit the close corporation to injudicious transactions, and the restricted num-
ber of members can inhibit the growth of a close corporation.
The Close Corporations Act, 69 of 1984 concurrent with the Companies Act, 71 of
2008, provides the legislative requirements pertaining to close corporations. An over-
view of the following parts of the Acts were given in this chapter: the formation and
juristic personality of a close corporation; Companies Act Regulations applicable to
Chapter 5: Close corporations 267
financial statements are in agreement with the accounting records of the corporation,
and whether the accounting policies that were represented to him as having been
applied in the preparation of the annual financial statements are appropriate. Should
an accounting officer find any contravention, irrespective of the significance thereof, to
a provision in the Close Corporations Act, he must describe the nature of such contra-
vention in his report.
It is the responsibility of the members of a close corporation to ensure that the financial
statements are prepared within nine months after the end of every financial year of the
corporation, in respect of that financial year.
In conclusion, certain statutory requirements in respect of deregistration of a close
corporation were discussed. Under normal circumstances, a close corporation which
ceases to carry on business or which is no longer in operation, will be deregistered. If
a close corporation has failed to lodge an Annual Return in compliance with the pro-
visions of the Close Corporations Act for a period longer than six months, it may also be
deregistered. When a close corporation is deregistered, the registration of its founding
statement is cancelled. Deregistration of a close corporation may not affect any liability
of a member of the close corporation to the close corporation or to any other person.
Should a close corporation be deregistered whilst having outstanding liabilities, the
members of the close corporation at the time of its deregistration are jointly and sever-
ally liable for the payment of such liabilities.
CHAPTER 6
Introduction to companies
Contents
Page
Overview of the introduction to companies ............................................................ 271
6.1 Introduction ................................................................................................... 273
6.2 Characteristics of a profit company .............................................................. 276
6.3 The formation (incorporation) of a profit company ....................................... 276
6.4 Types of companies ..................................................................................... 277
6.4.1 Profit companies .............................................................................. 277
6.4.1.1 Personal liability companies ............................................ 277
6.4.1.2 State-owned companies ................................................. 277
6.4.1.3 Private companies ........................................................... 277
6.4.1.4 Public companies ............................................................ 277
6.4.2 Non-profit companies ...................................................................... 278
6.5 Shareholders ................................................................................................. 278
6.6 The rights of shareholders ............................................................................ 278
6.6.1 The right to sell or buy shares in the company ............................... 278
6.6.2 The right to vote ............................................................................... 278
6.6.3 The right to receive a share of the profits ........................................ 279
6.6.4 The right to share in the net assets ................................................. 279
6.7 Share transactions ........................................................................................ 279
6.7.1 Introduction...................................................................................... 279
6.7.2 Authorised share capital.................................................................. 279
6.7.3 Issued share capital ........................................................................ 280
6.7.4 Classes of shares ............................................................................ 280
6.7.4.1 Ordinary shares ............................................................... 280
6.7.4.2 Preference shares ........................................................... 280
6.7.5 The issue of shares.......................................................................... 281
6.7.5.1 General aspects .............................................................. 281
6.7.5.2 Recording the issue of shares ........................................ 282
6.7.6 Schedule for the allotment of shares ............................................... 287
6.7.7 The issue of capitalisation shares ................................................... 289
6.7.8 Underwriting of shares .................................................................... 291
6.8 Dividends ...................................................................................................... 294
6.8.1 Introduction...................................................................................... 294
6.8.2 Preference dividends ...................................................................... 294
6.8.3 Ordinary dividends .......................................................................... 295
6.8.4 Interim, final and annual dividends ................................................. 295
269
270 About Financial Accounting: Volume 2
Page
6.9 Debenture transactions ................................................................................ 296
6.9.1 Introduction...................................................................................... 296
6.9.2 Types of debentures........................................................................ 297
6.9.3 The issue of debentures .................................................................. 297
6.10 Annual financial statements of companies ................................................... 311
6.10.1 Introduction...................................................................................... 311
6.10.2 Disclosure ........................................................................................ 312
6.10.3 Form and general contents of published annual financial
statements ....................................................................................... 312
6.11 Summary ....................................................................................................... 322
Chapter 6: Introduction to companies 271
A Company is:
an association of persons working
together to make a profit;
a legal entity;
independent of its owners (shareholders).
Capital
Ordinary shares
Debentures
Preference shares
Issue of shares
6.1 Introduction
STUDY OBJECTIVES
Of all the forms of business ownership, companies are the dominant form. The ability
of a company to attract and accumulate significant amounts of capital, together with
other attributes such as the limited liability of its owners, unlimited life span and com-
prehensive corporate legislation, contributes largely to this dominant role.
The purpose of this chapter is to serve as an introduction to companies and is not
intended to be a comprehensive explanation. The scope of this textbook covers the
financial statements of companies, appropriate to an introductory accounting know-
ledge level. In this chapter, the important aspect of share capital as the main equity
instrument of a company is discussed. This is the aspect where companies differ
mainly from other forms of business ownership and a sound understanding of the issue
of shares and debentures forms a solid foundation for future accounting studies.
A company is described as an association of persons working together with a view
towards making profit. A company is a legal entity incorporated in terms of legislation
and is independent of its owners, who are called shareholders. As a legal entity, a
company has continuous existence which is separate from that of its shareholders. The
274 About Financial Accounting: Volume 2
legal status of a company implies that by law it has the same legal status as that of a
natural person with contractual capacity. The company can have rights and obligations
in its own name, it can enter into contracts with other persons (natural or legal) and it
can be sued or sue others. As a separate legal entity, the company is a taxpayer and
pays tax at the prescribed rate for companies.
In South Africa, all matters pertaining to companies are regulated by the Companies
Act, 71 of 2008 (hereafter referred to as the “Companies Act”). The Companies Act
came into effect on 1 May 2011. The Companies Act, in terms of which a company is
established, consists of nine chapters containing 225 sections. In addition to the initial
nine chapters there are five schedules. The purpose of these schedules is to give
guidelines, procedures and additional requirements regarding various aspects of com-
panies. For financial reporting purposes, Chapter 2 and schedules 2 and 5 are the
most important sections of the Act and we will deal with some of these sections in this
chapter.
In addition to the Companies Act, the Companies Amendment Act, 3 of 2011 (hereafter
referred to as the Amendment Act) was assented by the presidency and was pub-
lished in the Government Gazette on 26 April 2011. The amendment Act rectifies
anomalties and errors in the Companies Act and needs to be read together with the
Companies Act. Further amendments have been incorporated in the recently issued
Companies Amendment Bill 2018.
Over and above the two acts mentioned above, the Minister of Trade and Industry has
published the Companies Regulations which took effect on the same day as the Com-
panies Act.
Section 7 of the Companies Act lists the purposes of the act and inter alia, includes the
following:
l promoting compliance with the Bill of Rights with respect to company law;
l providing for the development of the economy by encouraging entrepreneurship;
l providing for the incorporation, registration, organisation and management of
companies;
l balancing the rights and obligations of shareholders and directors;
l providing a predictable and effective environment for the regulation of companies;
and
l protecting the interests of third parties who deal with the company, for example
trade and other creditors.
The Companies Act, 71 of 2008, is characterised by flexibility, simplicity, transparency
corporate efficiency and regulatory certainty and is drafted in plain language for ease
of understanding.
The Companies Act is administered by the Companies and Intellectual Property Com-
mission ((CIPC) hereinafter referred to as the Commission) who is responsible for
registering companies and must also ensure that that all the legal requirements with
regards to companies are adhered to.
The following table illustrates the main differences between a company and other
forms of business ownership:
Chapter 6: Introduction to companies 275
a public company must end with the word “Limited” or its abbreviation “Ltd.”. The in-
corporators of a public company must at least be one person and this person can,
according to Section 1, also be a juristic person. This type of company must at least
have three directors. A public company can also be listed on the Johannesburg Secur-
ities Exchange Limited (abbreviated as JSE Limited) where trading of shares and other
security commodities normally takes place. A public company that trades its shares on
the JSE Limited is also referred to as a “listed company”.
6.5 Shareholders
In order to raise capital, a profit company issues security, usually in the form of shares,
to investors. According to Section 1 of the Companies Act, a share means one of the
units into which the proprietary interest in a profit company is divided. A share issued
by a company is moveable property and can be transferred in accordance with the
manner provided in Section 35(1) of the Companies Act. The term “securities” was
defined in paragraph 6.3 and includes shares. By purchasing shares, an investor
becomes a shareholder of the company and thus acquires equity (proprietary interest)
in the company. Any person with contractual capacity may become a shareholder of a
company. This includes other legal persons, which implies that one company may
become a shareholder in another company. According to the share structure of a com-
pany, all or at least a very large percentage of the shares of a company will be ordin-
ary shares held by ordinary shareholders (refer to paragraph 6.7.4.1 for a discussion
on ordinary shares).
there are shares available for issue, the company has an under-subscription of its
shares. This means that the company is unable to obtain the necessary capital. To
overcome the risk of under-subscription, a company can make use of underwriters
(refer to paragraph 6.7.8).
The Companies Act prohibits the company from allocating shares for which the full
purchase price has not been received and also prohibits the company from allocating
more shares than were originally offered to the public, even if the authorised capital is
more than the shares offered for issue.
6.7.5.2 Recording the issue of shares
There are three basic transactions which must be recorded when shares are issued:
l recording of the receipt of applications to subscribe for shares – remember that
the applicants must submit full payment together with their application forms;
l allotting shares to successful applicants; and
l returning the money of unsuccessful applicants.
As already mentioned the first issue is to the incorporators. Only after allotment of
these shares can the company proceed to issue shares to the public.
The basic account used to record all applications for the shares offered and eventually
the allotment of the shares to shareholders, is the application and allotment account.
The application and allotment account is an interim account which is only used to
record the subscription money received from potential shareholders and eventually to
allot shares to shareholders. After the allotment of shares and the refund to unsuccessful
applicants, this account is closed off to the applicable share capital account. The
following examples will illustrate the recording of the issue of shares in the books of a
public company.
Example 6.1 Issue of different classes of shares
Sparkle Ltd was registered on 1 June 20.5 with an authorised share capital consisting
of the following:
350 000 ordinary shares;
100 000 10% preference shares. All shares are no par value shares (NPV).
The company offered 50 000 ordinary shares, valued by the board of directors at
R50 000, to the incorporators of the company, all of which was taken up and paid for
on 1 June 20.5.
The company offers the following shares for subscription to the public:
200 000 ordinary shares, valued by the board of directors at R200 000.
50 000 10% preference shares, valued by the board of directors at R100 000.
The application closed on 1 August 20.5. The public took up the full offering of shares
which was allotted on 3 August 20.5.
Required:
Record the issue of the shares in the general journal of Sparkle Ltd. Post the journal to
the relevant accounts in the general ledger. Balance/close off all accounts.
Chapter 6: Introduction to companies 283
Solution:
Sparkle Ltd
General journal
Debit Credit
20.5 R R
Jun 1 Bank 50 000
Incorporators: Ordinary shares 50 000
Receipt of application money from incorporators of the
company
Incorporators: Ordinary shares 50 000
Share capital: Ordinary shares 50 000
Allotment of 50 000 ordinary shares to the incorpora-
tors of the company
Aug 1 Bank 300 000
Application and allotment: Ordinary shares 200 000
Application and allotment: 10% preference shares 100 000
Receipt of application money from the public
3 Application and allotment: Ordinary shares 200 000
Application and allotment: 10% preference shares 100 000
Share capital: Ordinary shares 200 000
Share capital: 10% preference shares 100 000
Allotment of 200 000 ordinary shares and 50 000
10% preference shares
Sparkle Ltd
General ledger
Dr Bank Cr
20.5 R 20.5 R
Jun 1 Incorporators: Aug 31 Balance c/d 350 000
Ordinary shares 50 000
Aug 1 Application and
allotment:
Ordinary shares 200 000
Application and
allotment:
10% preference
shares 100 000
350 000 350 000
Sep 1 Balance b/d 350 000
continued
284 About Financial Accounting: Volume 2
30 Applications were received for 260 000 ordinary shares, (R780 000) and
50 000 preference shares. The full offering of the 250 000 ordinary shares
and 50 000 preference shares was allotted and excess application
moneys repaid.
31 The company paid R10 000 towards share-issue expenses.
Required:
Record the transactions with regard to the issue of the shares in the general journal of
Pinco Ltd for March 20.6. Post the journal to the relevant accounts in the general ledger.
Balance/close off all accounts.
Solution:
Pinco Ltd
General journal
Debit Credit
20.6 R R
Mar 2 Bank 110 000
Incorporators: Ordinary shares 60 000
Incorporators: Preference shares 50 000
Receipt of application money from incorporators of
the company
20.6
Mar 2 Incorporators: Ordinary shares 60 000
Incorporators: Preference shares 50 000
Share capital: Ordinary shares 60 000
Share capital: 8% preference shares 50 000
Allotment of 20 000 ordinary shares and 10 000 8%
preference shares to incorporators of the company
30 Bank R(780 000 + 250 000) 1 030 000
Application and allotment: Ordinary shares 780 000
Application and allotment: 8% preference shares 250 000
Receipt of application money from the public
Application and allotment: Ordinary shares 750 000
Application and allotment: 8% preference shares 250 000
Share capital: Ordinary shares 750 000
Share capital: 8% preference shares 250 000
Allotment of 250 000 ordinary shares and 50 000 8%
preference shares
Application and allotment: Ordinary shares 30 000
R(780 000 – 750 000)
Bank 30 000
Cash refunded to unsuccessful applicants
31 Share-issue expenses 10 000
Bank 10 000
Payment of share-issue expenses
286 About Financial Accounting: Volume 2
Pinco Ltd
General ledger
Dr Bank Cr
20.6 R 20.6 R
Mar 2 Incorporators: Mar 30 Application and
Ordinary allotment:
shares 60 000 Ordinary
Incorporators: shares 30 000
Preference 31 Share-issue
shares 50 000 expenses 10 000
30 Application and Balance c/d 1 100 000
allotment:
Ordinary
shares 780 000
Application and
allotment:
8% preference
shares 250 000
1 140 000 1 140 000
Apr 1 Balance b/d 1 100 000
continued
Chapter 6: Introduction to companies 287
Dr Share-issue expenses Cr
20.6 R
Mar 31 Bank 10 000
On 1 April 20.9, the company had received applications for 242 000 shares (total value
R290 400). With a view of retaining control and to ensure an active market for the
shares, the following allotment schedule was approved and ratified at a meeting of the
board of directors. Shares will be allotted in units of 100 shares per unit.
Group 1: Applications for 100 to 400 shares each, will be granted in full.
Group 2: Applications for 500 to 900 shares each, will be granted at 60% of the
shares applied for.
Group 3: Applications of 1 000 shares and more each, will be granted at 50% of the
shares applied for.
The following is a breakdown of the applications received.
On 15 April 20.9, all the available shares were allotted, and the money repaid to un-
successful applicants.
Required:
(a) Prepare the allotment schedule for the allocation of the 180 000 ordinary shares.
(b) Record the application, allotment and issue of the shares in the general journal of
the company for April 20.9.
Solution:
(a) Allotment schedule: Ordinary shares
Number of Total number Received Cash repaid to
Shares
Group applications of shares from unsuccessful
allotted
in group applied for applicants applicants
R R
1 550 1 97 000 3 116 400 5 97 000 8
Calculations:
1 250 + 200 + 80 + 20 = 550
2 100 + 50 = 150
3 25 000 + 40 000 + 24 000 + 8 000 = 97 000
4 60 000 + 45 000 = 105 000
5 97 000/180 000 × R216 000 = R116 400 or 97 000/242 000 × R290 400 = R116 00
6 105 000/180 000 × R216 000 = R126 000 or 105 000/242 000 × R290 400 =
R126 000
7 40 000/180 000 × R216 000 = R48 000 or 40 000/242 000 × R290 400 = R48 000
8 97 000 × 100% = 97 000
9 105 000 × 60% = 63 000
10 40 000 × 50% = 20 000
11 R126 000 – (63 000/180 000 × R216 000) = R50 400 or 40% × R126 000 =
R50 400
12 R48 000 – (20 000/180 000 × R216 000) = R24 000 or 50% × R48 000 = R24 000
Capitalisation shares, often referred to as “bonus shares”, are issued to existing share-
holders in the same proportion as their current shareholding. Since the issue of capital-
isation shares is regarded as a bonus to shareholders, no payment is received from
shareholders for these shares and only an accounting entry is necessary to record the
issue.
Capitalisation shares can be issued by utilising distributable reserves such as retained
earnings. If a company has significant retained earnings, it may want to enable share-
holders to derive a tangible benefit from the retained earnings without negatively
affecting the company’s cash flow position by issuing dividends which is payable in
cash (refer to paragraph 6.8). The company can decide to distribute some of the
retained earnings to the shareholders in the form of capitalisation shares. In effect, it
means that the retained earnings are capitalised and will now form part of the share
capital of the entity. The immediate benefit for the shareholders is that they acquire
additional shares in the company without having to pay for them.
Example 6.4 Issue of capitalisation shares – utilising retained earnings
Echo Ltd, with an issued share capital of 10 000 8% preference shares and 30 000
ordinary shares (all shares are NPV shares), had a credit balance at 30 September
20.7 of R10 000 in the retained earnings account. At a general meeting of the compa-
ny it was decided that, in order to protect the liquidity of the company, there will be no
cash pay-out of dividends. Instead, the company will issue capitalisation shares to
shareholders in the ratio of one capitalisation share for every five preference shares
held, and one additional capitalisation share for every six ordinary shares held. The
board of the company deemed that a fair consideration for the preference shares
would be R2 000 and that of the ordinary shares would be R5 000.
Required:
(a) Calculate the number of capitalisation shares of each class which must be issued
to shareholders.
(b) Calculate the amount of distributable reserves that would be needed by the com-
pany to fulfil its obligation to shareholders.
(c) Record the capitalisation issue in the general journal of the company.
Solution:
(a) Number of capitalisation shares to be issued
Preference shares:
10 000/5 = 2 000 shares to be issued
Ordinary shares:
30 000/6 = 5 000 shares to be issued
(b) Reserves required
R
2 000 preference shares 2 000
5 000 ordinary shares 5 000
7 000
Chapter 6: Introduction to companies 291
Solution:
Benson Ltd
General journal
Debit Credit
20.7 R R
Sep 1 Bank 10 000
Incorporators: Ordinary shares 10 000
Receipt of application money from the incorporators
of the company
Incorporators: Ordinary shares 10 000
Share capital: Ordinary shares 10 000
Allotment of 10 000 ordinary shares to the incorpor-
ators of the company
Sep 15 Underwriters’ commission (R125 000 × 1%) 1 250
Abco Underwriters Ltd 1 250
1% underwriters’ commission due on R125 000 in
terms of underwriter’s agreement
Oct 15 Bank * 112 500
Application and allotment: Ordinary shares 112 500
Receipt of application money from the public
Oct 18 Application and allotment: Ordinary shares 112 500
Share capital: Ordinary shares 112 500
Allotment of 90 000 ordinary shares
Abco Underwriters Ltd ** 12 500
Share capital: Ordinary shares 12 500
Allotment of 10 000 ordinary shares to Abco Under-
writers Ltd
Oct 31 Bank 11 250
Abco Underwriters Ltd (12 500 – 1 250) 11 250
Balance paid by Abco Underwriters
Share-issue expenses 4 000
Bank 4 000
Share-issue expenses paid
Profit or loss 5 250
Underwriters’ commission 1 250
Share-issue expenses 4 000
Expenses written off to profit or loss
* 90 000 / 100 000 × R125 000 = R112 500
**10 000 / 100 000 × R125 000 = R12 500 or R(125 000-112 500) = R12 500
Chapter 6: Introduction to companies 293
Benson Ltd
General ledger
Dr Bank Cr
20.7 R 20.7 R
Sep 1 Incorporators: Oct 31 Share-issue
Ordinary shares 10 000 expenses 4 000
Oct 15 Application and Balance c/d 129 750
allotment:
Ordinary shares 112 500
31 Abco Underwriters
Ltd 11 250
133 750 133 750
Nov 1 Balance b/d 129 750
continued
294 About Financial Accounting: Volume 2
Dr Underwriters’ commission Cr
20.7 R 20.7 R
Sep 15 Abco Underwriters Oct 31 Profit or loss 1 250
Ltd 1 250
Dr Share-issue expenses Cr
20.7 R 20.7 R
Oct 31 Bank 4 000 Oct 31 Profit or loss 4 000
6.8 Dividends
6.8.1 Introduction
A dividend is a return on the shareholder’s original investment and is a distribution of
profits of the company to shareholders in the ratio in which shares are held. A dividend
can only be paid from profits that are available for distribution. The profit made during
previous trading periods and credited to retained earnings may be added to the profit
of the current year to arrive at a sum on which the dividends can be based. The com-
pany’s solvency and liquidity test should verify the fact that it has adequate cash
resources to pay the dividends. However, dividends need not necessarily be paid out
in cash, as discussed in paragraph 6.7.7.
A dividend is only due once it has been declared by the company. Before a dividend
can be declared, it must first be proposed by the directors of the company and ratified
by the shareholders at the annual general meeting. The directors also have to
announce a closing date for the share register and dividends are only payable to
shareholders whose names appear in the share register at the closing date of the
dividend declaration. These shareholders are referred to as the “registered sharehold-
ers of the company at the particular date”.
6.8.2 Preference dividends
Preference shareholders have a preferential right to dividends. This means that before
an ordinary dividend can be declared, preference shareholders have to receive their
dividend first. The dividend represents a fixed percentage of the value of preference
share capital (refer to paragraph 6.7.4.2). If no distributable reserves are available in
the particular year to declare a dividend, both ordinary and preference shareholders
forego their right to dividends, unless the preference shares are cumulative. A cumula-
tive preference shareholder retains the right to dividends from year to year, even if
dividends are not declared. When the company has sufficient distributable reserves
available to declare a dividend, arrear and current cumulative preference dividends
must be declared first, thereafter the ordinary preference dividends, and only then can
a dividend on ordinary share capital be declared.
Preference dividends are quoted as a fixed percentage of preference share capital
and the calculation of the dividend is done on the same principle as the calculation of
interest (period × dividend rate per annum × amount of issued preference share cap-
ital). For example, if a preference shareholder holds 200 10% preference shares with a
value of R5 each and acquired these shares six months before the closing of the share
register, the dividend he will receive amounts to R50 (200 × R5 × 10/100 × 6/12).
Chapter 6: Introduction to companies 295
On 15 March 20.7, the company made the necessary electronic fund transfers (EFT) to
its shareholders to pay the dividends declared.
Required:
Record the transactions with regard to the declaration and payment of dividends in the
general journal of ABC Ltd.
Solution:
ABC Ltd
General journal
Debit Credit
20.7 R R
Feb 15 Preference dividends [(R50 000 × 10/100) + (R50 000 7 500
× 10/100 × 6/12)]
Ordinary dividends (180 000 × R0,25 per share) 45 000
Dividends payable 52 500
Declaration of preference and ordinary dividends
Mar 15 Dividends payable 52 500
Bank 52 500
Payment of dividends to preference and ordinary
shareholders
Comments:
l Although no specific mention was made about the declaration of a dividend to
preference shareholders in the question, a company cannot declare a dividend to
ordinary shareholders unless it has sufficient distributable reserves to also declare
and pay a preference dividend. If a company does not declare a preference divi-
dend in any one year, it cannot declare an ordinary dividend. The fact that a divi-
dend was declared to ordinary shareholders, implies that the dividend to pref-
erence shareholders was also declared.
l It does not matter when the ordinary shares were issued in the current year be-
cause the dividend is declared as cents per share to all registered shareholders
on the declaration date. In the case of preference shares, the dividend is declared
at a predetermined rate per annum and based on the value of the shares. Pref-
erence shares not held for a full year will only receive a dividend proportional to the
time the shares were issued.
l Entries for the declaration and payment of interim dividends are done during the
financial year and not at year-end. The entry to record an interim dividend paid is:
debit dividend paid and credit bank account. It is not necessary to credit the divi-
dend payable account because entries are only made when the interim dividend is
paid to shareholders.
capital only by borrowing from another individual or from a financial institution such as
a bank. Companies have a much wider range of options to raise loan capital than any
other form of business ownership. A company has the option to publicly issue loan
capital or debentures, thereby broadening its base for obtaining loan finance.
A debenture is a debt owed by a company to a debenture holder on the conditions
specified in the debenture deed. A debenture is a written acknowledgement of debt by
the company issuing the debentures. The debenture deed contains the conditions upon
which the debentures are issued. Items that can be included in the debenture deed
are:
l whether or not the debentures are secured, and if secured, the assets encum-
bered;
l the interest rate payable on the debentures;
l the period of the debenture loan;
l repayment conditions;
l the possibility of converting debentures into shares; and
l the rights of the debenture holder, should the company default on the loan agree-
ment.
Debentures do not form part of the equity of a company and are classified under non-
current or current liabilities, depending on the repayment period stipulated in the
debenture deed. Debenture holders receive a fixed interest irrespective of whether or
not the company is making a profit. Interest on debentures may be paid, for example
quarterly, bi-annually or annually. Interest on debentures is a finance cost and dis-
closed as such in the statement of profit or loss and other comprehensive income.
interest rate” of the debenture. The annual interest payable is calculated by multiplying
the nominal or face value of the debenture by the nominal interest rate per annum. If
the debentures were issued for a period less than a year, the interest calculation will
be proportional. The market interest rate is the rate that is determined by supply and
demand for funds in the money market. The difference between the nominal interest
rate and the market interest rate determines whether the debentures are issued at
nominal value, or at a premium or discount. If the prevailing market interest rate on
similar instruments is higher than the nominal interest rate being offered to debenture
holders, the debentures will have to be issued at a discount to compensate the invest-
ors (debenture holders) for the lower interest rate they will receive on their investment
over the investment period. If the prevailing market interest rate on similar instruments
is lower than the nominal interest rate being offered to debenture holders, the issue will
probably be at a premium. The debenture holders will be prepared to pay more for an
instrument which carries the same risk but yields a higher income due to the higher
interest rate they will earn over their investment period. Similarly to a share issue, the
directors may also decide to underwrite the debenture issue in order to ensure a full
subscription.
The following table summarises the influence of interest rates on the value at which
debentures can be issued:
Table 6.2 Influence of interest rates on the issue of debentures
Rate of interest Debentures issued at
Nominal rate = Market rate Nominal value
Market rate < Nominal rate A premium
Market rate > Nominal rate A discount
The premium or discount which arises from the debenture issue must be allocated to
the statement of profit or loss and other comprehensive income over the period of the
debenture issue. This is in accordance to IAS 1 which states that related income and
expense items should be accounted for in the same accounting period (matching).
