Bachelor of Commerce in Accounting

Bachelor of Commerce
in Accounting
FINANCIAL ACCOUNTING 2B
Module guide
Copyright © 2021
MANCOSA
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Bachelor of Commerce
in Accounting
FINANCIAL ACCOUNTING 2B
Preface.................................................................................................................................................................... 1
Unit 1: Share Capital and Earnings Per Share ........................................................................................................ 9
Unit 2: Statement of Cash Flows ........................................................................................................................... 50
Unit 3: Ratio Analysis ............................................................................................................................................ 80
Unit 4: Intangible Assets ....................................................................................................................................... 98
References List ................................................................................................................................................... 108
i
Financial Accounting 2B
Preface
A. Welcome
Dear Student
It is a great pleasure to welcome you to Financial Accounting (FAC2B6). To make sure that you share our passion
about this area of study, we encourage you to read this overview thoroughly. Refer to it as often as you need to,
since it will certainly make studying this module a lot easier. The intention of this module is to develop both your
confidence and proficiency in this module.
The field of Financial Accounting is extremely dynamic and challenging. The learning content, activities and self-
study questions contained in this guide will therefore provide you with opportunities to explore the latest
developments in this field and help you to discover the field of Financial Accounting as it is practiced today.
This is a distance-learning module. Since you do not have a tutor standing next to you while you study, you need
to apply self-discipline. You will have the opportunity to collaborate with each other via social media tools. Your
study skills will include self-direction and responsibility. However, you will gain a lot from the experience! These
study skills will contribute to your life skills, which will help you to succeed in all areas of life.
We hope you enjoy the module.
MANCOSA does not own or purport to own, unless explicitly stated otherwise, any intellectual property
rights in or to multimedia used or provided in this module guide. Such multimedia is copyrighted by the
respective creators thereto and used by MANCOSA for educational purposes only. Should you wish to use
copyrighted material from this guide for purposes of your own that extend beyond fair dealing/use, you
must obtain permission from the copyright owner.
B. Module Overview
 The module is a 15 Credit module at NQF level 6
Course overview
The broad areas covered by this module include:
 Share Capital and Earning Per Share
 Statements of Cash Flow
 Ration Analysis
 Intangible Assets
1 MANCOSA – Bachelor of Commerce: Accounting

C. Exit Level Outcomes and Associated Assessment Criteria of the Programme

Exit Level Outcomes (ELOs) Associated Assessment Criteria (AACs)
 Display the necessary knowledge and skills,  Fundamental and specialist knowledge is applied in
attitudes and applied competence to enable an organisational context to identify and analyse
them to demonstrate administrative appropriate policies to achieve administrative
proficiency efficiency
 Appropriate processes are selected and

implemented to resolve administrative deficiencies
 Complex administrative problems are identified,

analysed and evaluated to apply appropriate problem
solving solutions to enhance administrative
proficiency
 Display knowledge of management in  Knowledge of key management terms and concepts

general are explained to understand and demonstrate
knowledge of disciplines or practices of management
 Components of fundamental and specialised

effective management knowledge are evaluated to
understand the various operational management
levels
 Context and systems in general management are

recognised and applied to organisational processes
in unfamiliar and variable contexts
 Apply skills of rational judgment and  Method and procedure in rational judgement and
planning planning is understood, selected and applied to
resolve problems or to introduce change within
practice
 Evidence – based solutions and theory driven

arguments are critically evaluated to address
complex problems in planning
 Ethics and professional practice is considered and

applied when planning to justify the decisions and
actions taken
MANCOSA – Bachelor of Commerce: Accounting 2

 Recognise and appreciate changes within  Knowledge of organisational contexts and their
organisations dynamics are analysed to inform current practice
to remain current in this regard
 Key change management principles are applied in

appropriate organisational contexts to appreciate
change within an organisation
 Make appropriate use of information  Accessing, processing and managing information

technology technology is demonstrated to develop appropriate
processes of information gathering and analysis for a
given context
 Information technology applied to independently

evaluate and validate the sources of information
 Appropriate information technology is utilised to

record, report on and maintain information
management systems for a variety of contexts within
an organisation
 Analyse and solve operational problems  Operational problems are identified, analysed and
evaluated to critically address complex problems
within an organisation by applying evidence based
solutions and theory–driven arguments
 Method and procedure in solving operational

problems are applied to resolve problems or to
introduce change within practice
 Display skills for the recording and  Accessing, processing and managing information are
processing of financial information within an explained to develop appropriate processes of
accounting framework recording within an accounting framework
 Key concepts, principles, knowledge, skills and

techniques in accounting and related fields are
applied to display these skills for the recording and
processing of financial information

 Display ethical behaviour in a corporate  Ethics and professional practice is considered and
management context applied in corporate management context to justify
the decisions and actions taken
 Prescribed ethical codes of conduct, values and

practices are discussed to inform appropriate
behaviour within the corporate management context
 Develop the functional competence of a  Scope of knowledge with respect to management

graduate to proceed to middle management competencies are analysed to be functional at middle
level within an accounting (auditing/tax) management level
environment.
 A range of methods and procedures are applied to
problem solving contexts in middle management
 Management decisions are discussed to apply

ethical and professional judgement
D. Learning Outcomes and Associated Assessment Standards of this Module Guide
LEARNING OUTCOMES OF THE MODULE ASSOCIATED ASSESSMENT CRITERIA OF THE

MODULE
 Demonstrate an understanding of share  The earnings per share and share capital is
capital and compute the earnings per computed to measure the performance of an entity
share for an entity according to IAS
 Analyse financial statements and cash flow  Financial statements and cash flow adjustments are
adjustments and calculate the net cash analysed and interpreted to provide information
flow for an entity about the cash flow activities of an entity
 Analyse and interpret financial statements  Financial statements are analysed and interpreted to
and compute relevant ratios enable the computation of relevant ratios and to
highlight the economic efficiency of an entity
 Recognise and measure intangible assets  Intangible assets are recognised and measured to
in accordance to IAS and IFRS determine the accurate value of the assets

E. Learning Outcomes Units

You will find the Unit Learning Outcomes on the introductory pages of each Unit in the Module Guide. The Unit
Learning Outcomes lists an overview of the areas you must demonstrate knowledge in and the practical skills you
must be able to achieve at the end of each Unit lesson in the Module Guide.
F. Notional Learning Hours
Notional Learning Hour Table for the Programme
Learning time
Types of learning activities
%
Lectures/Workshops (face to face, limited or technologically mediated) 10
Tutorials: individual groups of 30 or less 5
Syndicate groups 0
Practical workplace experience (experiential learning/work-based learning etc.) 0
Independent self-study of standard texts and references (study guides, books, journal articles) 60
Independent self-study of specially prepared materials (case studies, multi-media, etc.) 20
Other: Online 5
TOTAL 100
G. How to Use this Module

This Module Guide was compiled to help you work through your units and textbook for this module, by breaking
your studies into manageable parts. The Module Guide gives you extra theory and explanations where necessary,
and so enables you to get the most from your module.
The purpose of the Module Guide is to allow you the opportunity to integrate the theoretical concepts from the
prescribed textbook and recommended readings. We suggest that you briefly skim read through the entire guide to
get an overview of its contents. At the beginning of each Unit, you will find a list of Learning Outcomes and
Associated Assessment Criteria. This outlines the main points that you should understand when you have
completed the Unit/s. Do not attempt to read and study everything at once. Each study session should be 90 minutes
without a break
This module should be studied using the prescribed and recommended textbooks/readings and the relevant
sections of this Module