The premium or discount is deferred in the accounting records of the company and
systematically written off or added to the interest in the statement of profit or loss and
other comprehensive income over the period of the debenture issue.
The abovementioned procedure with regard to the handling of a premium or a dis-
count on the issue of debentures is called the “amortisation” (writing off) of the pre-
mium or discount using the straight-line method, i.e. amortised over the duration of the
debenture issue.
Remember that:
l when debentures are issued, it is necessary to distinguish between the nominal
(face) value and the actual issue price of the debentures; and
l the issue price represents the actual amount paid for the debenture and is some-
times indicated as a percentage of the nominal value, for example a R100 deben-
ture issued at 105% (or R105). This implies that the debenture is issued at a
premium (the investor paid more for the debenture than its nominal value of R100)
or if the debenture is issued at 97% (or R97), it implies that the debenture was
issued at a discount.
Chapter 6: Introduction to companies 299
Example 6.7 The issue of debentures at nominal value (nominal interest rate
is equivalent to the market-related interest rate)
On 1 March 20.1, Beehive Limited issued 4 000 12% debentures of R100 each at their
nominal value. The nominal value of these debentures are repayable by 1 March 20.11
and interest is payable annually on 28 February of every year. The security for the
debentures is a mortgage on land and buildings. Beehive Limited’s year-end is
28 February.
Required:
Prepare the general journal of Beehive Ltd for the financial year ended 28 February 20.2.
Show only the journal entries with regard to the issue of the debentures and the pay-
ment of interest on these debentures. Post the journal to the appropriate ledger
accounts. Close off/balance the accounts at 28 February 20.2
Solution:
Beehive Ltd
General journal
Debit Credit
20.1 R R
Mar 1 Bank 400 000
12% debentures (4 000 × R100) 400 000
Issue of 4 000 12% debentures at a nominal value of
R100 each
20.2
Feb 28 Interest on debentures (400 000 × 12%) 48 000
Bank 48 000
Interest paid to debenture holders
Beehive Ltd
General ledger
Dr Bank Cr
20.1 R 20.2 R
Mar 1 12% debentures 400 000 Feb 28 Interest on
debentures 48 000
Balance c/d 352 000
400 000 400 000
Mar 1 Balance b/d 352 000
Dr 12% debentures Cr
20.1 R
Mar 1 Bank 400 000
Dr Interest on debentures Cr
20.2 R 20.2 R
Feb 28 Bank 48 000 Feb 28 Profit or loss
account 48 000
300 About Financial Accounting: Volume 2
Blue Ltd
General ledger
Dr Bank Cr
20.1 R 20.2 R
Mar 1 10% debentures 200 000 Feb 28 Interest on
28 Premium on issue debentures 20 000
of debentures 10 000 Balance c/d 190 000
210 000 210 000
20.2
Mar 1 Balance b/d 190 000
continued
Chapter 6: Introduction to companies 301
Dr 10% debentures Cr
20.1 R
Mar 1 Bank 200 000
Dr Interest on debentures Cr
20.2 R 20.2 R
Feb 28 Bank 20 000 Feb 28 Premium on issue
of debentures 1 000
Profit or loss
account 19 000
20 000 20 000
Comment:
The interest paid is based on the nominal value of the debenture. When debentures
are issued at a premium, the debenture premium is amortised over the life of the
debenture and reduces the interest expense by an amount of R1 000 (R10 000/10
years). The debenture liability is reported at the nominal value of the debt (which is
repayable in future), irrespective of the issue price. The balance of the premium on
issue of debentures account (unamortised premium) is added to the debenture liability
in the statement of financial position. At the end of the debenture term, only the nomi-
nal value will remain to be repaid.
Example 6.9 The issue of debentures at a discount (nominal interest rate
is lower than the market-related interest rate)
On 1 March 20.0, Waters Limited issued 1 000 10% debentures of R100 each at 95%.
The debentures are repayable at par on or before 28 February 20.10 and interest is
payable annually on 28 February of every year. A mortgage on land and buildings
serves as security for the debentures. The discount on the debenture issue should be
amortised over the term of the debenture issue according to the straight-line method.
Waters Limited’s year-end is 28 February.
Required:
Prepare the general journal of Waters Limited for the financial year ended 28 February
20.1. Show only the journal entries with regard to the debentures transactions. Post the
journal to the appropriate ledger accounts. Close off/balance the accounts at 28 Feb-
ruary 20.1
302 About Financial Accounting: Volume 2
Solution:
Waters Ltd
General journal
Debit Credit
20.0 R R
Mar 1 Bank (1 000 × R100 × 95%) 95 000
Discount on issue of debentures 5 000
10% debentures (1 000 × R100) 100 000
Issue of 1 000 10% debentures at a nominal value of
R100 each and a discount of R5,00 per debenture
20.1
Feb 28 Interest on debentures (R100 000 × 10%) 10 000
Bank 10 000
Interest paid to debenture holders
Interest on debentures 500
Discount on issue of debentures (R5 000 × 1/10) 500
Amortisation of premium on issue of debentures over
term of debentures using the straight-line method
Waters Ltd
General ledger
Dr Bank Cr
20.0 R 20.1 R
Mar 1 10% debentures 95 000 Feb 28 Interest on
debentures 10 000
Balance c/d 85 000
95 000 95 000
20.1
Mar 1 Balance b/d 85 000
Dr 10% debentures Cr
20.1 R 20.0 R
Feb 28 Balance c/d 100 000 Mar 1 Bank 95 000
Discount on issue
of debentures 5 000
100 000 100 000
20.1
Mar 1 Balance b/d 100 000
continued
Chapter 6: Introduction to companies 303
Dr Interest on debentures Cr
20.1 R 20.1 R
Feb 28 Bank 10 000 Feb 28 Profit or loss
Discount on issue account 10 500
of debentures 500
10 500 10 500
Comment:
The interest paid is based on the nominal value of the debenture. When debentures
are issued at a discount, the discount is amortised over the life of the debenture and
increases the interest expense by an amount of R500 (R5 000/10 years). The deben-
ture liability is reported at the nominal value of the debt irrespective of the issue price.
The balance of the discount on issue of debentures account (unamortised discount) is
subtracted from the debenture liability in the statement of financial position. At the end
of the debenture term, only the nominal value will remain to be repaid.
Example 6.10 Comprehensive example – share transactions
KZN Limited, trading in computer equipment, was formed on 1 July 20.6 with an
authorised share capital of 500 000 ordinary shares and 80 000 8% preference shares.
All shares are NPV shares. The financial year end of KZN Limited is the last day of
February of every year. On 15 July 20.6, the company offered 40 000 ordinary shares
and 20 000 8% preference shares to the incorporators of the company. The ordinary
shares were offered at R80 000 and the 8% preference shares were offered at
R60 000. All these shares were taken up and paid for by 17 July 20.6.
The following transactions occurred in connection with the issue of shares to the public
during July and August 20.6:
July 20: The company offered 200 000 ordinary shares and 50 000 8% preference
shares to the public. The board of directors deemed that an appropriate
consideration for the ordinary shares to be R500 000 and for the pref-
erence shares, R250 000. The full issue is underwritten by Sharp Under-
writers Ltd for a 1,5% underwriter’s commission.
August 10: Applications were received for 190 000 ordinary shares and 56 000 pref-
erence shares.
August 30: The full offering of the ordinary shares and 50 000 preference shares was
allotted and the excess application money repaid.
304 About Financial Accounting: Volume 2
August 31: The share-issue expenses of R15 000 were paid and all transactions with
the underwriters were concluded.
The following transactions occurred during the 20.8 financial year:
At an annual general meeting of shareholders on 1 June 20.7, the directors proposed
that no dividends be paid for the financial period ending 28 February 20.7, but that the
company would issue capitalisation shares to its shareholders. The profit for the year,
amounting to R2 100 000, could then be used to expand the business’s operations in a
fast growing market and the capitalisation issue would also safeguard the company’s
cash flow. The shareholders approved the following capitalisation issue:
1 capitalisation share for every 4 ordinary shares held; and
1 capitalisation share for every 7 preference shares held.
The issue of these capitalisation shares must be done from retained earnings. The
capitalisation issue of ordinary and preference shares will take place at their current
market value of R2 and R5 per share respectively. All the capitalisation shares were
allotted on 31 August 20.7.
On 26 February 20.8, the company declared a dividend of 20c per ordinary share to all
shareholders registered on that date. The dividend will be paid on 15 April 20.8. This
proposal was ratified by the shareholders at the annual general meeting of the com-
pany at which the financial statements disclosed a profit for the year of R5 000 000.
The company met the necessary solvency and liquidity requirements. At the same
meeting, the chairman of the board stated that the company is experiencing an ever-
increasing demand for its products and that the expansion of its manufacturing facili-
ties is inevitable. To help finance this expansion, the directors decided to issue
200 000 ordinary shares. The directors deemed that an appropriate consideration for
ordinary shares issued is R520 000. Due to the anticipated high demand for the shares
of the company, it was decided not to use the services of underwriters for this issue.
To guard against the over-allotment of shares to shareholders and thereby jeopardis-
ing control of the company, the shares will be allotted in units of 100 shares per unit as
follows:
Group A: Applications for 100 to 500 shares will be granted in full.
Group B: Applications for 600 to 1 000 shares will be granted at 60% of the shares
applied for.
Group C: Applications for 1 100 to 1 500 shares will be granted at 40% of the shares
applied for.
Group D: Applications for 1 600 and more shares will be granted at 30% of the shares
applied for.
Chapter 6: Introduction to companies 305
The following transactions occurred during June 20.8 with regard to this issue:
June 1: The company offered 200 000 ordinary shares to the public.
June 15: The following applications were received:
Number of Number of
Number of
shares per shares
applications received
application applied for
100 70 7 000
200 88 17 600
300 30 9 000
400 49 19 600
500 68 34 000
600 30 18 000
700 20 14 000
800 22 17 600
900 10 9 000
1 000 25 25 000
1 100 20 22 000
1 200 15 18 000
1 300 10 13 000
1 400 14 19 600
1 500 40 60 000
1 600 20 32 000
Total 531 335 400
On 30 June 20.8, all the available shares were allotted and the money refunded to
unsuccessful applicants. On 15 July, the company paid R12 000 towards share-issue
expenses.
Required:
(a) Only record the transactions regarding the issue of shares for the period 1 July
20.6 to 30 June 20.8 in the general ledger of KZN Limited.
(b) Record the transactions regarding the declaration and payment of dividends in
the appropriate ledger accounts.
(c) Prepare an allotment schedule for the share issue in June 20.8.
The closing off of the accounts is not required but illustrated for clarity purposes.
306 About Financial Accounting: Volume 2
Solution:
(a) and (b) KZN Limited
General ledger
Dr Bank Cr
20.6 R 20.6 R
Jul 17 Incorporators: Aug 30 Application and
Ordinary shares 80 000 allotment:
Incorporators: 8% preference
Preference shares 1 30 000
shares 60 000 31 Shares expenses 15 000
Aug 10 Application and 20.7
allotment: Feb 28 Balance c/d 863 750
Ordinary
shares 1 475 000
Application and
allotment:
8% preference
shares 1 280 000
31 Sharp
Underwriters 13 750
908 750 908 750
20.7 20.8
Mar 1 Balance b/d 863 750 Apr 15 Dividends
payable 86 800
20.8 Jun 30 Application and
Jun 15 Application and allotment:
allotment: Ordinary shares 352 040
Ordinary shares 872 040 Jul 15 Share-issue
expenses 12 000
20.9
Feb 28 Balance c/d 1 284 950
1 735 790 1 735 790
20.9
Mar 1 Balance b/d 1 284 950
continued
Chapter 6: Introduction to companies 307
continued
308 About Financial Accounting: Volume 2
Dr Underwriter’s commission Cr
20.6 R R
Aug 31 Sharp Under-
writers Ltd 3 11 250
Dr Share-issue expenses Cr
20.6 R R
Aug 31 Bank 15 000
20.8
Jul 15 Bank 12 000
continued
Chapter 6: Introduction to companies 309
Dr Retained earnings Cr
20.7 R 20.7 R
Aug 31 Share capital: Feb 28 Appropriation
Ordinary shares 120 000 account 2 100 000
Share capital:
8% preference
shares 50 000
20.8
Feb 28 Balance c/d 1 930 000
2 100 000 2 100 000
20.8 20.7
Feb 28 Balance c/d 6 843 200 Mar 1 Balance b/d 1 930 000
20.8
Feb 28 Appropriation
account 4 913 200
6 843 200 6 843 200
20.8
Mar 1 Balance c/d 6 843 200
Dr Ordinary dividends Cr
20.8 R 20.8 R
Feb 26 Dividends Feb 28 Appropriation
payable 21 60 000 account 60 000
Dr Preference dividends Cr
20.8 R 20.8 R
Feb 26 Dividends Feb 28 Appropriation
payable 22 26 800 account 26 800
Dr Dividends payable Cr
20.8 R 20.8 R
Feb 28 Balance c/d 86 800 Feb 26 Ordinary
dividends 60 000
Preference
dividends 26 800
86 800 86 800
20.8 20.8
Apr 15 Bank 86 800 Mar 1 Balance b/d 86 800
continued
310 About Financial Accounting: Volume 2
Dr Appropriation account Cr
20.7 R 20.7 R
Feb 28 Retained earnings 2 100 000 Feb 28 Profit or loss 2 100 000*
20.8 20.8
Feb 28 Ordinary Feb 28 Profit or loss 5 000 000*
dividends 60 000
Preference
dividends 26 800
Retained earnings 4 913 200
5 000 000 5 000 000
* The amounts are included for illustration purposes. The debits were not accounted for due to lack of
information.
(c) Allotment schedule: Ordinary shares
Number of Total number Received Cash repaid to
Shares
Group applications of shares from unsuccessful
allotted
in group applied for applicants applicants
R R
A 305 4 87 200 8 226 720 11 87 200 14
Calculations:
1 1 August 10: Applications received
190 000/200 000 × R500 000 = R475 000
56 000/50 000 × R250 000 = R280 000
10 000/200 000 × 500 000 = 25 000 (ordinary shares taken up by underwriters)
2 Capitalisation issue – 31 August 20.7 R
Number of issued shares
Ordinary shares R(40 000 + 200 000) 240 000
Preference shares R(20 000 + 50 000) 70 000
Capitalisation issue
Ordinary shares (R240 000/4) 60 000
Preference shares (R70 000/7) 10 000
Capitalisation issue funded
Ordinary shares (R60 000 × R2) 120 000
Funded by retained earnings 120 000
Preference shares (10 000 × R5) 50 000
Funded by retained earnings 50 000
Chapter 6: Introduction to companies 311
3 Underwriters’ commission R
Subscription
200 000 ordinary shares 500 000
50 000 preference shares 250 000
Full issue underwritten by Sharp Underwriters Ltd 750 000
Underwriters’ commission (R750 000 × 1,5%) 11 250
4
Number of applications in group A: 70 + 88 + 30 + 49 + 68 = 305
5
Number of applications in group B: 30 + 20 + 22 + 10 + 25 = 107
6
Number of applications in group C: 20 + 15 + 10 + 14 + 40 = 99
7 Number of applications in group D: 20
8 7 000 + 17 600 + 9 000 + 19 600 + 34 000 = 87 200
9
18 000 + 14 000 + 17 600 + 9 000 + 25 000 = 83 600
10
22 000 + 18 000 + 13 000 + 19 600 + 60 000 = 132 600
11 87 200/200 000 × R520 000 = R226 720
17
12 83 600/200 000 × R520 000 = R217 360
13 132 600/200 000 × R520 000 = R344 760
14 Group A: All applications received were allotted
15 Group B: 83 600 × 60% = 50 160
16 Group C: 132 600 × 40% = 53 040
17 Group D: 32 000 × 30% = 9 600
18 83 600 – 50 160 = 33 440/200 000 × R520 000 = R86 944
19 132 600 – 53 040 = 79 560/200 000 × R520 000 = R206 856
20 32 000 – 9 600 = 22 400/200 000 × R520 000 = R58 240
21 Dividends = number of ordinary shares × cents per share
240 000 + 60 000 = 300 000 × 20c = R60 000
22 Preference dividend = proportionated value × fixed dividend percentage
(R310 000 × 8%) + (R50 000 × 8% × 6/12) = R26 800
23 32 000/200 000 × R520 000 = R83 200
6.10.2 Disclosure
The Companies Act 71 of 2008 contains certain specific requirements regarding the
disclosure of information in the annual financial statements of companies. Further
disclosure and format requirements can be found in the numerous International Finan-
cial Reporting Standards and specifically IAS 1 as discussed in paragraph 1.4.5.
R
Non-current assets 1 300 100
Current assets 250 000
Retained earnings (1 January 20.8) 300 700
Share capital: Ordinary shares 364 000
Non-current liabilities 530 000
Current liabilities 98 500
Profit for the year 256 900
The following transactions took place during December 20.8 and are yet to be record-
ed in the accounting records of the company:
On the date of its incorporation (1 January 20.7), the company’s shares traded at R4
per share. No other share issue occurred since then.
On 1 December 20.8, the directors offered 50 000 shares to the general public at R5
per share. All of the offered shares were taken up by the public and share issue costs
of R6 000 were incurred and paid.
On 15 December 20.8, directors approved the capitalisation issue of one share for
every five shares held at R4 per share. It was decided to fund the capitalisation issue
from retained earnings.
On 31 December 20.8, the company declared an ordinary dividend of 50 cents per
share.
Required:
Prepare a statement of changes in equity of BCN Limited for the year ended 31 De-
cember 20.8 in order to comply with the requirements of IFRS.
Chapter 6: Introduction to companies 315
BCN Limited
Statement of changes in equity for the year ended 31 December 20.8
Share Retained
Total
capital earnings
R R R
Balances at 1 January 20.7 364 000 300 700 664 700
Total comprehensive income for the year 256 900 256 900
Profit for the year
Issue of ordinary shares (50 000 x R5) 250 000 250 000
Issue of capitalisation shares 112 800 (112 800) –
Dividends: Ordinary shares ( ښ84 600) (84 600)
Balances at 31 December 20.8 726 800 360 200 1 087 000
Calculations:
ښDividends
Number of shares issued to the public:
R364 000 ÷ R4 = 91 000 shares
Number of shares issued:
50 000 shares (given)
Total number of shares issued:
91 000 + 50 000 = 141 000
Capitalisation issue: 141 000 × 1/5 = 28 200 shares
Value of capitalisation issue: 28 200 × R4 = R112 800
Dividend payable: [R0,50 × (141 000 + 28 200)] = R84 600
316 About Financial Accounting: Volume 2
Example 6.12
The following list of balances have been extracted from the accounting records of
Shully Limited:
Balances as at 31 March 20.3:
Dr Cr
R R
Share capital: Ordinary shares 870 000
Share capital: 8% Preference shares 50 000
Retained earnings (1 April 20.2) 309 000
Vehicles (at cost) 650 000
Land and buildings (at cost) 1 150 000
10% Debentures 100 000
Accumulated depreciation: Vehicles (1 April 20.2) 280 000
Bank 270 700
Trade payables control 598 800
Trade receivables control 166 000
Investment at cost 110 000
Inventory 179 600
Sales 1 295 000
Cost of sales 495 700
Credit losses 2 500
SARS (current income tax paid) 15 500
Dividends received from investment 6 000
Administrative expenses 101 200
Auditor’s remuneration 65 100
Salaries 302 500
3 508 800 3 508 800
Additional information:
1. Shully Limited is a listed company that was registered on 1 May 20.1 with an
authorised share capital of 500 000 ordinary shares and 100 000 8% preference
shares. All shares are NPV shares. On the date of incorporation, the company of-
fered 100 000 ordinary shares at a consideration of R120 000 and 50 000 prefer-
ence shares at a consideration of R50 000 to the incorporators of the company, all
of which were taken up. On 1 March 20.3 a number of ordinary shares were of-
fered to the general public at R5 per share and the full issue was paid up.
2. The debentures were issued on 1 April 20.1 and are repayable at par on
31 March 20.5. Interest is payable annually on 1 April of every year. Land and build-
ings serve as security for the debentures.
3. Included in salaries is an amount of R102 000 relating to directors’ remuneration.
4. Investment consists of shares bought from Mumish Ltd for R110 000 on
1 April 20.2. On 31 March 20.3 the fair value of the shares is R140 000.
5. The land was purchased for R250 000 on 15 May 20.1 and, subsequently to the
purchase, buildings at a cost of R900 000 were constructed on the land. Construc-
tion was completed on 31 August 20.1. No depreciation is written off on the build-
ings.
Chapter 6: Introduction to companies 317
6. During the year the land was revalued upwards by R134 100 by a sworn appraiser
as a result of the rezoning of the property. This transaction is yet to be recorded.
7. Vehicles must still be depreciated by 10% per annum according to the diminishing
balance method. No additions or sale of vehicles occurred during the year.
8. Current tax for the year amounts to R83 500 and must still be provided.
9. On 29 March 20.3 the directors declared a dividend of R0.25 cents per ordinary
share, which must still be recorded.
Required:
Prepare the following for Shully Limited on 31 March 20.3 in accordance with the
requirements of IFRS:
a) the statement of profit or loss and other comprehensive income;
b) the statement of changes in equity;
c) the statement financial position and;
d) the notes to the financial statements.
a) Shully Limited
Statement of profit or loss and comprehensive income for the year ended
31 March 20.3
Note R
Revenue 3 1 295 000
Cost of sales (495 700)
Gross profit 799 300
Other income 36 000
Fair value adjustment: Listed share investment R(140 000 – 110 000) 30 000
Dividend income: Listed share investment 6 000
835 300
Distribution, administrative and other expenses (508 300)
Salaries c 200 500
Administrative expenses 101 200
Auditor’s remuneration 65 100
Directors’ remuneration 102 000
Credit losses 2 500
Depreciation d 4 37 000
Finance costs (10 000)
Interest on debentures e 6 10 000
Profit before tax 317 000
Income tax expense (83 500)
Profit for the year 233 500
Other comprehensive income for the year 134 100
Revaluation surplus 134 100
Total comprehensive income for the year 367 600
318 About Financial Accounting: Volume 2
b) Shully Limited
Statement of changes in equity for the year ended
31 March 20.3
Share Revaluation Retained
Total
capital surplus earnings
R R R R
Balances at 1 April 20.2 R(120 000 + 50 000) 170 000 – 309 000 479 000
Total comprehensive income for the year 134 100 233 500 367 600
Profit for the year 233 500 233 500
Other comprehensive income for the year 134 100 134 100
Ordinary shares issued f 750 000 750 000
Dividendsh (66 500) (66 500)
Balances at 31 March 20.3 920 000 134 100 476 000 1 530 100
c) Shully Limited
Statement of financial position as at 31 March 20.3
Note R
ASSETS
Non-current assets 1 617 100
Property, plant and equipment 4 1 617 100
Current assets 756 300
Inventories 179 600
Listed share investment 5 140 000
Trade and other receivables 5 166 000
Cash and cash equivalents 5 270 700
d) Shully Limited
Notes for the year ended 31 March 20.3
Accounting policy
1. Basis of presentation
The annual financial statements have been prepared in accordance with Inter-
national Financial Reporting Standards. The annual financial statements have been
prepared on the historical cost basis, modified for the fair valuation of certain fi-
nancial instruments and incorporate the principle accounting policies set out be-
low. The statements are presented in South African Rand.
2. Summary of significant accounting policies
The annual financial statements incorporate the following principal accounting
policies which are consistent with those applied in previous years except where
otherwise stated.
2.1 Property, plant and equipment
Property, plant and equipment are initially recognised at cost price. No
depreciation is written off on buildings. Vehicles are subsequently measured
at cost less accumulated depreciation and accumulated impairment losses.
Depreciation on vehicles is written off at a rate deemed to be sufficient to
reduce the carrying amount of the assets over their estimated useful life to
their estimated residual value. The depreciation rates are as follows:
Vehicles: 10% per annum according to the diminishing balance method.
Depreciation is charged to profit or loss for the period. Gains or losses on dis-
posal are determined by comparing the proceeds with the carrying amount
of the asset. The net amount is included in profit or loss for the period.
2.2 Financial instruments
Financial instruments are recognised in the entity’s statement of financial
position when the entity becomes a party to the contractual provisions of an
instrument.
Financial instruments are initially measured at the transaction price, which is
fair value plus transaction costs, except for “Financial assets at fair value
through profit or loss” which is measured at fair value, transaction costs ex-
cluded. The entity’s classification depends on the purpose for which the entity
acquired the financial instruments. Financial instruments are subsequently
measured at fair value unless it is measured at amortised cost as required by
IFRS.
Financial instruments that are subsequently measured at amortised cost are
done so using the effective interest rate method.
Debt instruments that are classified as current assets or current liabilities are
measured at the undiscounted amount of the cash expected to be received or
paid, unless the arrangement effectively constitutes a financing transaction.
320 About Financial Accounting: Volume 2
2.3 Inventories
Inventories are initially measured at cost and subsequently valued at the
lower of cost or net realisable value. Cost is calculated using the first-in, first-
out method. Net realisable value is the estimated selling price in the ordinary
course of business less any costs of completion and disposal.
2.4 Revenue
Revenue is measured at the fair value of the consideration received or re-
ceivable. Revenue represents the transfer of promised goods to customers in
an amount that reflects the consideration to which the entity expects to be
entitled to in exchange for those goods. Revenue from the sale of goods con-
sists of the total net invoiced sales excluding value added tax and settlement
discount granted. Revenue is recognised when performance obligations are
satisfied.
3. Revenue R
Sale of goods 1 295 000
The land was purchased on 15 May 20.1 and subsequently a building with a cost
of R900 000 was constructed on the land. The land was revalued by a sworn
appraiser during the year and the property serves as security for the debentures
(refer note 7).
5. Financial assets
6. Share capital
Authorised R
500 000 Ordinary shares
100 000 8% Preference shares
Issued 920 000
250 000 Ordinary shares 870 000
50 000 8% Preference shares 50 000
All shares are NPV shares. During the current accounting period 150 000 ordinary
shares were issued for a consideration of R750 000.
7. Financial liabilities
Calculations:
R
c Salaries
R R(302 500 – 102 000) 200 500
d Depreciation
R[(650 000 – 280 000) × 10% 37 000
e Interest on debentures
R(100 000 × 10%) 10 000
f Issue of ordinary shares
R(870 000 – 120 000) 750 000
g Trade and other payables
R(598 800 + 10 000) 608 800
322 About Financial Accounting: Volume 2
h Dividends payable
(1) Ordinary dividend:
Number of shares issued to general public:
R(870 000 – 120 000) ÷ R5 = 150 000 shares
Number of shares issued to incorporators:
100 000 shares (Given)
Total shares issued: 150 000 + 100 000 = 250 000
Ordinary dividends 250 000 × R0,25 R62 500
(2) Preference dividend: R50 000 × 8% R4 000
Total dividends payable R66 500
i Current tax payable
R(83 500 – 15 500) R68 000
6.11 Summary
In this chapter, the reader was introduced to the company as a form of business own-
ership. The importance of this entity form is its ability to attract large amounts of capital
which enables growth and as such, positively influence the economy. Companies must
abide by strict juridical and accounting requirements.
The procedures for starting a company involve a very important document that must
be registered with the Companies and Intellectual Property Commission (CIPC), namely
the Memorandum of Incorporation. After all formalities have been adhered to, the Com-
mission issues a registration certificate to commence business.
Although there are different kinds of companies, this chapter concentrated on profit
companies. A profit company mainly obtains its capital by issuing shares to the public
and/or by issuing debentures. Investors who buy shares in the company become the
shareholders of the company, while investors buying debentures become creditors of
the company.
A shareholder’s interest in a company is represented by the number of shares he/she
holds and has the right to vote on policy matters at annual general meetings of the
company. If the profit company is a listed company, shareholders can sell their shares
(or buy additional shares) on the JSE Limited.
Strict rules, laid down by the Companies Act, not only regulate the formation and work-
ing of a company, but also the issue of shares and debentures. Shares can be classi-
fied as either ordinary or preference shares. Most of the shares issued are ordinary
shares and the ordinary shareholders are the owners of the company. Preference
shareholders normally have no voting rights and therefore cannot be regarded as the
“owners” of the company. Although there are different kinds of preference shares, the
basic principles regarding their issue, allotment and dividend policy are the same.
With regard to the issue of shares, the accounting entries needed to record these
transactions were dealt with. When issuing large amounts of shares, an allotment
schedule is prepared. To ensure a full subscription of its shares, a company can use
the service of underwriters. Underwriters charge a commission for the service they
offer and are obliged to take up the remainder of the share issue for which the public
did not apply.
Chapter 6: Introduction to companies 323
For their effort and risk, shareholders could receive a dividend on their investment. The
calculation of the dividend a shareholder will receive depends on the class of share.
The dividend on ordinary shares is usually expressed in cents per share and is calcu-
lated on the number of shares issued, whereas the dividend on preference shares is
calculated on the proportionated value of the issued preference shares using the fixed
dividend percentage. A dividend can also be made through an offer of “free” shares to
the shareholders and this offer is usually funded from retained earnings.
Debentures differ from shares in that the debenture holders are creditors of the com-
pany and debentures are therefore not part of the equity of a company. The issue of
debentures is done in much the same way as the issue of shares and the issue can
also be underwritten. Debenture holders earn interest on their investment. Debentures
can be issued either at nominal value or at a premium or discount.
In closing an overview of the requirements, content and presentation of company
financial statements was provided. Financial statements of a company, namely the
statement of profit or loss and other comprehensive income, the statement of changes
in equity, the statement of financial position and the notes to the financial statements
were introduced. A few items that are unique to financial statements of a company
were also mentioned and their treatment discussed, namely directors’ remuneration,
auditor’s remuneration and dividends paid. The directors’ and auditor’s reports were
also briefly mentioned.
CHAPTER 7
Statement of cash flows
Contents
Page
Overview of the statement of cash flows ................................................................ 326
7.1 Introduction ................................................................................................... 327
7.2 Main objective and advantages of a statement of cash flows...................... 328
7.3 Format of a statement of cash flows ............................................................. 328
7.4 Relationship between a statement of cash flows and other financial
statements .................................................................................................... 332
7.5 Identification of non-cash entries in financial statements prepared
on the accrual basis of accounting .............................................................. 332
7.6 Preparation of a statement of cash flows from financial statements
prepared on the accrual basis of accounting .............................................. 339
7.6.1 Cash flows from operating activities................................................ 339
7.6.1.1 Cash generated from or used in operations according
to the direct method ........................................................ 340
7.6.1.2 Cash generated from or used in operations according
to the indirect method ..................................................... 351
7.6.1.3 Operating activity items disclosed after the cash
generated from or used in operations ............................. 357
7.6.2 Cash flows from investing activities................................................. 359
7.6.3 Cash flows from financing activities ................................................ 363
7.6.4 Cash and cash equivalents ............................................................. 365
7.6.5 Disclosure of additional information concerning non-cash
transactions related to a statement of cash flows ........................... 366
7.7 Summary ....................................................................................................... 386
325
326 About Financial Accounting: Volume 2
Basic format
Cash flows from operating activities
• Cash generated from/(used in) operations
(direct or indirect method)
• Other items
7.1 Introduction
STUDY OBJECTIVES
The existence of a business entity without cash flows is impossible. Cash is con-
sidered to be the lifeblood of a business, and in the business world it is often men-
tioned that “cash is king”. Strangely enough, the disclosure of cash flow information
was initially not required, leaving the users of financial statements, such as sharehold-
ers and the issuers of financing debt, in the dark about this fundamental aspect. The
following overview of the history of W.T. Grant Company, the largest retailer in the
United States of America at its time, shows how the lack of cash flow information can
cause the performance of a business entity to be misinterpreted.
In 1906, W.T. Grant opened his first store in Massachusetts. During 1928, W.T. Grant
Company made its first public share offering. By 1950, the company had expanded to
approximately 500 stores. The company’s expansion continued well into the 1960s,
over which period another 410 new stores were opened. During 1973, the shares of
the company were selling at almost 20 times its earnings and peaked at around $71
per share. To safeguard their interest in W.T. Grant Company, a group of banks,
despite being aware that the company’s growth was debt-financed, loaned the com-
pany $600 million during September 1974 to boost its ailing performance at the time.
From 1966 to 1975, the cash flows from the operating activities of W.T. Grant Company
were almost always negative. Once the shareholders realised that the company could
no longer honour its increasing debt responsibilities, they traded their shares without
delay, causing an oversupply thereof in the equity market. During December 1974, the
share price dropped to $2 per share, a mere two months after the loan of $600 million
was granted. W.T. Grant Company reported profits of over $20 million for more than
ten consecutive years, up to 1973. Yet, the sharp decline in its performance hence-
forth due to lacking cash largely contributed to its bankruptcy in April 1976.
The misleading perception that the profit and working capital of the company were
sufficient to evaluate its business performance, led to the seriousness of its cash flow
problems being unrecognised by most of its stakeholders, mainly because no cash
flow information was disclosed. A thorough analysis of the company’s cash flows
328 About Financial Accounting: Volume 2
would have raised concern from as early as the 1970s, a considerable time before its
collapse.
To avoid problems occurring as in the above, it is required by IAS 7 that a business
entity shall prepare a statement of cash flows as an integral part of its financial state-
ments. In this chapter, a statement of cash flows is prepared according to IAS 7,
regardless of whether a business entity must adhere to the requirements of IFRS.
The main objectives of this chapter are to present an overview on the purpose and
importance of a statement of cash flows, and to discuss and illustrate the preparation
of an elementary statement of cash flows according to IAS 7. The examples in this
chapter pertain to the statements of cash flows of a partnership and close corpora-
tions.
The following are definitions of terms that are used in a statement of cash flows
(IAS 7.6):
Cash: Cash on hand and demand deposits.
Cash equivalents: Short-term, highly liquid investments that are readily convertible to
known amounts of cash and which are subject to an insignificant risk of changes in
value.
Cash flows: Inflows and outflows of cash and cash equivalents.
Operating activities: Principal revenue-producing activities of an entity and other
activities that are not investing or financing activities.
Investing activities: The acquisition and disposal of long-term assets and other
investments not included in cash equivalents. (To maintain consistency in respect of
terminology, the term “non-current asset(s)” is used instead of “long-term asset(s)” in
this chapter.)
Financing activities: Activities that result in changes in the size and composition of
the contributed equity and borrowings of an entity.
Negotiable instruments such as money orders are viewed as cash. A highly liquid
investment is considered an investment with a maturity period of a maximum of three
months.
Only amounts that were actually received and/or paid in cash are disclosed in a state-
ment of cash flows. However, such a strict adherence may in certain instances distort
the interpretation of the statement.
For example, assume that Joe, a sole proprietor, purchased a vehicle for R150 000
from Jenny for his business. He paid a deposit of R30 000 to Jenny from the funds of
the business and obtained a business loan of R120 000 from his father Aveen, to settle
the outstanding balance. Aveen paid the R120 000 directly to Jenny on Joe’s behalf.
Under this assumption, in the books of Joe’s business, if strictly adhered to the def-
inition of cash flows, only the cash outflow of R30 000 must be disclosed as an invest-
ing activity, and no cash inflow pertaining to the loan of R120 000 must be shown as
a financing activity, since the amount of the loan was not deposited into the bank
account of Joe’s business.
Alternatively, assume that Aveen paid the R120 000 into the bank account of Joe’s
business, and that Joe thereafter paid the R120 000 over to Jenny. In such a case, a
cash outflow of R150 000 in respect of an investing activity, and a cash inflow of
R120 000 in respect of a financing activity would have been disclosed.
To enhance the usefulness of a statement of cash flows, in application of substance
over form in respect of the first assumption, the alternative manner of disclosure is
more informative than the first manner of disclosure, since the loan was granted by
Aveen to the business, despite it not being paid out in cash directly to the business.
The following format of a statement of cash flows (notes thereto excluded) is prepared
according to the basic requirements of IAS 7. The entries that pertain to the direct and
indirect methods in the cash flows from operating activities section are shaded for
clarification purposes. The values pertaining to cash outflows and bank overdrafts are
shown in brackets.
330 About Financial Accounting: Volume 2
Indirect method
Profit/(Loss) for the year (sole proprietorship/ If If
partnership) or Profit before tax/Loss for the
year (close corporation/company) ..................... Profit (Loss)
Add back: Non-cash expenses in S of PL** ..... Add Subtract
Non-cash income in S of PL ............ (Subtract) (Add)
Operating expenses in S of PL to
be disclosed after this (shaded)
section (e.g. Interest and income
tax). ................................................. Add Subtract
Operating income in S of PL to
be disclosed after this (shaded) See
section ............................................ (Subtract) (Add) paragraph
7.6.1.2(c)
Answer
in this
If + If – chapter for
Decreases in applicable current assets ............ Add Subtract the
Increases in applicable current assets .............. Subtract Add applicable
Decreases in applicable current liabilities ......... Subtract Add accounts.
Increases in applicable current liabilities ........... Add Subtract
Answer The
Cash generated from operations ....................... If + [= Inflow] answers of
or the direct
Cash used in operations .................................... If – [= (Outflow)] and indirect
Dividends received (all entities) .......................... Inflow methods
Interest received (all entities) .............................. Inflow are the
Interest paid (all entities) ..................................... (Outflow) same.
Income tax paid (close corporation/company) ... (Outflow)
Drawings (sole proprietorship/partnership) ......... (Outflow)
Distribution to members paid
(close corporation)........................................... (Outflow)
Dividends paid
(company) ....................................................... (Outflow)
Proceeds from the sale of financial assets
at fair value through profit or loss: Held for
trading (such as listed share investments)
(all entities) ...................................................... Inflow
Acquisition of financial assets at fair value
through profit or loss: Held for trading (such
as listed share investments) (all entities) ......... (Outflow)
Net cash from/(used in) operating activities In-/(Outflow)
continued
Chapter 7: Statement of cash flows 331
R R
CASH FLOWS FROM INVESTING ACTIVITIES
Investments in property, plant and equipment
The result of
to maintain operating capacity ...................... (Outflow)
the shaded
Replacement of property, plant and
area.
equipment (all entities) ........................... (Outflow)
Identify the non-cash entries (that is, when no cash or cash equivalent account,
account,
such as a bank account, is used to record an entry
entry) in the following list:
No Entry •
1 A cash journal entry
2 An entry in the sales, purchases, sales returns or purchases returns
journal
3 An accrual based year-end adjustment
4 The recording of an asset purchased on credit
5 The recording of revenue: cash sales of trading inventory
6 The recording of revenue: credit sales of trading inventory
7 The recording of a cash payment to a creditor
8 The recording of depreciation
9 The creation or adjustment of an allowance for credit losses account
10 The recording of cash received from a debtor whose account was
written off as irrecoverable
11 The recording of inventory taken for personal use by a sole proprietor
without paying for the inventory in cash
12 The recording of rental expenses in arrears at financial year-end
13 The appropriation of salaries to partners according to their partner-
ship agreement
14 The cash payment of a salary to a partner
15 A capital contribution of cash by a member of a close corporation
16 The recording of rental income in arrears at financial year-end
17 At the beginning of a financial year (Y2):: The closing off of the bal-
ance of a prepaid expenses account (in respect of electricity) to an
electricity expense account concerning the financial year (Y2). The
balance of the prepaid expenses account was brought down from the
previous financial year (Y1)
18 The recording of a profit or loss made on the sale of a non-current
asset
19 Writing off a trade receivables account as irrecoverable
20 The recording of a settlement discount transaction
21 The recording of a non-capitalisation shares-issue by a company
22 In respect of Y2: The recording of the cash payment of rental ex-
penses in arrears (for Y1), in Y2
23 In respect of Y2: The recording of rental income at the beginning of
Y2, where cash pertaining to the Y2 rental income was received in
advance during Y1
Chapter 7: Statement of cash flows 335
Answer:
Non-cash entries: 2, 3, 4, 6, 8, 9, 11, 12, 13, 16, 17, 18, 19, 20, 23
Explanation:
No 2. Sales, purchases, sales returns and purchases returns journal entries pertain
solely to non-cash (credit) transactions.
No 3. Accrual-based year-end adjustments do not involve cash or cash equivalents.
No 4. The recording of an asset purchased on credit, for example, equipment pur-
chased on credit for R20 000:
Journal entry (extract)
Debit Credit
R R
Equipment at cost 20 000
Trade payables control 20 000
Since no cash payment was made on the date of the purchase of the asset, the
purchase is a non-cash transaction. That is, no cash or cash equivalent ac-
count was used to record this transaction. A cash outflow will occur when the
creditor is paid (debit: Trade payables control, credit: Bank).
No 6. The recording of revenue: credit sales of trading inventory. Such credit sales
are non-cash transactions that are included in the revenue as shown in the
statement of profit or loss and other comprehensive income. These credit sales
must be excluded from the cash receipts from customers, but the cash re-
ceived from debtors pertaining to the credit sales must be included.
No 8. The recording of depreciation, for example, the depreciation of furniture
amounting to R10 000:
Journal entry (extract)
Debit Credit
R R
Depreciation 10 000
Accumulated depreciation: Furniture 10 000
When the balance of an allowance for credit losses account is adjusted, for
example decreased by R2 000, the journal entry is:
Journal entry (extract)
Debit Credit
R R
Allowance for credit losses 2 000
Credit losses 2 000
In both the journal entries above, no cash or cash equivalent account was
used. Therefore, these entries are non-cash entries.
No 11. The recording of inventory taken for personal use by a sole proprietor without
paying for it in cash, for example inventory amounting to R3 000 that was taken
by sole proprietor I Draw, when the periodic inventory system is applied:
Journal entry (extract)
Debit Credit
R R
Drawings: I Draw 3 000
Purchases 3 000
Since the inventory was not paid for in cash, no cash or cash equivalent entry
was made with the recording of the inventory taken.
No 12. The recording of rental expenses in arrears at financial year-end, for example
rental expenses in arrears amounting to R8 000:
Journal entry (extract)
Debit Credit
R R
Rental expenses 8 000
Rental expenses in arrears 8 000
Since the rental expenses are in arrears, it was not paid. Therefore, this record-
ing is a non-cash entry. A cash outflow will occur when a payment is made to-
wards the rental expenses in arrears (debit: Rental expenses in arrears, credit:
Bank).
No 13. The appropriation of salaries to partners according to their partnership agree-
ment, for example an annual salary of R10 000 each to partners A and B.
(Each partner received R6 000 in cash as salaries during the financial year.):
Journal entry (extract)
Debit Credit
R R
Salary: Partner A 10 000
Salary: Partner B 10 000
Current account: Partner A 10 000
Current account: Partner B 10 000
Chapter 7: Statement of cash flows 337
Since the salaries recorded as per the partnership agreement show the appro-
priation that was made for the salaries in respect of a financial year, this re-
cording is a non-cash entry. All cash payments to partners, including salaries,
are recorded on the payment dates (debit: Drawings/Current account, credit:
Bank).
No 16. The recording of rental income in arrears at financial year-end, for example
rental income in arrears amounting to R3 000:
Journal entry (extract)
Debit Credit
R R
Rental income in arrears 3 000
Rental income 3 000
Since the rental income is in arrears, it was not received in cash. Therefore, this
recording is a non-cash entry. A cash inflow will occur when cash is received
in respect of the rental income in arrears (debit: Bank, credit: Rental income in
arrears).
No 17. At the beginning of a financial year (Y2):: The closing off of a prepaid ex-
penses account (in respect of electricity) to an electricity expense account
concerning the financial year (Y2). For example, electricity amounting to R1 500
was prepaid during the previous financial year (Y1):
Journal entry: Beginning of financial year (Y2) (extract)
Debit Credit
R R
Electricity 1 500
Prepaid expenses (electricity) 1 500
Since the electricity was prepaid during Y1, the closing off of the prepaid ex-
pense account at the beginning of Y2 is a non-cash entry.
No 18. The recording of a profit or loss made on the sale of a non-current asset, for
example a profit of R5 000 that was made on the sale of a vehicle (sold for
R35 000, cash):
Journal entry (extract)
Debit Credit
R R
Vehicle realisation 5 000
Profit on sale of vehicle 5 000
Cash (R35 000) was received and recorded on the date of the sale (debit:
Bank, credit: Vehicle realisation). The cash received has no bearing on the re-
cording of the profit that was made on the sale. Therefore, this recording is a
non-cash entry.
338 About Financial Accounting: Volume 2
No 19. Writing off a trade receivables account as irrecoverable, for example an irre-
coverable account of R10 000 written off against credit losses:
Journal entry (extract)
Debit Credit
R R
Credit losses 10 000
Trade receivables control 10 000
Since no cash or cash equivalent account was used in the entry above, it is a
non-cash entry.
Chapter 7: Statement of cash flows 339
Format of disclosure:
Name of business entity
Statement of cash flows for the year ended . . .
R R
CASH FLOWS FROM OPERATING ACTIVITIES
Cash receipts from customers (all entities) ........ Inflow*
Cash paid to suppliers and employees
(all entities) ......................................................... (Outflow)*
The
Answer difference
Cash generated from operations ........................ If net inflow between
or or the in- and
Cash used in operations..................................... If net (outflow) outflow.
* Cash inflows are shown without brackets, and cash outflows with brackets.
Step 2: Adjust each item to a cash amount if necessary, by using the related items in
the statements of financial position.
These steps, the sources of financial information used, and the reasons for application
are shown in Table 7.1.
Table 7.1 Calculation of income received in cash
Step Source of Reason
(How) information (Why)
1. IDENTIFY the income items for the Statement of profit or The income was earned
year under review (for Y1 ended) loss and other compre- during Y1 and could
hensive income for Y1 include cash amounts
2. ADJUST the identified items to cash amounts:
2.1 Add the income in arrears AND Statement of financial To calculate the income
subtract the income received in ad- position as at Y0 receivable in cash during
vance at the beginning of Y1 (end of Y0) Y1
2.2 Subtract the income in arrears Statement of financial To calculate the income
AND add the income received in position as at Y1 received in cash during
advance at the end of Y1 Y1
Solution:
Steps to follow (see Table 7.1; shown for explanatory purposes):
Step Source of information
1. IDENTIFY the income items for the year under review Statement of profit or loss and
(for Y1 ended) other comprehensive income for
the year ended 30 June 20.4
2. ADJUST to cash amounts:
2.1 Add the income in arrears (receivable) at the Statement of financial position as
beginning of Y1 (end of Y0) at 30 June 20.3
Income receivable during the year
Subtract the income in arrears (receivable) and add the Statement of financial position as
rental income received in advance at the end of Y1 at 30 June 20.4
Calculation:
Cash receipts from customers during the year ended 30 June 20.4 (Y1)
Step 1 Step 2.1 Step 2.2 Cash receipts
Identify Adjust Adjust from
customers
(for Y1 ended) (end of Y0) (end of Y1)
Item R R* R* R
Revenue 70 000 + 15 800 – 17 300 = 68 500
Rental income (earned) 6 800 + 500 + 1 000 = 8 300
76 800
* Since revenue pertains to sales, including the credit sales, the opening and closing balances of the trade
receivables pertaining to the sales of trading inventory are used to calculate the cash received from the
debtors during the year.
Alternative scenarios concerning the rental income:
If no rental income was earned during Y1 (for 20.4 ended):
R(500 + 1 000) = R1 500 (exclude the R6 800).
If no rental income was receivable at the end of Y0 (beginning of 20.4):
R(6 800 + 1 000) = R7 800 (exclude the addition of R500).
If no rental income was received in advance at the end of Y1 (end of 20.4):
R(6 800 + 500) = R7 300 (exclude the addition of R1 000).
(b) Cash paid to suppliers and employees
Formula:
Step 1: Identify the relevant expense items in the statement of profit or loss and other
comprehensive income for the financial period under review, for example sal-
aries and wages.
Step 2: Adjust each item to a cash amount if necessary, by using the related items in
the statements of financial position.
These steps, the sources of financial information used, and the reasons for application
are shown in Table 7.2.
Chapter 7: Statement of cash flows 343
Calculation:
Expenses paid in cash during the year ended 30 June 20.4 (Y1)
Step 1 Step 2.1 Step 2.2 Cash
Identify Adjust Adjust paid to
suppliers
(for Y1 ended) (end of Y0) (end of Y1)
and
Item employees
R R R R
Salaries and wages 31 700 – + 1 000 = 32 700
Rental expenses 7 500 + 650 – 400 = 7 750
40 450
Cleo CC
Statement of profit or loss and other comprehensive income for the year ended
30 April 20.3
R
Revenue 253 440
Cost of sales (144 000)
Gross profit 109 440
Other income 19 600
Profit on sale of non-current assets: Furniture 400
Dividend income: Listed share investments 8 640
Fair value adjustment: Listed share investments 10 560
129 040
Distribution, administrative and other expenses (45 840)
Salaries to members 30 000
Remuneration: Accounting officer 8 400
Depreciation (Furniture and equipment) 2 400
Water and electricity 1 440
Credit losses 1 500
General expenses 2 100
Finance costs (6 000)
Interest on long-term loan 6 000
Cleo CC
Statement of changes in net investment of members
for the year ended 30 April 20.3
Members’ Retained Total
contributions earnings
R R R
Balances at 1 May 20.2 144 000 25 650 169 650
Members’ contributions 48 000 48 000
Total comprehensive income for the year 56 632 56 632
Distribution to members (24 000) (24 000)
Balances at 30 April 20.3 192 000 58 282 250 282
346 About Financial Accounting: Volume 2
Cleo CC
Statement of financial position as at 30 April 20.3
20.3 20.2
R R
ASSETS
Non-current assets 141 125 93 600
Property, plant and equipment 141 125 93 600
Current assets 142 080 128 850
Inventories 45 120 48 000
Trade and other receivables 17 760 14 400
Listed share investments 79 200 52 800
Cash and cash equivalents – 13 650
Additional information:
1. During the financial year under review, the cash sales amounted to R61 800.
2. Inventory is purchased on credit and held for trading.
3. The following information was extracted from the note on property, plant and
equipment:
20.3 20.2
R R
Land and buildings at cost 129 525 76 800
Furniture and equipment at carrying amount 11 600 16 800
(cost price minus accumulated depreciation)
141 125 93 600
No land and buildings were sold, and no furniture and equipment were pur-
chased. It is business policy not to sell any furniture and equipment on credit.
Chapter 7: Statement of cash flows 347
Calculations:
c Cash receipts from customers
IDENTIFY (In the statement of profit or loss or other comprehensive income for the
year ended 30 April 20.3 – see extract below)
Revenue, R253 440
348 About Financial Accounting: Volume 2
Cleo CC
Statement of profit or loss and other comprehensive income for the year ended
30 April 20.3 (relevant extract)
R
Revenue 253 440 ¥
Cost of sales (144 000)
Gross profit 109 440
Other income 19 600
Profit on sale of non-current assets: Furniture 400
[Non-cash item: Not pertaining to revenue]
Dividend income: Listed share investments 8 640
[Taken into account after cash generated from operations]
Fair value adjustment: Listed share investments 10 560
[Non-cash item: Not pertaining to revenue]
129 040
ADJUST: (Refer to the statements of financial position as at 30 April 20.2 and 30 April 20.3.)
Trade and other receivables*
20.3 20.2
R R
Trade receivables control (in respect of the sales of trading
inventory) 17 760 13 680
Income in arrears (rent)** – 720
Calculation:
Cash receipts from customers during the year ended 30 April 20.3
Step 1 Step 2.1 Step 2.2
Identify Adjust Adjust
(for 20.3 ended) (end of 20.2) (end of 20.3)
Cash receipts
+ Income in – Income in from
arrears arrears
customers
– Income + Income
received in received in
Item advance advance
R R R R
Revenue 253 440 + 13 680* – 17 760* – 1 500** = 247 860
Rental income + 720 = 720
248 580
Comment:
The cash received from the debtors can also be calculated by reconstructing the trade
receivables control account (see below). Except for the bank entry (cash received
from the debtors), all the necessary information was given to reconstruct the account.
The balancing entry of R186 060 shows the cash received from the debtors. The sum
of the cash sales (Additional information 1) and the cash received from the debtors
during the year is equal to R247 860 (R61 800 + R186 060).
Trade receivables control
Dr (reconstructed for calculation purposes) Cr
20.2 R R
May 1 Balance b/d 13 680 Credit losses 1 500
Sales 191 640 Bank* 186 060
20.3
Apr 30 Balance c/d 17 760
205 320 205 320
20.3
May 1 Balance b/d 17 760
* Balancing entry
The purchases of trading inventory were not disclosed separately in the statement of
profit or loss and other comprehensive income and are calculated:
Source R
Cost of sales Statement of profit or loss and other comprehensive
income for the year ended 30 April 20.3 144 000
Adjust Cost of sales to purchases of trading inventory
Subtract: Inventories Statement of financial position as at 30 April 20.2 (48 000)
Add: Inventories Statement of financial position as at 30 April 20.3 45 120
* Balancing entry
* Similar to expenses in arrears, the opening balance of the trade payables control account is added to
purchases: trading inventory and the closing balance is subtracted.
** The reconstructed trade payables control account below illustrates an alternative method for the calcu-
lation of the cash paid in respect of the purchases of trading inventory.
Chapter 7: Statement of cash flows 351
* Balancing entry
** See calculation above
Comment:
To simplify this discussion, the calculation of cash generated from or used in oper-
ations is explained from the starting point of a profit for the year (in respect of a sole
proprietorship or partnership) or a profit before tax (in respect of a close corporation).
Refer to the format of disclosure above to view the calculations when a loss for the
year was made.
In overview, according to the format given above:
l The starting point of disclosure is either the profit for the year (in the case of a sole
proprietorship or a partnership) or the profit before tax (in the case of a close cor-
poration) as disclosed in the statement of profit or loss and other comprehensive
income.
l All the non-cash expense and income amounts that are separately disclosed in the
statement of profit or loss and other comprehensive income must be added back
to the profit for the year/profit before tax when the cash generated from or used in
operations section is prepared according to the indirect method. (For more infor-
mation, refer to paragraph (a) below.)
l The amounts to be disclosed after the cash generated from or used in operations
section that are shown in the statement of profit or loss and other comprehensive
income must be added back to the profit for the year/profit before tax. (For more
information, refer to paragraph (b) below.)
l After the above amounts were added back, the differences between the opening
and closing balances of the applicable current asset and current liability accounts
(the balances of these accounts are disclosed in the statements of financial pos-
ition or the notes thereto) are calculated and shown when the cash generated from
or used in operations section is disclosed according to the indirect method. The
calculation and disclosure of these differences are further explained in paragraph
(c) below.
(a) Adding back the non-cash expense and income amounts that are separately
disclosed and therefore easily identifiable
When calculating the cash generated from or used in operations according to the in-
direct method, the “adding back” of a non-cash expense amount that is separately
disclosed in the statement of profit or loss and other comprehensive income means
that the expense amount is added to the profit for the year or to the profit before tax to
cancel out the non-cash expense amount. Similarly, a non-cash income amount that is
separately disclosed in the statement of profit or loss and other comprehensive in-
come is subtracted from the profit for the year or the profit before tax to cancel out the
non-cash income amount (the adding back of the non-cash expense and income
amounts are illustrated in Examples 7.4, 7.9(b) and 7.10).
Examples of non-cash expense amounts that are separately disclosed in a statement of
profit or loss and other comprehensive income that must be added back when calcu-
lating the cash generated from or used in operations according to the indirect method,
are depreciation and credit losses.
It is important to note that, unlike the adding back of depreciation, the adding back of
credit losses involve two calculations instead of one. Firstly, the credit losses are
Chapter 7: Statement of cash flows 353
added to the profit for the year or to the profit before tax. Secondly, the credit losses
are added to the closing balance of the trade receivables control account. The in-
crease in the credit balance of the profit is thus offset by an increase of the same
amount in the debit balance of the trade receivables control account.
The offsetting effect resulting from the adding back of credit losses is illustrated below:
Given information:
Dr Trade receivables control Cr
20.2 R 20.2 R
Balance b/d 8 000 Credit losses 500
Sales 2 500 Balance c/d 10 000
10 500 10 500
20.3 Balance b/d 10 000
65 500
Increase in trade receivables control (2 500)
[R(10 000 + 500*) – R8 000]
Cash generated from operations 63 000
* The credit losses of R500 are added to the closing balance of the trade receivables control account
because this amount was added to the profit for the year.
Due to this offsetting effect, the credit losses do not have to be added back when
calculating the cash generated from or used in operations according to the indirect
method. For the purpose of confirmation, see the illustration below where the credit
losses are not added back and the cash generated from operations is also calculated
as R63 000:
Credit losses not added back R
Profit for the year 65 000
Increase in trade receivables control (2 000)
R(10 000 – 8 000)
Cash generated from operations 63 000
Cleo CC
Statement of profit or loss and other comprehensive income for the year ended
30 April 20.3 (extract)
R
Gross profit and other income 129 040
Distribution, administrative and other expenses (45 840)
Salaries to members 30 000
Remuneration: Accounting officer 8 400
Depreciation (Furniture and equipment) 2 400
Water and electricity 1 440
Credit losses 1 500
General expenses 2 100
Finance costs (6 000)
Interest on long-term loan 6 000
There are two separately disclosed non-cash expenses, namely depreciation and
credit losses.
As explained above, although credit losses is a non-cash entry, it is unnecessary to
add it back.
By adding the depreciation to the profit before tax, the depreciation is excluded from
the calculation pertaining to the cash generated from or used in operations according
to the indirect method. The result is an increase of the profit by R2 400 (R79 600 –
R77 200):
R
Profit before tax 77 200
Add: Depreciation 2 400
Adjusted amount 79 600
Alternatively, the same adjusted amount can be determined by omitting the depreci-
ation in the statement of profit or loss and other comprehensive income:
R
Gross profit and other income 129 040
Distribution, administrative and other expenses (43 440)
Salaries to members 30 000
Remuneration: Accounting officer 8 400
Depreciation (Furniture and equipment) –
Water and electricity 1 440
Credit losses 1 500
General expenses 2 100
Finance costs (6 000)
Interest on long-term loan 6 000
(b) Adding back the items to be disclosed in the statement of cash flows after
the cash generated from or used in operations section
According to the format of a statement of cash flows given in paragraph 7.3 of this
chapter, dividends received, interest received, interest paid, income tax paid, draw-
ings, distribution to members paid, dividends to shareholders paid, and the proceeds
from the sale and the acquisition of financial assets at fair value through profit or loss
are disclosed separately, after the cash generated from or used in operations section,
to determine the net cash from/used in the operating activities.
The items that must be excluded from the profit for the year or the profit before tax by
adding them back are therefore the dividends earned or received, the interest earned
or received, and the interest incurred or paid. These amounts are added back in the
same manner as what the separately disclosed expense and income amounts are
added back. (The adding back of the items to be disclosed in the statement of cash
flows after the cash generated from or used in operations section are illustrated in
Examples 7.4, 7.9(b) and 7.10.)
(c) Adding back non-cash amounts that are not disclosed separately in the
statement of profit or loss and other comprehensive income
After applying paragraphs (a) and (b), included in the entries in the statement of profit
or loss and other comprehensive income, are non-cash amounts that are not disclosed
separately – for example, the credit sales that are included in the revenue. These non-
cash amounts are now calculated and added back.
To calculate the non-cash amounts, the differences between the opening (end of Y0 =
beginning of Y1) and closing balances (end of Y1) of the applicable current accounts
are calculated. The applicable current accounts are the current assets and current
liabilities that form part of the cash generated from or used in operations. Generally,
these accounts are the trade receivables pertaining to the sales of trading inventory,
inventories, and the trade payables pertaining to the purchases of trading inventory.
Comment:
The differences between the opening and closing balances of the current accounts
that pertain to items that are disclosed after the cash generated from or used in oper-
ations section, are taken into account when those items are disclosed in the statement
of cash flows. Examples of such current accounts are dividends receivable, prepaid
interest or interest in arrears, current tax receivable or payable, distribution to mem-
bers payable and dividends to shareholders payable.
In the format of the statement of cash flows given in paragraph 7.3 of this chapter,
pertaining to the cash generated from or used in operations, the differences between
356 About Financial Accounting: Volume 2
the opening and closing balances of the applicable current asset accounts and the
applicable current liability accounts are disclosed separately for explanatory purposes.
These differences may be disclosed collectively as 1) a net increase/decrease in the
trade and other receivables, 2) a net increase/decrease in the inventories and as 3) a
net increase/ decrease in the trade and other payables. (The adding back of non-cash
amounts that are not disclosed separately in the statement of profit or loss and other
comprehensive income is illustrated in Examples 7.4, 7.9(b) and 7.10.)
Example 7.4 The disclosure of cash generated from or used in operations
according to the indirect method
Use the information given in Example 7.3.
Required:
Prepare the cash generated from or used in operations section in the statement of cash
flows of Cleo CC for the year ended 30 April 20.3 according to the indirect method to
comply with the requirements of IFRS. Comparative figures are not required.
Solution:
Cleo CC
Extract from the statement of cash flows for the year ended 30 April 20.3
R R
CASH FLOWS FROM OPERATING ACTIVITIES
Profit before tax 77 200
Adjustments for (add back)*:
Interest on long-term loan (because the cash flow of this 6 000
item is disclosed after the cash generated from oper-
ations)
Depreciation (because it is a non-cash entry) 2 400
Fair value adjustment: Listed share investments (because it (10 560)
is a non-cash entry)
Dividend income: Listed share investments (because the (8 640)
cash flow of this item is disclosed after the cash gener-
ated from operations)
Profit on sale of non-current assets: Furniture (because it is (400)
a non-cash entry)
66 000
250
Decrease in inventories R(48 000 – 45 120) 2 880
Increase in trade and other receivables** R(17 760 – 14 400) (3 360)
Increase in trade and other payables*** R(14 400 – 13 670) 730
* The credit losses are not added back. (Refer to paragraph 7.6.1.2(a) in this chapter.)
** The trade receivables and rental income in arrears pertain to the cash generated from operations and
are therefore taken into account.
*** Paragraph 8 under the additional information in Example 7.3 states that the trade and other payables
pertain solely to creditors from whom trading inventory was purchased. Therefore, the balances of the
trade and other payables were used without making any adjustments. For example, creditors pertaining
to the purchase of non-current assets would have been excluded from this calculation.
Chapter 7: Statement of cash flows 357
7.6.1.3 Operating activity items disclosed after the cash generated from or used
in operations
These items are identified in the statement of profit or loss and other comprehensive
income and in the statement of changes in equity (or net investment of members). All
amounts must be disclosed as cash flow amounts by excluding any non-cash entries
according to the methods shown in tables 7.1 and 7.2.
Example 7.5 Disclosure of operating activity items after the cash generated from
or used in operations
Use the information given in Example 7.3.
Required:
Disclose the operating activity items after the cash generated from operations, and the
net cash from operating activities in the statement of cash flows of Cleo CC for the
year ended 30 April 20.3 to comply with the requirements of IFRS. Comparative figures
are not required.
358 About Financial Accounting: Volume 2
Solution:
Cleo CC
Extract from the statement of cash flows for the year ended 30 April 20.3
R R
Cash generated from operations* 66 250
Dividends received** 8 640
Interest paid** (6 000)
Income tax paid** (20 568)
Distribution to members paidc (30 890)
Acquisition of financial assets at fair value through profit or loss:
Held for trading: Listed share investmentsd (15 840)
Net cash from operating activities 1 592
* Carried forward from the solution to Example 7.3 or 7.4.
** Since the dividend income and the interest and income tax expenses have no related account(s) in the
current assets and/or the current liabilities, it is concluded that these items were received/paid in cash.
Calculations:
c Distribution to members paid
Source R
Distribution to members Statement of changes in net
investment of members 24 000
Adjust to a cash amount
Add: Distribution to members payable Statement of financial position
as at 30 April 20.2 10 330
Subtract: Distribution to members payable Statement of financial position
as at 30 April 20.3 (3 440)
The amount of R15 840 pertains to the acquisition of financial assets. Since listed
shares are purchased with cash, the R15 840 is a cash outflow.
The investment account below illustrates the calculation of the acquisition of the listed
shares by means of the balancing figure on the account.
20.2 R 20.3 R
May 1 Balance b/d 52 800 Apr 30 Balance c/d 79 200
Gain (non-cash
entry) 10 560
Bank (acquisition) 15 840*
79 200 79 200
20.3
May 1 Balance b/d 79 200
increase was the net result of a cash purchase and a cash sale, a cash outflow as well
as a cash inflow occurred.
If an asset is disclosed at carrying amount, the difference between the opening and
closing balances will not directly indicate a transaction that could have caused a cash
flow, as was the case with an asset disclosed at cost, because asset accounts at carry-
ing amounts include non-cash entries such as depreciation. Similarly, asset accounts
that are disclosed at valuation include non-cash entries such as revaluation surpluses.
The financing methods for the purchasing of non-current assets and other investments
that are excluded from cash equivalents, indicate the cash outflows that occurred:
l If an investment is purchased on credit, no cash flow occurs. The relevant asset
account is debited and a liability account credited with the amount of the pur-
chase. Although an investing activity took place, it is not a cash investing activity,
and therefore not disclosed in the statement of cash flows. The credit purchases of
non-current assets and other investments that are excluded from cash equivalents
can be disclosed in a note to the statement of cash flows (refer to paragraph 7.6.5
in this chapter).
When a payment towards a liability account by which an investment was financed
is made, the payment must be disclosed in the statement of cash flows as either an
investing or a financing activity. To simplify matters, such payments are disclosed
as investing activities in this chapter.
l If a non-current asset or an investment that is excluded from cash equivalents is
purchased for cash, the purchase is disclosed as a cash outflow in the investing
activities section of the statement of cash flows.
l If a loan was obtained to finance the purchase of a non-current asset or an invest-
ment that is excluded from cash equivalents, the acquisition of the loan is shown as
a cash inflow from a financing activity. The cash purchase of the non-current asset
or the investment is shown as a cash outflow from an investing activity. The cash
inflow that occurred when the loan was obtained may not be netted off against the
cash outflow that occurred upon the purchase of the non-current asset or the in-
vestment.
In a statement of cash flows, the cash inflow on the sale of a non-current asset or an
investment that is excluded from cash equivalents, is disclosed in the investing activi-
ties section of the statement. For example, if equipment with a carrying amount of
R2 000 was sold on credit for R1 500, and R1 200 of the R1 500 was received in cash
during the financial year under review, only the cash received, namely R1 200, is dis-
closed as a cash inflow. The selling price of R1 500 (credit) and the loss of R500 on
the sale of the equipment are not disclosed in the statement of cash flows because no
bank account (cash) entries are made when such a sale and loss are recorded. If the
equipment was sold for R1 500, cash, this amount would have been shown as a cash
inflow in the investing activities section of the statement of cash flows.
Where the carrying amount of a non-current asset such as furniture is calculated
as cost minus accumulated depreciation, the selling price of the asset, when sold
at a profit, is calculated as follows:
Carrying amount plus Profit on sale = Selling price
Chapter 7: Statement of cash flows 361
Calculations:
c Additions to land and buildings
Step 1: Determine the difference.
R
Land and buildings at cost (Statement of financial position; note on property, 129 525
plant and equipment – 20.3)
Subtract: Land and buildings at cost (Statement of financial position; note on (76 800)
property, plant and equipment – 20.2)
Increase in land and buildings 52 725
20.2 R R
May 1 Balance b/d 16 800 Realisation* 2 800
20.3
Apr 30 Depreciation 2 400
Balance c/d 11 600
16 800 16 800
20.3
May 1 Balance b/d 11 600
* Balancing entry
R R
Furniture and Bank* 3 200
equipment at
carrying amount 2 800
Profit on sale of
furniture 400
3 200 3 200
* Balancing entry. Refer to Step 2 below for a discussion on the cash flow of this transaction.
Chapter 7: Statement of cash flows 363
20.5 20.4
R R
Non-current liabilities 140 000 150 000
Long-term borrowings 140 000 150 000
Current liabilities 10 000
Current portion of long-term borrowings 10 000 –
The difference between the long-term borrowings at 20.4 and 20.5 is Rnil [R150 000 –
R(140 000 + 10 000)], showing that no movement occurred.
Step 2: Determine whether cash flow is included in the difference.
To determine whether a difference pertains to a cash flow, specifics must be con-
sidered. For example, by means of information obtained from accounting records or
notes to the financial statements.
364 About Financial Accounting: Volume 2
Required:
Prepare the cash flows from financing activities section of the statement of cash flows
of Cleo CC for the year ended 30 April 20.3 to comply with the requirements of IFRS.
Comparative figures and notes thereto are not required.
Solution:
Cleo CC
Extract from the statement of cash flows for the year ended 30 April 20.3
CASH FLOWS FROM FINANCING ACTIVITIES R R
Proceeds from members’ contributionsc 48 000
Repayment of long-term borrowingd (16 800)
Net cash from financing activities 31 200
Calculations:
c Proceeds from members’ contributions
Step 1: Determine the difference.
R
Members’ contributions (Statement of financial position as at 30 April 20.3) 192 000
Subtract: Members’ contributions (144 000)
(Statement of financial position as at 30 April 20.2)
Increase in members’ contributions* 48 000
* The statement of changes in net investment of members also shows the contribution of R48 000.
* The current portion of the long-term borrowing is added to the non-current portion when calculating the
difference. Remember that the closing balance of the long-term loan in the general ledger is R12 000.
Solution:
Cleo CC
Extract of the statement of cash flows for the year ended 30 April 20.3
R R
Net cash from operating activities* 1 592
Net cash used in investing activities* (49 525)
Net cash from financing activities* 31 200
Net decrease in cash and cash equivalents (16 733)
Cash and cash equivalents at beginning of year 13 650
Cash and cash equivalents at end of year (3 083)
* The shaded area is not required and given for illustrative purposes. The amounts pertaining to operating,
investing and financing activities were obtained from the solutions to Examples 7.5, 7.6 and 7.7.
The cash and cash equivalents at the beginning (R13 650) and end ((R3 083)) of the
year are equal to the amounts disclosed in the statements of financial position:
Cleo CC
Extract of the statement of financial position as at 30 April 20.3
20.3 20.2
R R
Current assets
Cash and cash equivalents – 13 650
Current liabilities
Bank overdraft 3 083 –
enable the users of its financial statements to evaluate the changes in its liabilities that
arose from its financing activities. According to paragraph 44D of IAS 7, one way of
adhering to the disclosure requirement of IAS 7.44A, is for a business entity to provide
a reconciliation between the opening and closing balances in its statement of financial
position for those liabilities that arose from its financing activities. In IAS 7 IE, the
disclosure of this information is illustrated as a note to the statement of cash flows.
Example 7.9 Comprehensive example – statement of cash flows of a partnership
The following financial statements pertain to a partnership trading as Ukubuya Traders:
Ukubuya Traders
Statement of profit or loss and other comprehensive income for the year ended
31 December 20.9
R
Revenue 550 000
Cost of sales (360 350)
Inventory (1 January 20.9) 240 500
Purchases 300 250
540 750
Inventory (31 December 20.9) (180 400)
201 150
Distribution, administrative and other expenses (200 325)
Transport expenses 29 950
Salaries and wages 75 975
Stationery consumed 10 900
Insurance 21 050
Depreciation (Furniture and equipment) 20 000
Water and electricity 18 400
Credit losses 5 000
Loss on sale of non-current asset: Furniture 1 300
Internet and telephone expenses 12 000
General expenses 5 750
Finance costs (7 425)
Interest on mortgage 7 425
Ukubuya Traders
Statement of changes in equity for the year ended 31 December 20.9
Capital Current accounts Revalu-
ation Appro- Total
S Zulu W Phezi S Zulu W Phezi surplus priation equity
R R R R R R R
Balances at
1 January 20.9 100 000 200 000 (5 500) 2 600 10 000 – 307 100
Capital contribution 310 000 25 000 335 000
Total comprehensive
loss for the year (6 600) (6 600)
Interest on capital* 7 000 15 400 (22 400) –
Interest on current
accounts* (350) 130 220 –
Salaries* 120 000 120 000 (240 000) –
Partners’ share of
total compre-
hensive loss
for the year (134 390) (134 390) 268 780 –
Drawings (in cash)** (50 350) (60 900) (111 250)
Balances at
31 December 20.9 410 000 225 000 (63 590) (57 160) 10 000 – 524 250
* These amounts are determined as per partnership agreement. Therefore, the amounts do not
represent whether they have been paid/received in cash.
** All withdrawals (cash or non-cash) by partners are recorded in the drawings account. In this
example, all the drawings were made in cash.
Chapter 7: Statement of cash flows 369
Ukubuya Traders
Statement of financial position as at 31 December 20.9
Note* 20.9 20.8
ASSETS R R
Non-current assets 460 500 251 500
Property, plant and equipment 1 411 500 212 500
Fixed deposit 49 000 39 000
Current assets 235 300 263 110
Inventories 180 400 240 500
Trade and other receivables 42 800 22 610
Prepayments (general expenses) 1 700 –
Cash and cash equivalents 10 400 –
* Only the note pertaining to the property, plant and equipment is disclosed.
370 About Financial Accounting: Volume 2
Ukubuya Traders
Note for the year ended 31 December 20.9
Property, plant and equipment
Land and Furniture and
Total
buildings equipment
R R R
Carrying amount at 1 January 20.9 90 000 122 500 212 500
Valuation/Cost 90 000 175 000 265 000
Accumulated depreciation – (52 500) (52 500)
Additions 200 000 25 000 225 000
Disposals (carrying amount) – (6 000) (6 000)
Depreciation for the year – (20 000) (20 000)
Carrying amount at 31 December 20.9 290 000 121 500 411 500
Valuation/Cost 290 000 190 000 480 000
Accumulated deprecation – (68 500) (68 500)
Additional information:
1. All sales of trading inventory are on credit. Only the purchases and sales of
trading inventory are recorded in the purchases and sales accounts of Ukubuya
Traders.
2. The trade and other receivables comprise:
20.9 20.8
R R
Trade receivables control (debtors pertaining to the
sales of trading inventory) 44 000 23 740
Allowance for credit losses (2 200) (1 130)
Income in arrears (rental) 1 000 –
Total 42 800 22 610
Required:
(a) Prepare the statement of cash flows of Ukubuya Traders for the year ended
31 December 20.9 to comply with the requirements of IFRS, appropriate to the
business of the partnership. The cash generated from or used in operations must
be disclosed according to the direct method. Only the note pertaining to the non-
cash investing transaction must be disclosed. Comparative figures are not re-
quired.
(b) Prepare the statement of cash flows of Ukubuya Traders for the year ended
31 December 20.9 to comply with the requirements of IFRS, appropriate to the
business of the partnership. The cash generated from or used in operations must
be disclosed according to the indirect method. Notes and comparative figures are
not required.
Solution:
(a) Direct method
Ukubuya Traders
Statement of cash flows for the year ended 31 December 20.9
Note R R
CASH FLOWS FROM OPERATING ACTIVITIES
Cash receipts from customersc 530 110
Cash paid to suppliers and employeesd (483 925)
Cash generated from operations 46 185
Interest received* 5 500
Interest paid* (7 425)
Drawings (111 250)
Net cash used in operating activities (66 990)
CASH FLOWS FROM INVESTING ACTIVITIES**
Investment in property, plant and equipment to expand
operating capacity – additions to land and buildingse 1 (200 000)
Proceeds from the sale of furnituref 4 700
Acquisition: Fixed deposit (10 000)
R(49 000 – 39 000)
Net cash used in investing activities (205 300)
CASH FLOWS FROM FINANCING ACTIVITIES
Capital contribution 310 000
Proceeds from mortgage 150 000
Net cash from financing activities 460 000
Net increase in cash and cash equivalents 187 710
Cash and cash equivalents at beginning of year (177 310)
Cash and cash equivalents at end of year 10 400
* Since no current asset or current liability account pertains to the interest income and the interest on the
mortgage, it is concluded that the interest income was received and that the interest on the mortgage
was paid.
** The furniture contributed by Phezi is a non-cash transaction and therefore excluded from the investing
and financing activities.
372 About Financial Accounting: Volume 2
Ukubuya Traders
Note for the year ended 31 December 20.9
1. Property, plant and equipment: Non-cash transaction pertaining to an investing
and a financing activity
On 1 January 20.9, furniture to the value of R25 000 was contributed by Phezi to
the business.
Calculations:
c Cash receipts from customers
Comment:
The interest income is taken into account after the cash generated from or used in
operations.
For explanatory purposes, a more detailed calculation of the cash inflows from rev-
enue is given:
l Cash inflows from revenue:
R
Revenue 550 000
Add: Trade receivables control (opening balance) 23 740
Subtract: Credit losses* (3 930)
Trade receivables control (closing balance) (44 000)
* The credit losses in the statement of profit or loss and other comprehensive income are disclosed as
R5 000. This amount comprises those trade receivables accounts that were written off during the year
and the increase in the allowance for credit losses account (the increase of the allowance account is
R2 200 --- R1 130 = R1 070). To calculate the cash flows from revenue, only credit losses pertaining to
those trade receivables accounts that were written off must be taken into account. That is R(5 000 ---
1 070) = R3 930. The cash flows from revenue can also be calculated by reconstructing the credit losses
and trade receivables control accounts.
Chapter 7: Statement of cash flows 373
Credit losses
Dr (reconstructed for calculation purposes) Cr
20.9 R 20.9 R
Dec Trade receivables Dec 31 Profit or loss 5 000
control* 3 930
31 Allowance for credit
losses 1 070
5 000 5 000
* Balancing entry
20.8 R R
Jan 1 Balance b/d 23 740 Credit losses 3 930
Sales 550 000 Bank* 525 810
20.8
Dec 31 Balance c/d 44 000
573 740 573 740
20.9
Jan 1 Balance b/d 44 000
* Balancing entry
Comment:
The depreciation, credit losses, and the loss on sale of furniture are excluded be-
cause they are non-cash entries. The interest on the mortgage is excluded be-
cause it is taken into account after the cash generated from or used in operations.
e Additions to land and buildings
According to the note pertaining to property, plant and equipment, additions to
the land and buildings amount to R200 000. Paragraph 6 of the additional infor-
mation states that all the proceeds (R150 000) from the mortgage were used to
pay for a portion of the additions to the land and buildings. Since there is no liabil-
ity pertaining to the balance of R50 000 (R200 000 – R150 000), in respect of the
additions to the land and buildings, it is concluded that this amount (R50 000) was
paid. Therefore R200 000 R(150 000 + 50 000) is disclosed as a cash outflow in
the Cash Flows from Investing Activities section. The proceeds from the mortgage
is shown as a cash inflow of R150 000 in the Cash Flows from Financing Activities
section.
f Proceeds from the sale of furniture
Carrying amount – Loss on sale of furniture = Selling price
R(6 000 – 1 300) = R4 700
Comment:
The disposal of a non-current asset is disclosed at carrying amount in the note on
property, plant and equipment.
Chapter 7: Statement of cash flows 375
Comment:
Concerning the increase in the trade and other receivables, note that the credit losses
are not added back (refer to paragraph 7.6.1.2(a) in this chapter).
376 About Financial Accounting: Volume 2
331 861
Inventory (28 February 20.5) (12 625)
610 294
Distribution, administrative and other expenses (323 115)
Credit losses 4 491
Carriage on sales 11 562
Salaries to employees 150 000
Salaries to members 105 000
Telephone expenses 11 750
Stationery consumed 4 937
Remuneration: Accounting officer 17 500
Depreciation 17 875
Finance costs (21 000)
Interest on mortgage 13 500
Interest on loan from member 7 500
* In this example, only the note pertaining to the property, plant and equipment is disclosed. All further
necessary information to prepare the statement of cash flows is given as additional information.
Chapter 7: Statement of cash flows 377
Crazehill Enterprises CC
Statement of changes in net investment of members
for the year ended 28 February 20.5
Members’ Revalu- Loans Loans
Retained
contribu- ation from to Total
earnings
tions surplus members members
R R R R R R
Balances at
1 March 20.4 93 750 446 912 20 000 37 500 (125 000) 473 162
Changes in accounting
policy
Adjusted balances 93 750 446 912 20 000 37 500 (125 000) 473 162
Members’ contributions – –
Total comprehensive
income for the year 199 137 40 000 239 137
Profit for the year 199 137 199 137
Other comprehensive
income for the year 40 000 40 000
Distribution to members (75 000) 75 000
Loans to members (46 250) (46 250)
Balances at
28 February 20.5 93 750 571 049 60 000 112 500 (171 250) 666 049
Crazehill Enterprises CC
Statement of financial position as at 28 February 20.5
Note* 20.5 20.4
R R
ASSETS
Non-current assets
Property, plant and equipment 670 875 580 000
Current assets 353 777 281 237
Inventories 12 625 21 250
Trade and other receivables 44 527 27 957
Loans to members 171 250 125 000
Listed share investments 120 000 100 000
Cash and cash equivalents 5 375 7 030
continued
378 About Financial Accounting: Volume 2
* For the purpose of this example, only the note pertaining to property, plant and equipment is disclosed.
All further necessary information to prepare the statement of cash flows is given as additional information.
Crazehill Enterprises CC
Notes for the year ended 28 February 20.5 (extract)
Property, plant and equipment
Land Buildings Equipment Total
R R R R
Carrying amount at 1 March 20.4 150 000 350 000 80 000 580 000
Valuation/Cost 150 000 350 000 100 000 600 000
Accumulated depreciation – – (20 000) (20 000)
Revaluation surplus for the year 40 000 – – 40 000
Additions 50 000 18 750 68 750
Depreciation for the year – – (17 875) (17 875)
Carrying amount at 28 February 20.5 190 000 400 000 80 875 670 875
Valuation/Cost 190 000 400 000 118 750 708 750
Accumulated depreciation – – (37 875) (37 875)
The land and buildings consist of a shop and offices on Plot No. 40, Menlyn, and were
purchased on 4 July 20.2. During the 20.5 financial year, the land was revalued by an
independent sworn appraiser. On 31 January 20.5, expansions to the building were
completed and paid for. The total cost of the expansions amounted to R50 000. The
land and buildings serve as security for the mortgage. The additions to the equipment
were cash transactions.
Chapter 7: Statement of cash flows 379
Additional information:
1. Trade and other receivables
20.5 20.4
R R
Trade receivables control (debtors pertaining to the
sales of trading inventory) 31 260 20 457
Allowance for credit losses (1 563) (2 500)
Allowance for settlement discount granted (170) –
29 527 17 957
Income in arrears (dividends receivable) 15 000 10 000
44 527 27 957
2. The interest on the loans to members for the 20.5 financial year amounted to
R21 250. The interest was capitalised.
3. Trade and other payables
20.5 20.4
R R
Trade payables control (creditors pertaining to the 31 188 40 650
purchases of trading inventory)
Allowance for settlement discount received (52) –
Accrued expenses 37 250 7 500
Carriage on purchases 938 –
Carriage on sales 312 –
Salary: Hill 15 000 –
Interest on mortgage 13 500 –
Interest on loan from member 7 500 7 500
68 386 48 150
4. Loans to members
20.5 20.4
R R
Loans to members* 171 250 125 000
* The members of the close corporation are Y Craig, D Zeelie and S Hill. During the 20.5 financial year
a further loan was made to Hill. The loans granted to the members are regarded as operating activities.
5. Listed share investments
A listed share investment is held for trading at fair value through profit or loss. The
investment comprises 50 000 ordinary shares in Watsons Ltd (consideration
R90 000).
6. The entry: Other components of equity pertains to the revaluation surplus.
7. Long-term borrowings (statement of financial position)
20.5 20.4
R R
Mortgage 75 000 –
Loans from members 45 000 37 500
120 000 37 500
380 About Financial Accounting: Volume 2
Required:
Prepare the statement of cash flows of Crazehill Enterprises CC for the year ended
28 February 20.5 to comply with the requirements of IFRS. The cash generated from or
used in operations must be disclosed according to the indirect method. Only the note
pertaining to the non-cash financing transaction must be disclosed. Comparative
figures are not required.
Solution:
Crazehill Enterprises CC
Statement of cash flows for the year ended 28 February 20.5
CASH FLOWS FROM OPERATING ACTIVITIES Note R R
Profit before tax 266 179
Adjustments for (add back):
Interest on loan from member 7 500
Interest on mortgage 13 500
Depreciation 17 875
Fair value adjustment: Listed share investment (20 000)
Interest income (21 538)
Dividend income (15 000)
248 516
Decrease in inventories R(21 250 – 12 625) 8 625
Increase in trade and other receivablesc (11 570)
Increase in trade and other payablesd 6 736
Cash generated from operations 252 307
Dividends receivede 10 000
Interest received R(21 538 – 21 250*) 288
Interest paidf (7 500)
Income tax paidg (70 000)
Loan to memberh (25 000)
Net cash from operating activities 160 095
CASH FLOWS FROM INVESTING ACTIVITIES
Investments in property, plant and equipment to
expand operating capacity (68 750)
Addition to land and buildings (50 000)
Additions to equipment (18 750)
Net cash used in investing activities (68 750)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from mortgage 75 000
Loans from membersi 1 –
Repayment of long-term borrowing (168 000)
Net cash used in financing activities (93 000)
Net decrease in cash and cash equivalents (1 655)
Cash and cash equivalents at beginning of year 7 030
Cash and cash equivalents at end of year 5 375
Crazehill Enterprises CC
Note for the year ended 28 February 20.5
1. Non-cash transaction pertaining to a financing activity
The distribution to the members was capitalised against the loans from the members.
Calculations:
c Increase in trade and other receivables
R[(44 527 – 15 000*) – (27 957 – 10 000*)]
= R(29 527 – 17 957)
= R11 570
* The trade and other receivables include dividends receivable. The dividends received must be dis-
closed after the cash generated from operations, and are therefore excluded.
d Increase in trade and other payables
R[(68 386 – 21 000*) – (48 150 – 7 500*)]
= R(47 386 – 40 650)
= R6 736
* Since interest paid must be disclosed after the cash generated from operations, the interest paya-
ble is excluded.
e Dividends received
R
Dividend income 15 000
Add: Dividends receivable (opening balance) 10 000
Subtract: Dividends receivable (closing balance) (15 000)
Dividends received 10 000
f Interest paid
R
Interest on mortgage plus interest on loan from member R(13 500 + 7 500) 21 000
Add: Interest payable (opening balance – interest on loan from member) 7 500
Subtract: Interest payable (closing balance – interest on mortgage plus
interest on loan from member) (21 000)
Interest paid 7 500
h Loan to member
R
Loans to members (closing balance) 171 250
Subtract: Loans to members (opening balance) (125 000)
Increase 46 250
Subtract: Interest capitalised (non-cash entry) (21 250)
Granting of loan to member (Hill) 25 000
382 About Financial Accounting: Volume 2
Machinery
Land and
and equip- Total
buildings
ment
R R R
Carrying amount at 1 March 20.1 290 000 149 000 439 000
Cost 290 000 177 000 467 000
Accumulated depreciation – (28 000) (28 000)
Disposals (30 000) (15 000) (45 000)
Additions 50 000 52 000 102 000
Depreciation for the year – (27 000) (27 000)
Carrying amount at 28 February 20.2 310 000 159 000 469 000
Cost 310 000 209 000 519 000
Accumulated depreciation – (50 000) (50 000)
Chapter 7: Statement of cash flows 383
4. All the property, plant and equipment purchased during the 20.2 financial year
pertain to replacements and were paid in full.
5. The current income tax expense for the financial year ended 28 February 20.2
amounted to R41 610.
6. On 28 February 20.2, Khula Limited declared dividends for the financial year on
the preference and ordinary shares, totalling R36 000.
7. The profit after tax for the year ended 28 February 20.2 amounted to R59 000.
8. The interest expense on the long-term borrowing was disclosed as R8 500 in the
statement of profit or loss and other comprehensive income of Khula Limited for
the year ended 28 February 20.2.
9. On 31 August 20.1, the shareholders approved a capitalisation issue of one (1)
ordinary share for every four (4) ordinary shares held. On this date, immediately
prior to the capitalisation issue, a total of 120 000 ordinary shares have been issued
by Khula Limited. The capitalisation issue was financed from the retained earn-
ings at R0,50 per share. All the other shares were issued for cash.
Required:
Prepare the statement of cash flows of Khula Limited for the year ended 28 Feb-
ruary 20.2 to comply with the requirements of IFRS. The cash generated from or used
in operations must be disclosed according to the indirect method. Comparative figures
and notes to the statement of cash flows are not required.
384 About Financial Accounting: Volume 2
Solution:
Khula Limited
Statement of cash flows for the year ended 28 February 20.2
R R
CASH FLOWS FROM OPERATING ACTIVITIES
Profit before tax R(59 000 + 41 610) 100 610
Adjustments for:
Depreciation 27 000
Loss on sale of machinery and equipment 5 000
Interest expense 8 500
141 110
Increase in inventories R(45 000 – 37 000) (8 000)
Increase in trade and other receivables (9 000)
R(62 000 – 53 000)
Increase in prepayments R(4 000 – 0) (4 000)
Increase in trade and other payables R(37 000 – 32 000) 5 000
Cash generated from operations 125 110
Interest paid* (8 500)
Income tax paid R(13 000 + 41 610 – 9 000) (45 610)
Dividends paid R(28 000 + 36 000 – 32 000) (32 000)
Net cash from operating activities 39 000
CASH FLOWS FROM INVESTING ACTIVITIES
Investments in property, plant and equipment to maintain
operating capacity: (102 000)
Replacement of land and buildingsc (50 000)
Replacement of machinery and equipmentd (52 000)
Proceeds from the sale of land and buildings 30 000
Proceeds from the sale of machinery and equipmente 10 000
Net cash used in investing activities (62 000)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from shares issuedf 45 000
Repayment of long-term borrowing R(80 000 – 50 000) (30 000)
Net cash from financing activities 15 000
Net decrease in cash and cash equivalents (8 000)
Cash and cash equivalents at beginning of year 3 000
Cash and cash equivalents at end of year (5 000)
* Paragraph 3 under the additional information does not show an interest expense in arrears. Therefore, the
interest expense was paid in cash.
Chapter 7: Statement of cash flows 385
Calculations:
c Replacement of land and buildings
R
Land and buildings at cost (28 February 20.2) 310 000
Add: Land and buildings sold (at cost) 30 000
Less: Land and buildings at cost (1 March 20.1) (290 000)
Land and buildings purchased 50 000
Comment:
The note on property, plant and equipment provides the information used in cal-
culations c and d, and it also discloses the additions to the assets. The calcula-
tions above are provided to demonstrate how to calculate the purchases of prop-
erty, plant and equipment when the note is not given.
e Proceeds from the sale of machinery and equipment
Paragraph 2 under the additional information states that machinery and equip-
ment with a carrying amount of R15 000 were sold for cash at a loss of R5 000.
Therefore, the selling price is R(15 000 – 5 000) = R10 000.
f Proceeds from shares issued
R
Ordinary shares issued during the financial year R(235 000 – 187 500) 47 500
Less: Capitalisation issue [R0,50 × (120 000 shares × ¼*)] (non-
(non- (15 000)
cash)
Cash proceeds from ordinary shares issued 32 500
Cash proceeds from preference shares issued R(190 000 – 177 500) 12 500
Proceeds from shares issued (total) 45 000
7.7 Summary
IAS 7
Requires that information about the historical changes in the cash and cash equivalents of a
business entity over a specific financial period be provided by means of a statement of cash
flows.
Cash and cash equivalents
• Cash
Cash on hand and demand deposits.
• Cash equivalents
Short-term, highly liquid investments readily convertible to known amounts of cash and
which are subject to an insignificant risk of changes in value.
Main objective of a statement of cash flows
To disclose how the cash and cash equivalents of a business entity were generated and
used.
Cash basis
The statement of cash flows discloses information according to a cash basis of accounting,
whereas the other financial statements are prepared according to the accrual basis of ac-
counting. This means that when a statement of cash flows is prepared from the other financial
statements, the accrued amounts must be adjusted to cash amounts.
Usefulness
Information disclosed in a statement of cash flows is useful to assess the soundness of the
financial performance of a business entity and therefore complements the other financial
statements.
Period
A statement of cash flows is prepared for a financial period, and not on a specific date.
Three main sections
A statement of cash flows comprises:
• Cash flows from operating activities
• Cash flows from investing activities
• Cash flows from financing activities
Additional information
IAS 7 requires that certain additional information to the statement of cash flows be disclosed.
In this chapter, only the requirement stated in IAS 7.43 (namely that non-cash investing and
financing activities must be disclosed elsewhere in the financial statements in a way that
provides all the relevant information about these activities) is illustrated by means of a note to
a statement of cash flows.
Chapter 7: Statement of cash flows 387
Presentation
Name of entity
Statement of cash flows for the year ended . . .
Links (by which to identify the items to be disclosed in a statement of cash flows)
Contents
Page
Overview of analysis and interpretation of financial statements ............................. 390
8.1 Introduction ................................................................................................... 391
8.2 The nature and scope of financial statement analysis ................................. 392
8.3 The objectives of financial statement analysis ............................................. 392
8.4 Application of financial statement analysis ................................................... 393
8.4.1 Profitability ratios ............................................................................. 394
8.4.1.1 Return on equity (ROE) ................................................... 395
8.4.1.2 Return on total assets (ROA) ........................................... 395
8.4.1.3 Gross profit percentage .................................................. 396
8.4.1.4 Profit margin .................................................................... 396
8.4.1.5 Financial leverage and financial leverage effect ............ 397
8.4.2 Liquidity ratios ................................................................................. 397
8.4.2.1 Current ratio .................................................................... 398
8.4.2.2 Acid test or quick ratio .................................................... 398
8.4.2.3 Trade receivables collection period ................................ 399
8.4.2.4 Trade payables settlement period .................................. 399
8.4.2.5 Inventory turnover rate .................................................... 400
8.4.2.6 Inventory-holding period ................................................. 401
8.4.3 Solvency ratios ................................................................................ 401
8.4.3.1 Debt-equity ratio .............................................................. 401
8.4.3.2 Times interest earned ratio .............................................. 402
8.5 Limitations of financial statements analysis .................................................. 402
8.6 Summary ....................................................................................................... 408
389
390 About Financial Accounting: Volume 2
Financial statement analysis entails the examination of financial statements with the
objective of disclosing significant relationships and trends in the activities of the entity
to establish if the entity is profitable, liquid and solvent.
8.1 Introduction
STUDY OBJECTIVES
An entity uses its annual financial statements to convey information about its financial
activities to the users of such financial statements. Financial statements are the most
used and comprehensive way of communicating information about the financial per-
formance and financial position of an entity. Although financial statements provide
information about the performance (statement of profit or loss and other comprehen-
sive income), financial position (statement of financial position) and cash flow (state-
ment of cash flows) of an entity for a specific financial period, information about the
risks and prospects of its business activities cannot be immediately obtained by merely
reading the financial statements. To make a thorough evaluation of and to come to a
meaningful conclusion about an entity’s financial performance and financial position,
the user needs to look at more than just easily available figures like sales, profits, total
assets and liabilities. The user of financial information must be able to read “between
the lines” of an entity’s financial statements to make more informed decisions about the
financial performance and financial position of an entity. Meaningful information from
financial statements can be obtained by analysing the data in financial statements and
interpreting the analysed data in relation to previous years and/or comparing it with
norms and standards set for the industry in which the entity operates. The purpose of
financial statement analysis is to examine the past and current financial data, pre-
sented in the financial statements of an entity, with the aim of evaluating the perform-
ance and predicting the prospects of the entity.
392 About Financial Accounting: Volume 2
Fuze Limited
Statement of financial position as at 31 December 20.2
20.2 20.1
R R
ASSETS
Non-current assets 717 050 512 690
Property, plant and equipment 697 050 484 690
Fixed deposit 20 000 28 000
Current assets 177 236 102 157
Inventories 15 150 12 100
Trade and other receivables 153 636 85 757
Cash and cash equivalents 8 450 4 300
Fuze Limited recorded a decrease in the return on total assets. A decrease in the
return on total assets can indicate a lack of managerial commitment to using total
assets optimally to earn profit for the year. Acquiring assets just before the end of the
financial year can also result in a decrease in the return on total assets ratio because
assets cannot be properly deployed to earn profits.
8.4.1.3 Gross profit percentage
The gross profit percentage is a measure of the entity’s ability to generate gross profit
from sales. It is often used to assess the intent of an entity’s management to control
inventory costs, for example, by bargaining for lower purchase prices. The gross profit
percentage also indicates the percentage of income that is left from sales to meet
other operating expenses after deducting the cost of sales. The gross profit percentage
is calculated by dividing the gross profit by sales. The gross profit percentage for Fuze
Limited is calculated as follows:
20.2 20.1
Gross profit R836 780 R589 187
Gross profit percentage = × 100 = × 100 : × 100
Sales R1 312 500 R909 000
= 63,70% : = 64,82%
The gross profit percentage declined slightly in 20.2. Changes in the gross profit
percentage are usually linked to variations in sales volumes, selling prices and cost of
sales.
8.4.1.4 Profit margin
The profit margin ratio expresses profit before tax for the year as a percentage of
sales. The profit margin indicates management’s ability to operate an entity with suf-
ficient success, not only to recover the cost of inventories purchased, expenses of
operating a business, and the interest payable on borrowed funds, but also to ensure
that a reasonable amount of profit is available to the owners as compensation for
investing in the entity. The profit margin is calculated by dividing the profit before tax
by sales. The profit margin percentage for Fuze Limited is calculated as follows:
20.2 20.1
Profit before tax R118 581 R94 887
Profit margin = × 100 = × 100 : × 100
Sales R1 312 500 R909 000
= 9,03% : = 10,44%
The profit margin declined in year 20.2, which can be attributed to an increase in one
or more of the components that make up distribution, administrative and other expenses,
without a corresponding increase in sales or/and selling prices.
Chapter 8: Analysis and interpretation of financial statements 397
liquid asset. The acid test ratio is calculated by dividing current assets less inventory
by current liabilities. An acid test ratio of 1:1 or higher is generally regarded as good
and indicates that an entity does not have to rely on the sale of inventory to raise
money to meet its short-term obligations. The acid test ratio for Fuze Limited is calcu-
lated as follows:
20.2 20.1
Acid test Current assets less inventory R(177 236 – 15 150) R(102 157 – 12 100)
= = :
ratio Current liabilities R160 702 R96 361
= 1,01: 1 : = 0,93 : 1
The acid-test ratio improved to an acceptable level in year 20.2. Improvement in the
acid-test ratio can be attributed to either an increase in current assets, excluding
inventory, or a decrease in current liabilities, or a combination of both and, as already
explained, needs to be analysed further by calculating other liquidity ratios.
8.4.2.3 Trade receivables collection period
A trade receivables (trade debtors) collection period measures the efficiency of an
entity’s debt collection practices by showing how long it takes for trade debtors to
settle their accounts. The collection period is the time period between the date of the
credit sales and receipt of payment from trade debtors for those sales. The signifi-
cance of this ratio as a liquidity ratio is that it gives an indication of the time an entity
has to wait before receiving cash from trade debtors. The ratio is calculated by multi-
plying the average of trade receivables balances with the number of days in a year
(365) and dividing the answer by the total credit sales for that period. The shorter the
collection period, the faster is the collection of cash from credit sales, and the better
the liquidity position of the entity. Assuming that all sales by Fuze Limited are credit
sales and that the opening balance of trade receivables at the beginning of the 20.1
financial period amounted to R91 600, the trade receivables collection period is calcu-
lated as follows:
Trade 20.2 20.1
receivables Average trade receivables R119 697c R88 679d
collection = Credit sales
× 365 =
R1 312 500
× 365 :
R909 000
× 365
period
= 33,29 days : = 35,61 days
c R(153 636 + 85 757) ÷ 2 = R119 697
d R(85 757 + 91 600) ÷ 2 = R88 679
The collection period improved slightly in 20.2 when compared with 20.1. An improve-
ment in the collection period ratio is usually associated with good management of trade
debtors, which could in turn affect the availability of cash to meet the entity’s short-
term financial obligations. In the absence of more information in this example, trade
and other receivables are assumed to consist of trade debtors only.
8.4.2.4 Trade payables settlement period
The trade payables settlement period ratio measures the time period it takes an entity
to settle its trade creditors. Entities in general strive to extend this period to longer than
the trade receivables collection period. This is because the cash that is received from
trade debtors is often used to settle trade creditors. The longer the payment period,
400 About Financial Accounting: Volume 2
the more time is available for an entity to generate cash to settle its trade creditors. The
trade payables settlement period is calculated by multiplying the average trade pay-
ables balances with the number of days in a year (365) and dividing the answer by the
total credit purchases for that period. Assuming that trade creditors at the beginning of
the 20.1 financial period amounted to R60 155, that all purchases are made on credit,
and that credit purchases for the 20.1 financial period amounted to R323 180, the
payables settlement for Fuze Limited is calculated as follows:
Trade 20.2 20.1
payables Average trade payables R68 946c R57 960d
= × 365 = × 365 : × 365
settlement Credit purchases R478 770e R323 180
period = 52,56 days : = 65,46 days
c R(82 126 + 55 765) ÷ 2 = R68 946
d R(55 765 + 60 155) ÷ 2 = R57 960
e Purchases for 20.2: = R(475 720 + 15150 – 12 100) = R478 770
The trade payables settlement period of Fuze Limited for 20.2 deteriorated, which
indicates that the entity is expected to settle its creditors accounts 12,90 days (65,46 –
52,56) earlier than it was in 20.1. However, when compared to the trade receivables
collection period, the trade payables settlement period for both years can be regarded
as favourable because the Fuze Limited has enough time to collect payments from
trade debtors before it settles its trade creditors. In the absence of more information in
this example, trade and other payables are assumed to consist of trade creditors only.
8.4.2.5 Inventory turnover rate
The inventory turnover rate measures the approximate number of times inventory
acquired is converted into sales in a specific financial period. This provides an indi-
cation of the efficiency with which the entity manages its inventory levels. The manage-
ment of inventory levels is crucial to an entity because inadequate inventory levels can
result in a decline in sales volumes due to inventory shortages. Conversely, high in-
ventory levels expose an entity to excessive storage costs, insurance costs, and risks
associated with the loss of inventory. An entity is expected to maintain moderate inven-
tory levels that are proportional to its activities. The inventory turnover rate is calculated
by dividing the cost of sales for a specific financial period by the average inventory for
that period. The average inventory is calculated by adding the opening and closing
balances of inventory for that period and dividing it by 2. A high inventory turnover is
suggestive of good inventory management, while a low turnover could suggest exces-
sive inventory levels, the presence of damaged inventory and low sales volumes. The
inventory turnover rate for Fuze Limited is calculated as follows:
20.2 20.1
Cost of sales R475 720 R319 813
Inventory turnover rate = = :
Average inventory R13 625c R10 417d
= 34,92 times : = 30,70 times
c Average inventory: R(15 150 + 12 100) ÷ 2 = R13 625
d Opening inventory = Cost of sales + Closing inventory – Purchases (all on credit)
R(319 813 + 12 100 – 323 180) = R8 733
Average inventory: R(12 100 + 8 733) ÷ 2 = R10 417
Chapter 8: Analysis and interpretation of financial statements 401
The inventory turnover rate improved in year 20.2 when compared with year 20.1.
Generally, an improvement in the inventory turnover ratio is considered to be a positive
indicator of efficiency in the management of inventory, since an investment in inventory
produces no revenue and increases the cost associated with holding the inventory.
8.4.2.6 Inventory-holding period
The inventory-holding period measures the number of days it takes to convert inven-
tory into sales. The higher this period, the higher the investment in inventory, which
indicates that funds that could be used to improve the entity’s ability to meet its short-
term obligations are tied up in inventory. The inventory-holding period is calculated by
multiplying the average inventory by the number of days in a year (365) and dividing
the result by the cost of sales for that period. The inventory-holding period for Fuze
Limited is calculated as follows:
20.2 20.1
Inventory-holding Average inventory R13 625 R10 417
= × 365 = × 365 : × 365
period Cost of sales R475 720 R319 813
= 10,45 days : = 11,89 days
The inventory-holding period improved in 20.2 when compared with 20.1. The
improvement in the inventory-holding period is generally associated with an increase
in the demand of the product being sold.
The debt-equity ratio of Fuze Limited deteriorated in 20.2 when compared with 20.1,
which indicates an increase in the level of financial risk for the entity. Deterioration in
the debt-equity ratio is generally associated with increased levels of borrowed funds
without a corresponding increase in the level of equity funding.
8.4.3.2 Times interest earned ratio
The times interest earned ratio measures the ability of an entity to meet its interest obli-
gations from available profits. This ratio provides an indication of whether an entity is
earning enough profits to cover the interest payment on its debt. The importance of
this ratio as a measure of solvency is that it indicates if the entity, given the amount of
debt proportion, will be able to meet its interest obligations as they come due. Failure
on the part of an entity to meet this obligation could lead to legal action being taken
against the entity and consequently liquidation of the entity. The ratio is calculated by
dividing the profit before interest and tax by finance costs (total interest payments).
20.2 20.1
Times interest earned Profit before interest and tax R150 081c R115 887d
= = :
ratio Finance costs R31 500 R21 000
= 4,76 times : = 5,52 times
c R(118 581 + 31 500) = R150 081
d R(94 887 + 21 000) = R115 887
The times interest earned ratio deteriorated in 20.2 when compared with 20.1. Despite
the decline of this ratio for Fuze Limited, the profit that is generated by the entity is still
4,76 times more than its interest obligations.
Example 8.1
Boom and Shaka are in partnership trading as Boom-Shaka Traders. The following
information relates to Boom-Shaka Traders at 28 February 20.5, the end of the financial
period.
Abstract from the financial statements of Boom-Shaka Traders as at
28 February 20.5
20.5 20.4
Capital accounts: R R
Boom 225 000 225 000
Shaka 150 000 150 000
Current accounts:
Boom (Cr) 26 400 9 000
Shaka (Cr) 21 600 6 000
Long-term borrowing 70 000 100 000
Land and buildings at cost 240 000 276 000
Machinery and equipment at cost 177 000 191 000
Accumulated depreciation: Machinery and equipment 43 000 49 000
Unlisted share investments 35 000 50 000
Inventory – 28 February 25 000 21 000
Trade and other receivables (Trade receivables) 36 000 37 000
Bank 47 000 –
Trade and other payables (Trade payables) 24 000 34 000
Bank overdraft – 2 000
Sales 234 000 179 800
Purchases 74 500 57 400
Administrative expenses 27 500 19 250
Interest on long-term borrowing 8 400 12 000
Profit for the year 123 600 91 150
Additional information:
1. All sales and purchases are on credit. The trade receivables and trade payables,
at the beginning of the 20.4 financial year, amounted to R27 500 and R29 000 re-
spectively.
2. Inventory at the beginning of the 20.4 financial year amounted to R15 000.
3. The unlisted share investment is designated as at fair value through profit or loss.
404 About Financial Accounting: Volume 2
Required:
Calculate the following ratios and interpret the calculated ratios for Boom-Shaka
Traders in relation to the industry averages. Assume 365 days in a year.
(a) Profitability ratios;
(b) Liquidity ratios; and
(c) Solvency ratios.
Solution:
(a) Profitability ratios
20.5 20.4
Profit for the year* R123 600 R91 150
Return on equity = × 100 = × 100 : × 100
Total equity R423 000e R390 000e
= 29,22% : = 23,37%
The return attributed to partners improved in 20.5 when compared with 20.4. When
compared to the industry average of 18,30%, the partners are earning above average
returns on their invested funds.
20.5 20.4
Return on Profit before interest* R132 000c R103 150c
= × 100 = × 100 : × 100
total assets Total assets R517 000h R526 000h
= 25,53% : = 19,61%
Boom-Shaka Traders recorded an improvement in the return on total assets in 20.5
when compared with 20.4. The return on assets is also relatively higher than the in-
dustry average of 15,80%, which is an indication of good management skills in the
deployment of assets by the entity.
20.5 20.4
Gross profit R163 500d R128 400d
Gross profit percentage = × 100 = × 100 : × 100
Sales R234 000 R179 800
= 69,87% : = 71,41%
When compared to 20.4, the gross profit percentage deteriorated by 1,54% (71,41 –
69,87). At 69,87% for 20.5 it is still higher than the industry average of 53,55%. It is
possible that the entity achieved a better gross profit percentage than the industry as a
result of a higher mark-up on inventory, or that inventory was obtained at a lower cost,
or a combination of both.
20.5 20.4
Profit for the year* R123 600 R91 150
Profit margin = × 100 = × 100 : × 100
Sales R234 000 R179 800
= 52,82% : = 50,70%
________________________
* A partnership does not pay tax, as the partners are taxed in their personal capacity. As a
result, profit for the year is used in the calculations instead of profit before tax.
Chapter 8: Analysis and interpretation of financial statements 405
Boom-Shaka Traders recorded a lower profit margin than the industry average of
53,69%. It slightly increased from 20.4 to 20.5. The deviation from the industry average
can possibly be attributed to higher distribution, administrative and general expenses.
20.5 20.4
Return on equity 29,22% 23,37%
Financial leverage = = :
Return on assets 25,53% 19,61%
= 1,14 : = 1,19
The financial leverage for Boom-Shaka Traders deteriorated in 20.5 when compared
with 20.4. The financial leverage of the entity is also slightly below the industry average
of 1,16. However the entity’s financial leverage still exceeds one, which indicates that
the entity is generating positive returns on borrowed funds.
20.5 20.4
Return on equity 29,22% 23,37%
Leverage effect = :
Less: Return on total assets (25,53%) (19,61%)
3,69% : 3,76%
The effect of financial leverage gives an indication of the surplus amount of profit that
is attributable to the partners from the use of borrowed funds. Despite a decline in the
leverage effect, the partners are still generating positive returns from the use of bor-
rowed funds.
20.5 20.4
Profit before interest R132 000c R103 150c
Times interest earned ratio = = :
Interest expense R8 400 12 000
= 15,71 times : = 8,60 times
The times interest earned ratio is slightly better than that of the industry average of
13,24. It also improved during 20.5 when compared with 20.4.
Calculations:
c Profit for the year before interest
20.5 20.4
R R
Profit for the year 123 600 91 150
Interest on long term borrowings 8 400 12 000
132 000 103 150
e Equity
R R
Capital R(225 000 + 150 000) 375 000 375 000
Current accounts R(26 400 + 21 600) 48 000
R(9 000 + 6 000) 15 000
423 000 390 000
f Non-current assets
R R
Property, plant and equipment R(240 000 + 177 000 – 43 000) 374 000
R(276 000 + 191 000 – 49 000) 418 000
Unlisted investment at fair value through profit or loss 35 000 50 000
409 000 468 000
g Current assets
R R
Inventories 25 000 21 000
Trade receivables 36 000 37 000
Cash and cash equivalents 47 000 –
108 000 58 000
408 About Financial Accounting: Volume 2
h Total assets
R R
Non-current assets 409 000 468 000
Current assets 108 000 58 000
517 000 526 000
i Non-current liabilities
R R
Long-term borrowing 70 000 100 000
70 000 100 000
j Current liabilities
20.5 20.4
R R
Trade payables 24 000 34 000
Bank overdraft – 2 000
24 000 36 000
8.6 Summary
The purpose of financial statement analysis is to examine the past and current financial
data presented in the financial statements of an entity, with the aim of evaluating the
performance and predicting the prospects of the entity. It is often associated with ratio
analysis, which examines the relationships among various financial statement items
both at a point in time and over time. Financial ratios are useful indicators of an entity’s
performance and financial position and are grouped according to the information they
provide. The three groups of financial ratios discussed in this chapter are profitability,
liquidity and solvency ratios. Profitability ratios measure the ability of an entity to gen-
erate profits. Liquidity ratios measure the entity’s ability to pay its short-term financial
obligations on time. Solvency ratios measure the ability of an entity to pay its long-term
financial obligations and thereby remain solvent and avoid cash flow problems, which
may consequently lead to liquidation if not managed appropriately.
The determined ratios are only useful when compared with specific industry standards,
as well as with past performances of the entity regarding each specific ratio. This is
referred to as trend analysis and compares ratios over time. Ratios, however, have
limitations which the analyst should take cognisance of when interpreting the results to
draw meaningful conclusions.
CHAPTER 9
Branches
Contents
Page
Overview of accounting for branches ..................................................................... 410
9.1 Introduction ................................................................................................... 411
9.2 Accounting for dependent branches ............................................................ 412
9.3 Recording of transactions where inventory sent to the branch is invoiced
at cost price .................................................................................................. 412
9.3.1 Introduction...................................................................................... 412
9.3.2 Inventory sent to the branch and purchases by the branch ........... 413
9.3.3 Inventory returned to head office .................................................... 414
9.3.4 Sale of inventory by the branch ....................................................... 415
9.3.5 Settlement discount granted to debtors .......................................... 415
9.3.6 Inventory marked down ................................................................... 416
9.3.7 Cash embezzled or stolen ............................................................... 416
9.3.8 Inter-branch inventory transactions ................................................. 418
9.3.9 Branch expenses............................................................................. 419
9.3.10 Inventory in transit ........................................................................... 420
9.3.11 Inventory on hand ............................................................................ 420
9.3.12 Inventory shortages and surpluses at the branch ........................... 420
9.3.13 Balancing of branch accounts ........................................................ 421
9.4 Recording of transactions where inventory sent to the branch is invoiced
at selling price .............................................................................................. 426
9.4.1 Introduction...................................................................................... 426
9.4.2 Calculation of the profit mark-up in branch inventory ..................... 426
9.4.3 Inventory sent to the branch and purchases by the branch ........... 427
9.4.4 Inventory returned to head office .................................................... 428
9.4.5 Sale of inventory by the branch ....................................................... 429
9.4.6 Settlement discount granted to debtors .......................................... 430
9.4.7 Inventory marked down ................................................................... 430
9.4.8 Cash embezzled.............................................................................. 434
9.4.9 Inter-branch inventory transactions ................................................. 434
9.4.10 Branch expenses............................................................................. 436
9.4.11 Inventory in transit ........................................................................... 436
9.4.12 Inventory on hand ............................................................................ 436
9.4.13 Inventory shortages and surpluses at the branch ........................... 436
9.4.14 Balancing of branch accounts ........................................................ 437
9.5 Summary ....................................................................................................... 445
409
410 About Financial Accounting: Volume 2
9.1 Introduction
STUDY OBJECTIVES
Trading and service entities in search of wider markets establish branches in suburbs,
towns and cities which operate separately from the central (main) entity. The concept
of “branches” implies that there is one managing entity, referred to as the “head
office”, which is remote from the branches. “Branches” are business centres which are
established with the aim of increasing turnover and ultimately the profitability of the
business entity. Other reasons why business entities might want to establish branches
are to reduce administrative costs by centralising administration at head office, and to
negotiate better purchase discounts when buying is centralised and on a large scale.
The way branches are organised and operated differs from entity to entity, ranging
from dependent branches (managed and controlled by the head office) to independ-
ent branches (managed as separate business entities that report their financial results
periodically to the head office).
The method of branch organisation and operation adopted by an entity depends on
the requirements of the business organisation. Some entities operate branches which
merely display inventory samples and accept sales orders which are sent to the head
office for further processing. Other entities operate branches at which only certain types
of inventories are kept. Inventories not on hand can be ordered at the branch and are
sent to customers from the head office. Most entities, however, permit branches to have
a full selling function, that is, all types of inventories are kept at the branch and the
412 About Financial Accounting: Volume 2
branch is even allowed to make a limited amount of its own purchases if the need
arises. Because there is no uniformity in branch organisation and operation, account-
ants and bookkeepers must adopt an accounting system that will suit the needs of the
head office and the conditions under which the branch operates. The discussion in
this chapter will only cover the accounting procedures for dependent branches that
have a full selling function and are permitted to make a limited amount of their own
purchases. The accounting records of a dependent branch are kept by the head office
and it is from that perspective that all transactions of the branch are recorded.
The abovementioned accounts are exclusively used to record all inventory trans-
actions of the head office with its branch. A branch inventory account and inventory to
branch account will have to be opened for every branch of the entity. Other types of
transactions that involve, for example, the settlement of branch debtors’ accounts or
payment of branch expenses that may be incurred in the operation of the branch, are
recorded in the accounts that are specifically opened for these transactions and will
again be for every branch the entity has.
Where inventory is invoiced to the branch at cost price, the branch inventory account
serves the same purpose as the normal trading account because when balanced at
the end of the accounting period, the balance represents the gross profit or loss of the
branch. The gross profit or loss is the result of the difference between the price at
which inventory is received from the head office and the price at which it is sold by the
branch. The gross profit or loss is transferred to the credit side (when a profit is made)
or debit side (when a loss is made) of the branch expense account to balance the
branch inventory account.
At the end of the accounting period, the inventory to branch account is closed off to
the head office trading account. This entry is necessary to record inventory that was
purchased by the head office but subsequently sent to the branch.
Examples 9.1 to 9.9 illustrate the basic concepts underlying the recording of branch
transactions in the books of the head office of AB Traders when inventory is invoiced
to the branch at cost price. The compilation of branch accounts will progress with
every example, as transactions occur. The recording of new transactions, illustrated in
the examples, will be highlighted as opposed to information that originated in subse-
quent examples.
Solution:
AB Traders (Head office)
General ledger
Dr Branch inventory: Aye (at cost price) Cr
R
Inventory to branch: Aye 50 000
(Deliveries at cost)
Bank (Branch local purchases at 10 500
cost)
Dr Bank Cr
R
Branch inventory: Aye 10 500
(Branch local purchases at cost)
Dr Bank Cr
R R
Branch inventory: Aye (Cash sales) 25 000 Branch inventory: Aye 10 500
(Branch local purchases at cost)
Required:
Record the above transaction in the general ledger of head office.
Solution:
AB Traders (Head office)
General ledger
Dr Bank Cr
R R
Branch inventory: Aye (Cash sales) 25 000 Branch inventory: Aye 10 500
Branch trade receivables control: 4 900 (Branch local purchases at cost)
Aye (Debtors’ payments)
that has been embezzled. The entries in the branch trade receivables control account
are necessary to reflect the payment by a debtor. The bank account is debited with
the amount of cash banked.
Example 9.5 Cash embezzled or stolen
After an investigation, it was discovered that R500 cash received from cash sales of
R2 000 and R250 cash received from a debtor in full settlement of his account of
R3 250 was stolen at Aye branch. Due to the pending investigation, the transactions
were not yet accounted for.
Required:
Record the above transactions in the general ledger of head office.
Solution:
Dr Bank Cr
R R
Branch inventory: Aye (Cash sales) 25 000 Branch inventory: Aye 10 500
Branch trade receivables control: 4 900 (Branch local purchases at cost)
Aye (Debtors’ payments)
Branch inventory: Aye (Cash sales) 1 500
Branch inventory: Aye 3 000
(Debtors’ payments)
continued
418 About Financial Accounting: Volume 2
Note that in both instances, cash embezzled is debited to the branch expenses
account to reflect the loss on the part of Aye branch.
Dr Bank Cr
R R
Branch inventory: Aye (Cash sales) 25 000 Branch inventory: Aye 10 500
Branch trade receivables control: 4 900 (Branch local purchases at
Aye (Debtors’ payments) cost)
Branch inventory: Aye (Cash sales) 1 500 Branch expenses: Aye 4 500
Branch inventory: Aye (Branch maintenance)
Branch inventory: Aye 3 000
(Debtors’ payments)
Comments:
l At the end of the accounting period, inventory in transit from the branch to head
office (R1 000), is recorded as a balance carried down on the debit side of the
422 About Financial Accounting: Volume 2
branch inventory account. This becomes the opening balance for the new account-
ing period on the credit side of the branch inventory account.
l Inventory in transit from head office to the branch (R2 500) is recorded as a sep-
arate balance carried down on the credit side of the branch inventory account. At
the beginning of the new accounting period, it becomes the opening balance that
is recorded on the debit side of the branch inventory account.
l When the branch inventory account is balanced, the branch gross profit of R9 150
is obtained. The gross profit equals the difference between the prices at which in-
ventory was sold by the branch (selling price) and the prices at which inventory
was received by the branch (cost price). The gross profit is transferred to the credit
side of the branch expense account.
Dr Inventory to branch: Aye (at cost price) Cr
R R
Branch inventory: Aye 2 000 Branch inventory: Aye 50 000
(Returns at cost) (Deliveries at cost)
Head office trading account 48 000
50 000 50 000
Comment:
The branch expenses account serves the same function as the profit or loss account
and records all expenses incurred by the branch. The balance on this account repre-
sents the branch profit for the year of R3 850, which is incorporated into the head
office profit or loss account.
Chapter 9: Branches 423
Dr Bank Cr
R R
Branch inventory: Aye 25 000 Branch inventory: Aye 10 500
(Cash sales) (Branch local purchases at
Branch trade receivables cost)
control: Aye 4 900 Branch expenses: Aye 4 500
(Debtors’ payments) (Branch maintenance)
Branch inventory: Aye 1 500 Balance c/d 19 400
(Cash sales)
Branch trade receivables
control: Aye 3 000
(Debtors’ payments)
34 400 34 400
Balance b/d 19 400
Additional information:
1 Inventory is invoiced to the branch at cost price.
2 Inventory at 31 December 20.1 amounted to R2 200 which was in agreement with
the inventory count.
Required:
Prepare the following accounts in the general ledger of Country Trading CC:
(a) Branch inventory;
(b) Inventory to branch;
(c) Bank;
(d) Branch trade receivables control;
(e) Branch expenses; and
(f) Settlement discount granted.
Balance and close off all the accounts at 31 December 20.1.
Solution:
(a) Country Trading CC (Head office)
General ledger
* In the case where the head office has a single branch, it is not necessary to identify each branch
account by adding the name of the branch to the ledger account, as was the case in the previous ex-
amples (refer to Aye and Bee branches).
(b)
Dr Inventory to branch (at cost price) Cr
20.1 R 20.1 R
Dec 31 Branch inventory 1 000 Dec 31 Branch inventory 20 000
(Returns at cost) (Deliveries at cost)
Head office trading
account 19 000
20 000 20 000
Chapter 9: Branches 425
(c)
Dr Bank Cr
20.1 R 20.1 R
Jan 1 Balance b/d 1 000 Dec 31 Branch expenses 400
Dec 31 Branch inventory 16 000 Balance c/d 22 600
(Cash sales)
Branch trade receiv-
ables control 6 000
(Debtors’
payments)
23 000 23 000
20.2
Jan 1 Balance b/d 22 600
(d)
Dr Branch trade receivables control Cr
20.1 R 20.1 R
Jan 1 Balance b/d 2 500 Dec 31 Bank (Debtors’ 6 000
Dec 31 Branch inventory 9 500 payments)
(Credit sales) Settlement discount
granted 200
Balance c/d 5 800
12 000 12 000
20.2
Jan 1 Balance b/d 5 800
(e)
Dr Branch expenses Cr
20.1 R 20.1 R
Dec 31 Bank (Sundry 400 Dec 31 Branch inventory 3 500
expenses) (Branch gross
Head office: Profit or profit for the year)
loss (Branch profit
for the year) 3 100
3 500 3 500
(f)
Dr Settlement discount granted: Aye Cr
R R
Branch trade receivables control: 200 Branch inventory 200
(Settlement discount granted)
200 200
426 About Financial Accounting: Volume 2
The selling price includes the profit mark-up. To determine profit mark-up, the follow-
ing calculation is necessary:
25/125 × R250 = R50
The cost price is therefore:
R250 – R50 = R200
The cost price can also be determined directly as a percentage of the selling price.
Using the above example, the cost price can be calculated as follows:
100/125 × R250 = R200
Examples 9.11 to 9.16 illustrate the basic concepts underlying the recording of branch
transactions, in the books of XYZ Traders (the head office), when inventory is invoiced
to the branch at selling price. The compilation of branch accounts will progress with
every example as transactions occur. The recording of new transactions, illustrated in
the examples, will be, highlighted as opposed to information that originated in sub-
sequent examples.
Required:
Record the above transactions in the general ledger of head office.
428 About Financial Accounting: Volume 2
Solution:
XYZ Traders (Head office)
General ledger
Dr Branch inventory: Omega (at selling price) Cr
R
Inventory to branch: Omega 100 000
(Deliveries at cost)
Branch adjustment: Omega c25 000
(Mark-up on deliveries)
Branch trade payables control:
Omega 20 000
(Local purchases at cost)
Branch adjustment: Omega d5 000
(Mark-up on local purchases)
Calculations:
c R100 000 × 25% = R25 000
d R20 000 × 25% = R5 000
Calculations:
c R15 000 × 100/125 = R12 000
d R15 000 × 25/125 = R3 000 or R15 000 – R12 000 = R3 000
Required:
Record the above transactions in the general ledger of head office.
Solution:
Dr Bank Cr
R
Branch inventory: Omega 75 000
(Cash sales)
was recorded when inventory was received by the branch from the head office so that
the branch inventory account maintains its function as a control account over the
inventory transactions of the branch.
Example 9.13 Inventory marked down
Inventory is invoiced to Omega branch at selling price, which is cost plus 25%. During
the year, Omega branch sold inventory at a discount of 20% on selling price for
R3 200 cash.
Required:
Record the above transaction in the general ledger of head office.
Solution:
The discount on the normal selling price can be determined as follows:
%
Cost price 100
Profit mark-up 25
Original selling price 125
Mark-down (20% × 125) (25)
Sold at 100
Dr Bank Cr
R
Branch inventory: Omega 75 000
(Cash sales)
Branch inventory: Omega 3 200
(Cash sales)
It may also happen that the inventory is marked down or discounted to below cost.
Remember that when inventory was invoiced to the branch at cost price, the mark
down of inventory to below cost required no entry in the books because the branch
inventory account fulfilled the purpose of a trading account. When inventory is in-
voiced to the branch at selling price, the branch inventory account now functions as a
control account of all inventory transactions of the branch. Thus, the mark down to
below cost price must be recorded on the credit side of the branch inventory account,
or else the branch inventory account will reflect a shortage of inventory. The second
account that is affected by the mark down on cost is the branch expense account,
which is credited with the amount of the mark down on cost.
Note that the accounting treatment of a mark down below cost consists of two parts,
namely, (1) a mark down on the normal selling price to cost, and (2) an additional mark
down on the cost of the inventory.
Example 9.14 Inventory marked down below cost
Inventory is invoiced to Omega branch at selling price, which is cost plus 25%. During
the year, inventory was sold at a discount of 30% on the selling price for R2 940 cash.
Required:
Record the above transaction in the general ledger of head office.
Solution:
The normal selling price can be calculated as follows:
%
Cost price 100
Profit mark-up 25
Original selling price 125
Mark-down (30% × 125) (37,5)
Sold at 87,5
Dr Bank Cr
R
Branch inventory: Omega 75 000
(Cash sales)
Branch inventory: Omega 3 200
(Cash sales)
Branch inventory: Omega 2 940
(Cash sales)
continued
434 About Financial Accounting: Volume 2
Dr Branch expenses Cr
R
Branch inventory: Omega 420
(Mark-down on cost)
Solution:
XYZ Traders (Head office)
General ledger
Dr Branch inventory: Omega (at selling price) Cr
R R
Inventory to branch: Omega 100 000 Inventory to branch: Omega 12 000
(Deliveries at cost) (Returns at cost)
Branch adjustment: Omega 25 000 Branch adjustment: Omega 3 000
(Mark-up on deliveries) (Mark-up on returns)
Branch trade payables control: Bank (Cash sales) 75 000
Omega 20 000 Branch trade receivables control:
(Local purchases at cost) Omega 18 750
Branch adjustment: Omega 5 000 (Credit sales)
(Mark-up on local purchases) Bank (Cash sales) 3 200
Branch inventory: Alpha c10 400 Branch adjustment: Omega 800
(Inventory transferred from (Mark-down on sales)
Alpha branch) Bank (Cash sales) 2 940
Branch adjustment: Omega d2 600 Branch adjustment: Omega 840
(Mark-up on inventory (Mark-down on sales)
transferred from Alpha branch) Branch expenses: Omega 420
(Mark-down on cost)
Calculations:
c R13 000 × 100/125 = R10 400
d R13 000 × 25/125 = R2 600
436 About Financial Accounting: Volume 2
Required:
(a) Record the above information in the general ledger of head office.
(b) Balance and close off the following accounts:
l Branch inventory: Omega (at selling price);
l Branch adjustment: Omega (mark-up at 25% on cost);
l Inventory to branch: Omega (at cost price);
l Branch expenses.
438 About Financial Accounting: Volume 2
Solution:
(a) and (b) XYZ Traders (Head office)
General ledger
Dr Branch inventory: Omega (at selling price) Cr
R R
Inventory to branch: Omega 100 000 Inventory to branch: Omega 12 000
(Deliveries at cost) (Returns at cost)
Branch adjustment: Omega 25 000 Branch adjustment: Omega 3 000
(Mark-up on deliveries) (Mark-up on returns)
Branch trade payables control: Bank (Cash sales) 75 000
Omega 20 000 Branch trade receivables
(Local purchases at cost) control: 18 750
Branch adjustment: Omega 5 000 Omega (Credit sales)
(Mark-up on local Bank (Cash sales) 3 200
purchases) Branch adjustment: Omega 800
Branch inventory: Alpha 10 400 (Mark-down on sales)
(Inventory transferred from Bank (Cash sales) 2 940
Alpha branch) Branch adjustment: Omega 840
Branch adjustment: Alpha 2 600 (Mark-down on sales)
(Mark-up on inventory Branch expenses: Omega 420
transferred from Alpha (Mark-down on cost)
branch) Balance (Inventory in transit) c/d 11 500
Balance (Closing inventory) c/d 34 160
Branch adjustment: Omega 390
(Inventory shortage)*
163 000 163 000
Balance (Inventory in transit) b/d 11 500
Balance (Opening inventory) b/d 34 160
* The inventory shortage amounting to R390 is a balancing figure calculated after recording the inventory
on hand and inventory in transit.
continued
Chapter 9: Branches 439
Calculations:
c R11 500 × 25/125 = R2 300
d R34 160 × 25/125 = R6 832
Comment:
The gross profit of R18 438 is a balancing figure and can only be obtained after
recording the balance carried down (unrealised profit in closing inventory) of R6 832,
and profit mark-up on inventory in transit of R2 300. This gross profit represents the
profit derived from the branch’s trading activities and is transferred to the branch
expenses account.
Dr Inventory to branch: Omega (at cost price) Cr
R R
Branch inventory: Omega 12 000 Branch inventory: Omega 100 000
(Returns at cost) (Deliveries at cost)
Head office trading account 88 000
100 000 100 000
Solution:
(a) Fish CC (Head office)
General ledger
Dr Branch inventory (at selling price)* Cr
20.1 R 20.1 R
Jan 1 Balance b/d c11 040 Dec 31 Branch trade re-
Dec 31 Inventory to branch 108 000 ceivables control 38 400
(Deliveries at (Credit sales)
cost) Bank (Cash sales) 88 000
Branch adjustment d21 600 Inventory to branch 2 400
(Mark-up on (Returns at cost)
deliveries) Branch adjustment e480
Bank g12 500 (Mark-up on
(Local purchases returns)
at cost) Branch expenses 2 000
Branch adjustment g2 500 (Damaged inven-
(Mark-up on local tory at cost)
purchases) Branch adjustment f400
Branch adjustment 490 (Mark-up on
(Inventory damaged
surplus)** inventory)
Branch expenses 750
(Cash
embezzled)
Branch adjustment h5 000
(Mark-down on
sales)
Branch expenses i2 500
(Mark-down on
cost)
Branch expenses 4 000
(Stolen inventory
at cost)
Branch adjustment j800
(Mark-up on
stolen inventory)
Branch expenses k1 500
(Donated inven-
tory at cost)
Branch adjustment k300
(Mark-up on do-
nated inventory)
Balance c/d 9 600
156 130 156 130
20.2
Jan 1 Balance b/d 9 600
* In the case where the head office has a single branch, it is not necessary to identify each branch
account by adding the name of the branch to the ledger account as was the case in the previous
examples (refer to Alpha and Omega branches).
** Inventory surplus amounting to R490 is a balancing figure calculated after recording the inventory on
hand.
442 About Financial Accounting: Volume 2
(b)
Dr Inventory to branch (at cost price) Cr
20.1 R 20.1 R
Dec 31 Branch inventory 2 400 Dec 31 Branch inventory 108 000
(Returns at cost) (Deliveries at
Head office trading cost)
account 105 600
108 000 108 000
(c)
Dr Branch adjustment (mark-up at 20% on cost) Cr
20.1 R 20.1 R
Dec 31 Branch inventory 480 Jan 1 Balance (Mark-up c1 840
(Mark-up on on opening
returns) inventory)
Branch inventory 400 Dec 31 Branch inventory 21 600
(Mark-up on (Mark-up on
damaged deliveries)
inventory) Branch inventory 2 500
Branch inventory 5 000 (Mark-up on local
(Mark-down on purchases)
sales) Branch inventory 490
Branch inventory 800 (Inventory
(Mark-up on surplus)
stolen inventory)
Branch inventory 300
(Mark-up on
donated
inventory)
Settlement discount
granted 600
Branch expenses 17 250
(Branch gross
profit for the year)
Balance c/d l1 600
(Mark-up on
closing inventory)
26 430 26 430
20.2
Jan 1 Balance (Mark-up b/d 1 600
on opening
inventory)
Chapter 9: Branches 443
(d)
Dr Branch trade receivables control Cr
20.1 R 20.1 R
Dec 31 Branch inventory 38 400 Dec 31 Bank (Debtors’ 20 000
(Credit sales) payments)
Settlement discount
granted 600
Balance c/d 17 800
38 400 38 400
20.2
Jan 1 Balance b/d 17 800
(e)
Dr Bank Cr
20.1 R 20.1 R
Jan 1 Balance b/d 10 000 Dec 31 Branch inventory 12 500
Dec 31 Branch inventory 88 000 (Local purchases
(Cash sales) at cost)
Branch trade Balance c/d 105 500
receivables
control (Debtors’ 20 000
payments)
118 000 118 000
20.2
Jan 1 Balance b/d 105 500
(f)
Dr Settlement discount granted Cr
R R
Branch trade receivables control 600 Branch adjustment 600
(Settlement discount granted)
600 600
(g)
Dr Branch expenses Cr
20.1 R 20.1 R
Dec 31 Branch inventory 2 000 Dec 31 Branch adjustment 17 250
(Damaged inven- (Branch gross
tory at cost) profit for the year)
Branch inventory 750
(Cash embezzled)
Branch inventory 2 500
(Mark-down on
cost)
continued
444 About Financial Accounting: Volume 2
Dr Branch expenses Cr
20.1 R 20.1 R
Branch inventory 4 000
(Stolen inventory
at cost)
Branch inventory 1 500
(Donated inven-
tory at cost)
Head office: Profit
or loss (Branch 6 500
profit for the year)
17 250 17 250
Calculations:
c Balance on 1 Jan 20.1 (Mark-up on opening inventory)
%
Cost 100
Profit mark-up 20
Selling price 120
9.5 Summary
To expand business activities and increase profitability, business entities establish
branches in areas where there are markets that can be penetrated. Branches are busi-
ness centres that operate remotely from the main entity, the head office. Branches can
be classified as either dependent or independent branches. Dependent branches are
centrally controlled branches and rely on the head office for the provision of inventory
and payment of the major expenses. Accounting records of dependent branches are
kept by the head office. In contrast, independent branches are managed as separate
business entities and report their financial results periodically to the head office. The
discussion in this chapter was confined to dependent branches only.
Inventory can be sent and invoiced by head office to the branch either at cost or sell-
ing price. Where inventory is invoiced to the branch at cost price, the branch inventory
and inventory to branch accounts are opened to record all inventory transactions
between the head office and its branch. Additional accounts are also opened to deal
with the specific transactions of the branch, for example a trade receivables control
account to record all debtor transactions of the branch and a branch expenses
account to record all expenses that may be incurred by the branch in its operations.
The purpose of the branch inventory account is to record all inventory transactions, at
cost price, between the head office and its branch as well as purchases by the branch
from third parties. The branch inventory account is also used to record all the inventory
transactions between the branch and its customers. All transactions that may have an
influence on the inventory of the branch are recorded in the branch inventory account.
It follows that if inventory is invoiced at cost price, the branch inventory account func-
tions as a trading account, which is balanced to obtain a gross profit or loss. The gross
profit (or loss) equals the difference between the prices at which inventory is received
by the branch and the prices at which it is sold.
If inventory is sent to the branch and invoiced at the selling price, the head office will
need an additional account, the branch adjustment account, over and above the
branch inventory account and inventory to branch account to record inventory trans-
actions with the branch. When inventory is invoiced to the branch at selling price, the
purpose of the branch inventory account changes from that of a trading account
(where inventory is invoiced at cost) to that of an inventory control account. All entries
in this account are made at selling prices but are split into a cost price element and a
profit mark-up element. All transactions that may have an influence on inventory of the
branch are also recorded in the branch inventory account. The cost price on all inven-
tory transactions between the branch and head office is recorded in the inventory to
branch account. The branch adjustment account represents a trading account when
inventory is invoiced at selling price. The profit mark-up on all inventory transactions
between the branch and head office, and when the branch makes its own purchases,
is recorded in the branch adjustment account. When balanced, a gross profit or loss is
446 About Financial Accounting: Volume 2
calculated. In both instances, when inventory is invoiced at cost price and when inven-
tory is invoiced at selling price, the gross profit or loss is transferred to the branch
expenses account. The branch expenses account deals with all expenses of the
branch paid for by the branch or head office. When the branch expenses account is
balanced, a profit or loss of the branch is obtained. This profit or loss of the branch is
incorporated on the statement of profit or loss and other comprehensive income of the
head office when financial statements of the head office are prepared. The preparation
of the financial statements of the head office, however, falls outside the scope of this
chapter.
CHAPTER 10
Manufacturing entities
Contents
Page
Overview of an accounting system for manufacturing entities ............................... 448
10.1 Introduction ................................................................................................... 449
10.2 Introducing a manufacturing cost statement ................................................ 450
10.3 Defining manufacturing costs ....................................................................... 451
10.3.1 Direct material ................................................................................. 451
10.3.2 Direct labour .................................................................................... 451
10.3.3 Primary costs ................................................................................... 451
10.3.4 Manufacturing overheads................................................................ 451
10.4 Stages of the manufacturing process ........................................................... 453
10.5 Recording the transactions of a manufacturing entity .................................. 453
10.6 Preparing a manufacturing cost statement .................................................. 460
10.7 Recording the transactions relating to the sale of finished products
inventory and the incurrence of administrative expenses by a
manufacturing entity ..................................................................................... 461
10.8 Adjusting the allowance for unrealised profit in finished products
inventory ....................................................................................................... 463
10.9 Preparing the statement of profit or loss and other comprehensive income
of a manufacturing entity .............................................................................. 465
10.10 Summary ....................................................................................................... 469
447
448 About Financial Accounting: Volume 2
10.1 Introduction
STUDY OBJECTIVES
In the preceding chapters, the discussion of accounting systems and procedures was
devoted to service and trading entities whose activities are conducted through differ-
ent types of ownership, for example sole traders, partnerships and close corporations.
In contrast to the activities of a trading entity, which buys manufactured products and
sells them at a profit, a manufacturing entity manufactures the products that the trading
entities buy and sell. A manufacturing entity transforms basic raw materials into market-
able products, for example, a manufacturer of motorcars buys steel, rubber, aluminium,
plastics and other materials, from which it manufactures motorcars. These materials are
called “raw materials” and during the manufacturing process they change form and
shape to become marketable products. The manufactured cars are delivered to car
dealers and the trading entities who sell them to the customers.
Although keeping a set of accounting records for a manufacturing entity does not dif-
fer markedly from that of a trading entity, the unique characteristics of a manufacturing
entity require additional accounting applications and procedures regarding cost allo-
cations. In the case of a trading entity, the cost of purchases can easily be determined
by adding the purchase invoices. The cost of sales and closing inventories are there-
fore easy to calculate. On the other hand, the cost of finished products for a manufac-
turing entity cannot be calculated from invoices alone. The manufacturing costs include
other items, for example materials used, labour and other manufacturing costs that
must be taken into account before the cost of a finished product can be determined.
The objective of accounting for manufacturing entities is to ensure that accurate cost
allocations are made so that the entity can determine the manufacturing cost of its
450 About Financial Accounting: Volume 2
products accurately. Accurate cost allocations will also ensure that closing inventories
of finished products are shown at the correct cost price. In most manufacturing en-
tities, there are three main stages for which the inventory must be accounted for, at the
end of the financial period. These stages are:
l unprocessed inventory (raw materials);
l partly completed inventory (work-in-progress); and
l completed inventory (finished products).
for primary costs. Manufacturing overheads can be divided into three main categories,
namely:
l Indirect materials include those material items used in the manufacturing process
which cannot be directly and accurately traced to a specific product or which are
so insignificant in value that it may not be cost-effective to trace it to a specific fin-
ished product. For example, the nails and screws that were used in the manufactur-
ing of wooden furniture can be so inexpensive in comparison with the other direct
material costs that were incurred, that it is uneconomical to allocate the costs of
the nails and screws to a specific finished product. The nails and screws, however,
still form part of the manufacturing costs of the e furniture (refer to the framework of
a manufacturing cost statement in paragraph 10.2).
l Indirect labour includes the wages of all employees who do not work on the manu-
factured product itself, but who assist in the overall manufacturing operation.
Examples of indirect labour are the wages of factory cleaners, security and main-
tenance personnel as well as the salary-related expenses rather as you use it
throughout of these employees such as unemployment insurance fund contri-
butions, skills development levies and pension fund contributions paid by the
employer. The salary of a production supervisor or foreman is also indirect by
nature, as this person’s role in the manufacturing process is to control and oversee
the whole manufacturing process. For information purposes, however, these sal-
aries and salary-related expenses are normally disclosed separately in the manu-
facturing cost statement (refer to the framework of a manufacturing cost statement
in paragraph 10.2).
l Other manufacturing overheads consist of that portion of the costs, other than
indirect materials and indirect labour, that are linked to the manufacturing process,
but which cannot be directly allocated to a specific product. This includes costs
such as factory insurance, maintenance and depreciation of factory equipment.
In certain instances, it may be necessary to allocate certain shared cost items
between the manufacturing and other administrative departments, such as the
general administration and sales departments housed within the entity. Examples
of shared costs are rent, water, electricity, and telephone expenses. Normally
management formulates allocation criteria that are used to allocate these types of
costs to the administrative and manufacturing departments of the entity. For ex-
ample, the floor space occupied by each department could be used as the basis
to allocate the cost of rent for the entire premises between the administrative and
the manufacturing departments. A fixed percentage allocation can also be used,
for example, 60% of the water and electricity that were consumed by the entity can
be allocated to the administrative department, and the remaining 40% to the manu-
facturing department. Selling, administrative and other general non-production
costs do not form part of the manufacturing process and are not included in manu-
facturing overheads. These costs are incurred by the selling and administrative
departments of the entity and are reported on the statement of profit or loss and
other comprehensive income as distribution, administrative and other expenses.
Chapter 10: Manufacturing entities 453
Solution:
Raw materials purchased, the railage costs incurred, and the returns and issuing of
raw materials to production:
Khaya Manufacturers
General journal
Debit Credit
20.8 R R
Dec 31 Inventory: Raw materials 52 000
Trade payables control 52 000
Purchases of raw materials
Railage: Raw materials 1 000
Bank 1 000
Railage paid on purchases of raw materials
Trade payables control 7 500
Inventory: Raw materials 7 500
Raw materials returned
Inventory: Work-in-progress 79 600
Manufacturing overheads – indirect material 10 000
Inventory: Raw materials 89 600
Issue of direct and indirect materials
Inventory: Raw materials 1 000
Railage: Raw materials 1 000
Transfer of railage cost to inventory of raw materials
Khaya Manufacturers
General ledger
Dr Inventory: Raw materials Cr
20.8 R 20.8 R
Jan 1 Balance b/d 90 000 Dec 31 Trade payables
Dec 31 Trade payables control 7 500
control 52 000 Inventory: Work-in-
Railage: Raw progress 79 600
materials 1 000 Manufacturing
overheads 10 000
Balance c/d 45 900
143 000 143 000
20.9
Jan 1 Balance b/d 45 900
Comment:
When raw materials are purchased, both the direct and indirect materials are recorded
in the inventory: raw materials account. The inventory: raw materials account is debited
with the cost price of inventory purchased (R52 000). The cost of transporting the
purchased raw materials to the production site is debited in the railage: raw materials
account (R1 000). When issuing direct materials to the manufacturing process, the
inventory: raw materials account is credited with the direct materials issued to manufac-
turing (R79 600) and a new account, unique to manufacturing entities, namely the in-
ventory: work-in-progress account, is debited with the direct materials costs (R79 600).
The indirect materials that were issued to the production process must be transferred
to the manufacturing overheads account. Therefore, the inventory: raw materials
account is credited with R10 000 and manufacturing overheads debited. At the end of
the accounting period, the railage: raw materials account is closed off to the inventory:
raw materials account to record the total cost of raw materials purchased during the
accounting period.
Labour costs incurred:
Khaya Manufacturers
General journal
Debit Credit
20.8 R R
Dec 31 Labour costs 15 500
Bank 15 500
Payment of direct and indirect labour costs
Inventory: Work-in-progress (direct labour cost) 10 075
Manufacturing overheads (salary of a factory 5 425
manager)
Labour costs 15 500
Allocation of labour costs between direct and in-
direct costs
Khaya Manufacturers
General ledger
Dr Labour costs Cr
20.8 R 20.8 R
Dec 31 Bank 15 500 Dec 31 Inventory:
Work-in-progress 10 075
Manufacturing
overheads 5 425
15 500 15 500
Comment:
When labour costs are incurred, the total amount thereof, which in this example equals
R15 500, is recorded in the labour costs account. The labour costs are then allocated
according to the nature of the labour, that is, the direct labour cost of R10 075
(R15 500 × 65%) is allocated to the inventory: work-in-progress account, and the
Chapter 10: Manufacturing entities 457
salary of R5 425 (R15 500 × 35%) that was paid to the factory manager is recorded in
the manufacturing overheads account.
Other manufacturing expenses incurred and the allocation thereof to manufactur-
ing overheads:
Khaya Manufacturers
General journal
Debit Credit
20.8 R R
Dec 31 Water and electricity 500
Repairs: Factory machinery 1 000
Bank 1 500
Recording of payments
Depreciation: Factory machinery 20 000
Accumulated depreciation on factory machinery 20 000
Recording of annual depreciation
Manufacturing overheads 21 400
Water and electricity (factory) (R500 × 80%) 400
Repairs: Factory machinery 1 000
Depreciation: Factory machinery 20 000
Transfer of other manufacturing expenses to manu-
facturing overheads
Khaya Manufacturers
General ledger
Dr Manufacturing overheads Cr
20.8 R 20.8 R
Dec 31 Inventory: Dec 31 Inventory:
Raw materials 10 000 Work-in-progress 36 825
Labour costs: Salary
factory foreman 5 425
Dr Manufacturing overheads Cr
20.8 R R
Dec 31 Water and electricity 400
Repairs: Factory
machinery 1 000
Depreciation:
Factory machinery 20 000
36 825 36 825
Comment:
The allocation of other manufacturing costs (excluding indirect material and indirect
labour already dealt with) to production, is recorded in the manufacturing overheads
account. This account is a control account for all indirect manufacturing costs. The
total expense incurred in respect of water and electricity is R500, of which R400
relates to the manufacturing activity and is therefore treated as manufacturing
458 About Financial Accounting: Volume 2
overheads. The difference of R100 (R500 – R400) is a general expense which must be
disclosed on the statement of profit or loss and other comprehensive income as part of
selling, administrative and general expenses. Repairs and depreciation on factory
machinery are also factory-related costs, and therefore form part of manufacturing
overheads.
At the end of the accounting period, the total of the manufacturing overheads
account (R36 825), is transferred to inventory: work-in-progress by debiting the inven-
tory: work-in-progress account and crediting the manufacturing overheads account.
This is illustrated as follows:
Transferring manufacturing overheads to inventory – work in progress:
Khaya Manufacturers
General journal
Debit Credit
20.8 R R
Dec 31 Inventory: Work-in-progress 36 825
Manufacturing overheads 36 825
Allocation of manufacturing overheads
Khaya Manufacturers
General ledger
Dr Inventory: Work-in-progress Cr
20.8 R 20.8 R
Jan 1 Balance b/d 28 000 Dec 31 Inventory: Finished
Dec 31 Inventory: Raw products 111 500
materials 79 600 Balance c/d 43 000
Direct labour costs 10 075
Manufacturing
overheads 36 825
154 500 154 500
20.9
Jan 1 Balance b/d 43 000
Comment:
The inventory: work-in-progress account is used to accumulate the total manufacturing
cost as it is incurred in the manufacturing process. This account shows that resources
amounting to R154 500 were put into the production process. This amount is rep-
resented by the opening balance of inventory: work-in-progress (production not com-
pleted in the previous production cycle) of R28 000, raw materials issued to production
of R79 600, direct labour cost incurred of R10 075, and manufacturing overheads of
R36 825. At the end of the current production cycle, production amounting to R43 000
is still incomplete, which implies that R111 500 (R154 500 – R43 000) production
resources put into the manufacturing process, was completed and transferred to the
sales department. The following journal entries illustrate the recording of the transfer of
completed products from inventory: work-in-progress account to the inventory: finished
products account.
Chapter 10: Manufacturing entities 459
It was mentioned previously that when finished products are transferred from the
manufacturing department to the sales department, a profit mark-up is added to the
cost of products manufactured (refer to paragraph 10.4). In this example, products are
transferred to the sales department at cost plus 25%. To account for the profit mark-up
on manufactured products, the following entry is necessary:
Adding the profit mark-up to inventory – finished products:
Khaya Manufacturers
General journal
Debit Credit
20.8 R R
Dec 31 Inventory: Finished products 27 875
Manufacturing profit mark-up R(111 500 × 25%) 27 875
Recording of profit mark-up
Khaya Manufacturers
General ledger
Dr Inventory: Finished products Cr
20.8 R 20.8 R
Jan 1 Balance b/d 65 000 Dec 31 Cost of sales 115 975
Dec 31 Inventory: Work-in- Balance c/d 88 400
progress 111 500
Manufacturing profit
mark-up 27 875
204 375 204 375
20.9
Jan 1 Balance b/d 88 400
Comment:
The profit mark-up on finished products is recorded on the debit side of the inventory:
finished products account. This will in effect adjust the cost of finished products to
approximate the cost at which similar products can be purchased externally by the
460 About Financial Accounting: Volume 2
entity. The manufacturing profit mark-up account is credited with the profit mark-up of
R27 875 on manufactured products. At the end of the financial period, the manu-
facturing profit mark-up account is normally closed off to the profit and loss account.
For the sake of simplicity, the profit and loss account is not prepared in this chapter.
The manufacturing profit mark-up is therefore directly disclosed on the statement of
profit or loss and other comprehensive income.
Required:
Prepare the manufacturing cost statement of Khaya Manufacturers for the year ended
31 December 20.8
Chapter 10: Manufacturing entities 461
Solution:
Khaya Manufacturers
Manufacturing cost statement for the year ended 31 December 20.8
R
Direct materials used 79 600
Inventory: Materials (1 January 20.9) 90 000
Purchases: Raw materials (R52 000 – R7 500 – R10 000)* 34 500
Railage: Raw materials 1 000
125 500
Inventory: Raw materials (31 December 20.9) (45 900)
Direct labour 10 075
Primary costs 89 675
Manufacturing overheads 36 825
Indirect materials used* 10 000
Salary: Factory manager 5 425
Water and electricity: Factory 400
Repairs: Factory machinery 1 000
Depreciation: Factory machinery 20 000
Total manufacturing costs 126 500
Inventory: Work-in-progress (1 January 20.9) 28 000
154 500
Inventory: Work-in-progress (31 December 20.9) (43 000)
Cost of finished products manufactured 111 500
Manufacturing profit (R111 500 × 25%) 27 875
Cost of finished products manufactured transferred to the sales department 139 375
* The amount of direct raw materials purchased is calculated by subtracting the amount of indirect raw
materials of R10 000 (disclosed as manufacturing overheads), and raw materials returned of R7 500.
for the year ended 31 December 20.8. Post the general journal to the following
accounts in the general ledger of Khaya Manufacturers:
l cost of sales;
l sales; and
l trade receivables control.
Close off and balance the accounts at 31 December 20.8.
Solution:
Khaya Manufacturers
General journal
Debit Credit
20.8 R R
Dec 31 Cost of sales 115 975
Inventory: Finished products 115 975
Recording the cost of sales
Trade receivables control 150 000
Sales 150 000
Recording of sales
Salaries and wages (administrative personnel) 5 000
Bank 5 000
Recording of salaries and wages
Khaya Manufacturers
General ledger
Dr Cost of sales Cr
20.8 R 20.8 R
Dec 31 Inventory: Dec 31 Trading account 115 975
Finished products 115 975
Dr Sales Cr
20.8 R 20.8 R
Dec 31 Trading account 150 000 Dec 31 Trade receivables
control 150 000
Comment:
When products are sold, the cost thereof is debited to the cost of sales account (per-
petual inventory system) and the inventory: finished products account is credited. At
the same time, the selling price of the products sold on credit is debited to the trade
receivables control account and credited to the sales account. The cost of sales and
sales accounts are normally closed off to the trading account. However, in this
Chapter 10: Manufacturing entities 463
chapter, the trading account is not prepared and therefore the cost of sales and sales
are directly disclosed on the statement of profit or loss and other comprehensive
income.
Adjustment of the allowance for unrealised profit in finished products inventory at the
end of the year:
R
Allowance for unrealised profit in inventory: Finished products 13 000
(opening inventory)
Allowance for unrealised profit in inventory: Finished products (17 680)
(closing inventory) (R88 400 × 25/125)
Adjustment – increase in the allowance (4 680)
At the beginning of the current year, the accounting records of Khaya Manufacturers
indicate a balance of R13 000 as the allowance for unrealised profit in the inventory of
finished products. At the end of the current year, the inventory level of finished prod-
ucts is different. Therefore, the balance of R13 000 must be adjusted to reflect a cor-
rect allowance for unrealised profit in the inventory of finished products at the end of
the current year. The allowance for unrealised profit in inventory of finished products
must be increased by R4 680 (R17 680 – R13 000). To record an increase in the
allowance for unrealised profit in the inventory of finished products, the unrealised
profit in inventory: finished products account is debited and the allowance for unreal-
ised profit: finished products account is credited.
Khaya Manufacturers
General journal
Debit Credit
20.8 R R
Dec 31 Unrealised profit in inventory: Finished products 4 680
Allowance for unrealised profit in inventory:
Finished products 4 680
Adjustment of the allowance for unrealised profit in
finished products inventory
Khaya Manufacturers
General ledger
Dr Allowance for the unrealised profit in inventory: Finished products Cr
20.8 R 20.8 R
Dec 31 Balance c/d 17 680 Jan 1 Balance b/d 13 000
Dec 31 Unrealised profit
in inventory:
Finished products 4 680
17 680 17 680
20.9
Jan 1 Balance b/d 17 680
continued
Chapter 10: Manufacturing entities 465
Comment:
At the end of the accounting period, the balance of the unrealised profit in inventory:
finished products account is closed off to the profit and loss account.
The allowance for the unrealised profit in inventory: finished products account is a
contra asset account. Therefore, the balance of this account is not closed off to another
account. For disclosure purposes on the statement of financial position, the balance of
this account is deducted from the cost of finished products inventory figure.
Solution:
Khaya Manufacturers
Statement of profit or loss and other comprehensive income for the year ended
31 December 20.9
R
Revenue 150 000
Cost of sales (115 975)
Inventory: Finished products (1 January 20.9) 65 000
Cost of finished products transferred 139 375
204 375
Inventory: Finished products (31 December 20.9) (88 400)
* The unrealised profit in the finished products inventory is disclosed as a deduction in statement of profit
or loss and other comprehensive income because the finished products inventory level increased during
the year, resulting in an increase in the allowance for unrealised profit in inventory: finished products
(refer to paragraph 10.8).
R
Wages and salaries paid (factory personnel) 33 000
Rent expenses: Factory 4 950
Offices 3 300
Insurance expense: Factory 2 145
Offices 825
Water and electricity: Factory 26 730
Offices 4 785
Depreciation: Manufacturing equipment 3 000
Office furniture 900
Sales during the year 150 000
Provisional income tax payments 16 000
Additional information: R
1. Inventory balances – 28 February 20.9:
Raw materials 33 450
Work-in-progress 52 455
Finished products 32 200
2. All indirect materials issued were used in the production process.
3. 30% of salaries and wages is an indirect labour cost of which R3 900 was paid to
the factory supervisor.
4. Products are transferred to the sales department at cost plus 15%.
5. At 1 March 20.8, the allowance for the unrealised profit in finished products inven-
tory amounted to R6 000.
6. Income tax for the year amounted to R16 767 and must still be provided for.
Required:
(a) Prepare the manufacturing cost statement of Zombo Manufacturers CC for the
year ended 28 February 20.9.
(b) Prepare the statement of profit or loss and other comprehensive income of Zombo
Manufacturers CC for the year ended 28 February 20.9 to comply with the require-
ments of IFRS. Notes and comparative figures can be ignored.
468 About Financial Accounting: Volume 2
Solution:
(a) Zombo Manufacturers CC
Manufacturing cost statement for the year ended
28 February 20.9
R
Direct materials used 31 800
Inventory: Raw materials (1 March 20.8) 15 750
Purchases R(50 130 – 630) 49 500
65 250
Inventory: Raw materials (28 February 20.9) (33 450)
Direct labour R(33 000 × 70%) 23 100
Primary costs 54 900
Manufacturing overheads 47 355
Indirect material 630
Indirect labour [R(33 000 × 30%) – R3 900] 6 000
Salary: Factory supervisor 3 900
Rent expense 4 950
Insurance expense 2 145
Water and electricity 26 730
Depreciation 3 000
Calculation:
c Adjustment of the unrealised profit in inventory of finished products
R
Allowance for the unrealised profit in inventory: Finished products 6 000
(opening inventory)
Allowance for the unrealised profit in inventory: Finished products (4 280)
(closing inventory) (R32 200 × 15/115)
Adjustment – decrease in the allowance 1 800
10.10 Summary
In this chapter, accounting systems and procedures for manufacturing entities are dis-
cussed. A manufacturing entity is described as a business entity that transforms basic
raw materials into marketable products. It differs from a trading entity in that a trading
entity buys finished products and sells it at a profit.
Manufacturing costs in a manufacturing entity relate to the cost of resources put into
the production process and consist of three categories: direct material, direct labour,
and manufacturing overheads. Direct material cost comprises the cost of raw materials
470 About Financial Accounting: Volume 2
Contents
Page
Overview of a master budget of a manufacturing entity ......................................... 472
Overview of a master budget of a trading entity ..................................................... 473
11.1 Introduction .................................................................................................. 474
11.2 Description and main function of a budget ................................................. 474
11.3 The relationship between budgets and managerial activities ..................... 475
11.3.1 Planning .......................................................................................... 475
11.3.2 Coordination ................................................................................... 475
11.3.3 Control ............................................................................................ 476
11.4 Employee participation ................................................................................ 476
11.5 Advantages and limitations of budgets ....................................................... 476
11.6 The role of accounting information in the budgetary process ..................... 477
11.7 The budgeting procedure ............................................................................ 477
11.8 The structure of an elementary master budget ........................................... 478
11.8.1 The operating budget ..................................................................... 479
11.8.2 The financial budget ....................................................................... 479
11.8.3 The budgeted financial statements ................................................ 479
11.9 The structure and preparation of the operating budget of a manufacturing
entity ............................................................................................................ 480
11.9.1 Main operating budgets ................................................................. 480
11.9.1.1 The sales budget ........................................................... 480
11.9.1.2 The production budget .................................................. 481
11.9.2 Subsidiary operating budgets ........................................................ 482
11.9.2.1 The direct raw materials usage budget ......................... 482
11.9.2.2 The direct raw materials purchase budget .................... 482
11.9.2.3 The direct labour budget ............................................... 483
11.9.2.4 The manufacturing overhead budget ............................ 484
11.9.2.5 The cost of sales budget ................................................ 485
11.10 Preparation of a cash budget ...................................................................... 490
11.11 Summary ...................................................................................................... 495
471
Overview of a master budget of a manufacturing entity
FINANCIAL BUDGET BUDGETED FINANCIAL STATEMENTS
Cash budget
(refer to Example 10.9) Budgeted
statement of
financial position
Budgeted
Cost of sales budget Non-manufacturing
Budgeted statement
(refer to Example 10.7) income and expense budget
statement of profit of cash
or loss and other flows
comprehensive
Direct raw materials budget income
Direct raw Direct raw materials Manufacturing
Direct labour overhead budget
materials usage purchase budget
budget (refer to (refer to
budget (refer to (refer to
Example 10.5) Example 10.6)
Example 10.3) Example 10.4)
Budgeted
manufacturing
Production budget cost statement
(refer to Example 10.2)
Sales budget
(refer to Example 10.1)
Overview of a master budget of a trading entity
FINANCIAL BUDGET BUDGETED FINANCIAL STATEMENTS
11.1 Introduction
STUDY OBJECTIVES
standards and schedules which will cloud the creativity and motivation of personnel.
On the other hand, over-simplified or casually applied budgets may lead to the omis-
sion of core directives and can cause workers to perceive budgets as of lesser im-
portance which may readily be deviated from.
11.3.1 Planning
Planning entails the formulation of objectives and goals for a business as a whole, and
for each section of a business entity and the selection of the most appropriate activity
plan to attain these objectives and goals. Plans are influenced by the environment of a
business and are based on forecasts pertaining to aspects such as demand, supply
and expected technological improvements.
Objectives can be distinguished from goals in that objectives are representative of the
expected broad long-term future position of a business, whereas goals are set to attain
objectives by focusing on shorter periods, delegating responsibilities and setting
quantitative standards. Planning therefore encompasses strategic (long-term) activi-
ties, such as investment management, as well as tactical (short-term) activities, such
as setting monthly sales targets.
Since planning sets requirements, budgetary calculations are formulated based on the
planning. For example, the setting of required sales and inventory levels of finished
products during the planning process will influence the preparation of the production
budget of a business. Thus, planning and budgetary processes are interrelated and
complementary. The direction towards the attainment of goals of a business is largely
influenced by a strong execution of these processes.
11.3.2 Coordination
Limited resources, such as cash and production capacity, and the interrelatedness of
business activities necessitate the task of coordination. Coordination is the synchron-
isation of individual actions with the result that each subdivision of an entity effectively
works toward the common objective, with due regard for all other subdivisions and
with united effort. Each member of the management team must be informed of the
strategic and tactical plans of the business as a whole for them to align their individual
plans with those pertaining to the rest of the business.
Since plans usually have a direct effect on more than one section or subdivision of a
business, they need to be coordinated, and the related budgets structured accordingly.
The design of a budgetary system is thus dependent on the quality of the co-
ordination activities of management.
476 About Financial Accounting: Volume 2
11.3.3 Control
Control can be considered as the process of measuring actual performance against a
quantified and/or qualified standard to determine any significant differences (vari-
ances) according to which appropriate steps must be taken. Since budgets are quan-
titative performance standards which relate to specific time periods in the future, they
can serve as frameworks against which objective controlling activities can be per-
formed. A sound budgetary system will be embedded within the planning and control-
ling activities of management. As such it serves as an organised link between these
two activities, sustaining co-ordination and continuity.
annual budgetary system. However, it should be noted that the flexibility induced by a
continuous budgetary system should not impede its controlling advantages. To attain
the objective of enhanced flexibility, continuous budgets are prepared for shorter
periods than a year, usually on a quarterly basis, divided into months. A continuous
budget does not expire in its entirety. It is sustained by replacing an expired period of
the budget (such as a monthly period within a quarterly budget) by a future period of
the budget which is of equal length as the expired period. For example, if a quarterly
continuous budget is prepared monthly, say for January, February and March, and the
first month of the budget (January) has expired, then the budget for January will be
deleted and the budget for April will be added to the budget.
Budgetary systems are time related, and a selected budget period will thus direct the
budgetary system to be applied. When determining a budget period, the advantages
and disadvantages of the different budgetary systems must thus be considered. For
example, a continuous budgetary system might not induce sufficient financial benefits
to carry the cost of sustaining it.
Step 3: Prepare the necessary budgets.
Once the key performance areas and the budget period(s) have been determined, a
master budget can be prepared. Any further budgets deemed necessary, should then
be based on the master budget.
Step 4: Implement, evaluate and revise the budgets.
The implementation of budgets should neither be too rigid; to discourage the taking of
unforeseen opportunities, nor too flexible; to vindicate a casual approach towards the
importance of budgetary control. To maintain the practicality of budgets, they should
be evaluated frequently, but revisions should be made with caution.
Master budgets indicate only the basic operating and financial budgets which pertain
to the entity, and the way these budgets are linked to each other. In this chapter we
will only focus on the shaded budgets indicated in the overview. Since the master
budget of a manufacturing entity is more comprehensive than that of a trading entity,
the discussion will further focus on the budgets of a manufacturing entity.
In similar fashion, a budgeted statement of changes in equity (in part) and a budgeted
statement of financial position can be prepared from a financial budget. A budgeted
statement of cash flows can primarily be prepared from the other budgeted financial
statements. It is also possible to prepare a budgeted statement of cash flows accord-
ing to the direct method from a cash budget. The preparation of budgeted financial
statements falls outside the scope of this chapter.
* These entries do not form part of the budget and are shown for calculation purposes only.
Example 11.4 Layout of a direct raw materials purchase budget (units and value)
Direct raw materials purchase budget for the year ended 31 December 20.6
(units and value)
Budgeted
Budgeted
quantity Budgeted Budgeted
Required Required cost
of direct quantity quantity Estimated
closing opening price
Direct raw of direct of direct cost
inventory inventory of direct
raw materials raw raw price
of direct of direct raw
materials usage materials materials per
raw raw materials
(refer to to be to be unit
materials materials to be
Example available purchased
purchased
11.3)
A* B* A + B* C* (A + B) – C* D* [(A + B) – C]
× D*
Kg Kg Kg Kg Kg R R
Material
P-1005
Product X 70 500 517 500 588 000 65 500 522 500 1,50 783 750
Material Ɛ Ɛ Ɛ Ɛ Ɛ
Q-1006
Product Y 24 900 325 500 350 400 22 900 327 500 2,25 736 875
1 520 625
* These entries do not form part of the budget and are shown for calculation purposes only.
* These entries do not form part of the budget and are shown for calculation purposes only.
Calculations:
c Product X: R83 880 × 57 000/102 000 = R46 874
Product Y: R83 880 × 45 000/102 000 = R37 006
d Product X: R36 150 × 57 000/102 000 = R20 202*
Product Y: R36 150 × 45 000/102 000 = R15 948*
* Rounded off
e Product X: R120 030 × 57 000/102 000= R67 076
Product Y: R120 030 × 45 000/102 000= R52 954
11.9.2.5 The cost of sales budget
The cost of sales budget is prepared from the required values of the inventories of
opening and closing finished goods, as well as from the budgeted manufacturing
costs of the finished goods over a specific budget period. The budgeted manufactur-
ing costs of the finished goods pertain to the budgeted direct raw materials usage, the
direct labour and the manufacturing overhead expenses. The layout of a cost of sales
budget is illustrated in Example 11.7.
Example 11.7 Layout of a cost of sales budget
Assume that the budgeted opening inventory of finished goods amounted to R873 623
in respect of product X and to R893 940 in respect of product Y. The budgeted manu-
facturing costs can be carried forward from Examples 11.3, 11.5 and 11.6.
Cost of sales budget for the year ended 31 December 20.6
Product X Product Y Total
R R R
Required opening inventory – finished products
(given) 873 623 893 940 1 767 563
Budgeted manufacturing costs 1 096 826 935 329 2 032 155
Direct raw materials usage (refer to Example 11.3) 776 250 732 375 1 508 625
Direct labour (refer to Example 11.5) 253 500 150 000 403 500
Manufacturing overhead expenses
(refer to Example 11.6) 67 076 52 954 120 030
1 970 449 1 829 269 3 799 718
Required closing inventory – finished productsc (982 311) (909 621) (1 891 932)
Cost of sales 988 138 919 648 1 907 786
486 About Financial Accounting: Volume 2
Calculations:
c Value of the budgeted closing inventory of finished products
Required number of finished products in closing inventory × manufacturing cost
per unit
Product X: R63,58c × 15 450* = R982 311
Product Y: R28,74c × 31 650* = R909 621
* Refer to Example 11.2.
Manufacturing cost per unit
Product X Product Y
Cost divided Manu- Cost divided by Manu-
by number facturing number of units facturing
of units cost manufactured cost
manufactured per unit per unit
R R
Direct raw materials usage
(refer to Example 11.3) R776 250/17 250 45,00 R732 375/32 550 22,50
Direct labour:
Skilled (refer to Examples
11.2 and 11.5) R240 000/17 250 13,91 R120 000/32 550 3,69
Unskilled (refer to Examples
11.2 and 11.5) R13 500/17 250 0,78 R30 000/32 550 0,92
Manufacturing overhead
expenses (refer to
Examples 11.5 and 11.6) R67 076/17 250 3,89* R52 954/32 550 1,63*
63,58 28,74
(c) The direct raw materials usage budget (units and value)
Wonderworld CC
Direct raw materials usage budget for the year ended 31 December 20.8
(units and value)
Quantity of Budgeted
Budgeted
Budgeted direct raw Estimated cost price
quantity of
amount of materials cost of direct
Product direct raw
units to be required to price raw
materials
produced produce per kg/Ɛ materials
usage
one unit usage
Hero 127 500 3 kg 382 500 kg R3,50 R1 338 750
Zero 101 000 5 l 505 000 l R2,50 R1 262 500
Total R2 601 250
(d) The direct raw materials purchase budget (units and value)
Wonderworld CC
Direct raw materials purchase budget for the year ended 31 December 20.8
(units and value)
Budgeted Budgeted Budgeted
Required Budgeted Required
quantity quantity cost price
closing quantity opening Estimated
of direct of direct of direct
inventory of direct inventory cost price
Product raw raw raw
of direct raw of direct per
materials materials materials
raw materials raw unit
to be to be to be
materials usage materials
available purchased purchased
Hero 29 350 kg 382 500 kg 411 850 kg 25 000 kg 386 850 kg R3,50 R1 353 975
Zero 22 000 l 505 000 l 527 000 l 18 000 l 509 000 l R2,50 R1 272 500
Total R2 626 475
R R R
Fixed overhead expenses 246 681c 390 819c 637 500
Variable overhead expenses 49 336d 78 164d 127 500
Total manufacturing overhead expenses 296 017 468 983 765 000
Calculations:
c Product Hero: R637 500 × 255 000/659 000* = R246 681
c Product Zero: R637 500 × 404 000/659 000* = R390 819
d Product Hero: R127 500 × 255 000/659 000* = R49 336
d Product Zero: R127 500 × 404 000/659 000* = R78 164
* Refer to Solution (e).
or
c Product Hero: R637 500/659 000 × 2 × 127 500* = R246 681
c Product Zero: R637 500/659 000 × 4 × 101 000* = R390 819
d Product Hero: R127 500/659 000 × 2 × 127 500* = R49 336
d Product Zero: R127 500/659 000 × 4 × 101 000* = R78 164
* Refer to Solution (e).
Calculations:
c Value of the budgeted closing inventory of finished products
Required number of finished products in closing inventory × manufacturing cost
per unit
Product Hero: 15 000 × R22,82c = R342 300
Product Zero: 10 000 × R33,14c = R331 400
Manufacturing cost per unit
Product Hero Product Zero
Cost divided Manu- Cost divided Manu-
by number facturing by number facturing
of units cost of units cost
manufactured per unit manufactured per unit
R R
Direct raw materials
usage R1 338 750/127 500 10,50 R1 262 500/101 000 12,50
Direct labour R1 275 000/127 500 10,00 R1 616 000/101 000 16,00
Manufacturing
overhead expenses R296 017/127 500 2,32* R468 983/101 000 4,64*
22,82 33,14
3. Approximately 50% of the goods are sold on credit. This percentage must be
used to calculate the budgeted credit sales.
4. It was decided to budget for the cash receipts from the debtors according to the
following analysis of the payments which were previously made by the debtors:
During the month of sale 5%
During the first month after the month of sale 50%
During the second month after the month of sale 30%
During the third month after the month of sale 10%
Irrecoverable 5%
5. The rental income for the financial year amounts to R750 per month and is receiv-
able before the fifth of every month.
6. Expense items in the abovementioned table will be paid as follows:
– Materials and manufacturing overhead expenses – during the month after the
month in which these expenses incur.
– Labour costs – during the month in which these expenses incur.
7. Distribution and administrative expenses must be calculated at 5% of the total
sales for a month and must be paid during the next month.
8. It is envisaged that a distribution of total comprehensive income to the amount of
R8 500 will be paid to the members during May 20.6.
9. The purchase of machinery to the amount of R46 500 is planned for April 20.6,
and it will be paid in full on 15 May 20.6.
10. A long-term loan of R15 000 was granted to the close corporation during 20.2.
Interest at 15% per annum on the capital amount is payable half-yearly on
1 December and 1 June. The capital amount of the loan is repayable during 20.8.
Required:
Prepare the cash budgets of Abakar CC for the months April, May and June 20.6.
492 About Financial Accounting: Volume 2
Solution:
Abakar CC
Cash budgets for April, May and June 20.6
Details April May June
R R R
Bank balance at beginning of month 22 500 37 200* (280)*
Cash receipts 78 825 89 175 88 275
Cash salesc 45 000 49 500 43 500
Receipts from debtorsd 33 075 38 925 44 025
Rent 750 750 750
Cash available during the month 101 325 126 375 87 995
Cash payments (64 125) (126 655) (83 745)
Materials 39 000 45 000 54 000
Manufacturing overhead expenses 7 425 7 755 7 920
Labour costs 14 100 14 400 15 750
Distribution and administrative expensese 3 600 4 500 4 950
Distribution to members – 8 500 –
Machinery – 46 500 –
Interest (R15 000 × 15% × 6/12) – – 1 125
* Carried forward from the budgeted bank balance at the end of the previous month.
Calculations:
c Sales
January February March April May June
R R R R R R
Cash (50%) 33 750 31 500 36 000 45 000 49 500 43 500
Credit (50%) 33 750 31 500 36 000 45 000 49 500 43 500
Total sales 67 500 63 000 72 000 90 000 99 000 87 000
The above calculations reflect the actual and budgeted cash receipts from the debtors
in respect of all the credit sales that took place from January until June. However, only
the budgeted cash receipts from the debtors for the periods April, May and June are
required. The following table is a summary of the calculations given in the shaded
areas (which pertain to the budgeted periods of April, May and June) above.
April May June
R % R % R % R
Credit sales in:
January 33 750 10 3 375 – –
February 31 500 30 9 450 10 3 150 –
March 36 000 50 18 000 30 10 800 10 3 600
April 45 000 5 2 250 50 22 500 30 13 500
May 49 500 – 5 2 475 50 24 750
June 43 500 – – 5 2 175
33 075 38 925 44 025
Chapter 11: Budgets 495
11.11 Summary
It is the responsibility of management to direct a business entity in such a manner that
it attains its objectives and goals as cost efficiently as possible. pla such as planning,
organising, staffing and controlling largely determine whether a business is properly
managed or not, and whether it will be able to attain its objectives and goals. Since
budgets can be used to substantially increase the effectiveness with which such
managerial duties are performed, they are regarded as instruments of vital im-
portance.
In essence, a budget can be regarded as a set of standards that directs the quantity
and quality of the activities of an entity in order to meet set standards.
Budgets have both advantages and limitations which must be borne in mind. It is im-
portant to balance the rigidity that budgets can instil on the activities of a business with
the flexibility needed to react timeously and appropriately under unforeseen circum-
stances.
Accounting information can contribute substantially to the preparation, implementation
and evaluation of budgets, especially when it is used to set standards against which
actual performance can be measured for control purposes.
The basic budgeting procedure is simple: it implies identifying the key performance
areas, determining the budget period, preparing the necessary budgets accordingly,
and implementing, evaluating and revising the budgets according to any variances.
A master budget presents a broad overview of the anticipated activities of a business
entity and is structured according to specific needs. Therefore, the layout or format of
master budgets may vary. Possible layouts of elementary master budgets for a manu-
facturing and a trading entity were illustrated. These illustrations are based on the
approach that a master budget of a business entity can consist out of three sets of
budgets, namely an operating budget, a financial budget, and budgeted financial
statements.
The major difference between an operating budget of a manufacturing entity and an
operating budget of a trading entity is that the latter does not include manufacturing-
related budgets. Since the preparation of an operating budget of a manufacturing
entity is more comprehensive and includes most of the budgets of a trading entity,
only the preparation of an operating budget of a manufacturing entity was discussed
and illustrated. The sales and production budgets are usually considered to be the
main operating budgets, whilst the other operating budgets, such as the direct raw
materials usage, the direct raw materials purchases, the direct labour, the manufactur-
ing overhead and the cost of sales budgets, are usually referred to as “subsidiary
operating budgets”.
496 About Financial Accounting: Volume 2
The financial budget of a business is primarily based on its operating budget. The
position thereof within the structure of a master budget, as well as its contents, was
briefly discussed. The only financial budget illustrated, was the cash budget.
The budgeted financial statements are based on the operating and the financial
budgets. The position of the budgeted financial statements in the master budget was
illustrated and briefly discussed.
Index
Page Page
A Branches – continued
Accounting policies .............. 44, 56, 260, 319 inter-branch inventory ................... 418, 434
Accounting for purchases ...................... 412–414, 426–427
dependent branches ............................. 412 settlement discounts ..................... 415, 430
Accounting Practices Board (APB) .............. 7 Budgets
Accrual basis of accounting ....... 38, 332, 338 accounting information .......................... 477
Acid test ratio ............................ 398–399, 405 advantages ............................................ 476
Allotment of shares ........................... 287, 303 cash ...............................477, 479, 491, 497
Allotment schedule ........................... 288, 310 co-ordination ................................. 475–476
Analysis of financial statements ............... 392 control ............................................ 474–476
Annual financial cost of sales .................................. 479, 485
statements ........................ 53, 81, 242–249, description ............................................. 474
254, 316 employee participation .......................... 476
Appropriation account ................................ 73 financial statements....................... 477–480
Assets ................................. 18, 22, 40, 47, 55 limitations ............................................... 476
main function ......................................... 474
Authorised share capital ........................... 279
managerial activities.............................. 475
B planning ................................................. 475
procedure .............................................. 477
Branch accounts structure ........................................ 478–480
balancing of................................... 421, 437 raw materials ......................................... 482
branch debtors ...................................... 415
branch expenses.................. 418–419, 422, C
436–439, 444 Calculation of goodwill acquired .............. 110
cash embezzled .................... 416–418, 434 Capital
Branch inventory accounts .................................................. 71
in transit ......................... 420–422, 437–438 concepts .................................................. 27
invoiced at cost price ............................ 412 maintenance ............................................ 28
invoiced at selling price ........................ 426 Capitalisation shares ................................ 289
marked down......................... 416, 430, 432 Cash and cash equivalents ...................... 365
on hand ......................................... 420, 436 Cash basis of accounting ................. 332, 386
profit mark-up ................................ 426–427 Cash budgets ........................................... 490
returned ......................................... 414, 428 Cash flows
sales .............................................. 415, 429 advantages ............................................ 328
sent ................................................ 413, 429 background ........................................... 327
shortages............................... 420–421, 436 objective ................................................ 328
surpluses ............................... 420–421, 436 Cash flows from financing activities ......... 363
Branches Cash flows from investing activities .......... 359
accounting for ....................................... 410 Cash flows from operating activities ......... 339
concept of ............................................. 411 Cash generated from or used in
discount granted ........................... 415, 430 operations ...................................... 339, 351
497
498 About Financial Accounting: Volume 2
Page Page
Financial reporting International Accounting Standards
objective .................................................. 13 Board (IASB) ....................................... 8, 35
standards ................ 7, 8, 9, 35, 46, 81, 248 International Financial Reporting
Financial statements .......... 17, 33, 36, 39, 53, Standards (IFRSs) ................... 8, 11, 35, 46
81, 242, 249, 311 Inventory turnover rate ...... 398, 400–401, 406
analysis of.............................. 392–393, 409 Inventory-holding period........................... 401
application of analysis ........................... 393 Investing activities ........... 326, 329, 331, 359,
budgeted ....................................... 478–480 386–388
companies ............................................. 311 Investments in equity
elements .................................................. 18 instruments .............................................. 47
interpretation ......................................... 390 Issue of shares .......................................... 281
limitations of analysis............................. 402 Issued share capital ................................. 280
non-cash entries .................................... 332
objectives of ............................................ 13 J
partnerships ............................................ 81 JSE Limited ................................... 8, 278, 279
presentation............................................. 33
profit or loss ........... 36, 41, 54, 90, 258, 317
L
purpose ................................................... 36
structure .................................................. 39 Labour
Financing activities ........... 326, 329, 331, 363 budgets ................................................. 483
Formation of a company ........................... 276 in manufacturing entities ............... 451–453
Formation of a partnership ......................... 68 Legal approach .......................................... 71
Framework .................................................. 11 Legal perspective .....100, 102, 121, 161, 162
Liabilities ......................................... 19, 41, 55
G Limitations of analysis ............................... 402
Garner versus Murray rule ............... 164, 165, Liquidation ................................................ 163
168, 179, 221 account .................................................. 166
Generally Accepted Accounting calculation of interim repayments 184, 191
Practice (GAAP) ........................................ 7 loss on ................................................... 175
Going concern ...................................... 17, 38 methods ................................................. 165
Going-concern piecemeal ..............167, 183, 192, 212, 221
perspective............ 100, 120, 140, 161, 162 profit on ................................................. 170
Goodwill .................................................... 109 simultaneous liquidation ........ 166, 168, 221
calculation of ........................ 110, 125, 129, surplus-capital
136, 146, 156 method .......................184, 188, 213, 222
Gross profit percentage............ 394, 396, 404 Liquidity ratios................... 390, 397–399, 405
Loan accounts ............................................ 72
H Loss on liquidation .................................... 175
Historical cost ............................................. 24
M
I Manufacturing cost statement .......... 450, 460
IAS 1 ..................................................... 33, 53 Manufacturing costs ................................. 449
IAS 7 ................................. 326–328, 366, 386 administrative expenses................ 461–462
Income .................................................. 21, 54 definition ................................................ 449
Income Tax Act 58 of 1962 ....................... 240 description of ......................................... 461
Incorporated entity...................................... 67 financial statements....................... 450, 463
Incorporation............................................. 276 labour cost ............................. 449–453, 456
Indirect method – cash flows .... 330, 351, 387 overheads ...................................... 451–454
Interest ........................................................ 60 preparing a cost statement ................... 460
500 About Financial Accounting: Volume 2
N Q
Non-cash entries............................... 332, 388 Qualitative characteristics
Non-profit companies ........................... 9, 278 enhancing................................................ 16
Notes to the fundamental............................................. 14
financial statements..... 37, 43, 56, 260, 319
R
O Realisable value.......................................... 24
Offsetting .................................................... 38 Recognition ................................................. 21
Operating budgets ................... 478---480, 482 Redeemable preference shares ............... 281
Ordinary dividends ................................... 295 Relevance ................................................... 14
Ordinary shares ........................................ 280 Repayments .............................164, 184, 188,
Overhead budgets............................ 482---485 191, 192, 221, 222
Ownership structure Reporting period ......................................... 17
of partnerships ................ 99, 115, 120, 160 Return on equity................394---395, 397, 404
Return on total assets ...............395---397, 404
P
Participating preference shares ............... 281 S
Partners................................................. 68, 73 Sale of finished products .......................... 461
legal position ........................................... 68 Sales budgets ........................................... 480
retirement or death ................................ 113 SARS ......................................................... 240
Partnership............................................ 65, 67 Sequestration .................................... 165, 221
accounting procedures ........................... 70 Shareholders ............................................. 278
agreement ............................................... 69 Shares
definition ............................................ 66, 67 allotment ................................................ 287
dissolution ............................................... 70 classes of .............................................. 280
financial statements................................. 81 issue of ..................................281, 282, 289
formation of.............................................. 68 preference ............................................. 280
liquidation .............................................. 163 transactions ........................................... 279
ownership ................................................ 99 underwriting ........................................... 291
salaries .................................................... 73 Simultaneous liquidation ..........165, 166, 168,
Partnership agreement ....... 69, 101, 160, 179 170, 175, 179, 221
Personal transaction ................. 100, 115, 161 loss on liquidation.................................. 175
Piecemeal profit on liquidation ................................ 170
liquidation ......166, 167, 183, 192, 212, 221 Solvency ratios..........................401, 404, 407
loss-absorption-capacity Statement of cash flows ............... 37, 43, 325
method ....................... 191, 194, 213, 222 additional information ............................ 366
surplus-capital advantages.................................... 326, 328
method ....................... 184, 188, 213, 222 format ....................................326, 328, 387
Preference dividends................................ 294 objective ........................................ 326, 328
Preference shares..................................... 280 preparation ............................................ 339
Index 501
Page Page
Statement of cash flows – continued Trade receivables collection period . 398–400
relationship with other Transaction costs........................................ 51
financial statements ........................... 332 Transactions
Statement of changes in equity .................. 43 debenture .............................................. 296
Statement of financial position .................... 39 of manufacturing entities ....................... 453
Statement of profit or loss and other Transferral account ................... 122, 141, 162
comprehensive income ........................... 41
STRATE ..................................................... 279 U
Subsequent measurement of Underwriting of shares.............................. 291
financial assets/liabilities ......................... 52 Unrealised profits
Subsidiary operating budgets .................. 482 manufacturing entities ........................... 463
Surplus-capital method..... 184, 188, 213, 222
V
T Valuation account ............103, 107, 122, 141,
Times interest earned ratio ............... 401–402 157, 162
Trade payables settlement period ... 398–400, Valuation adjustments.............. 100, 102, 103,
407 107, 122, 141, 162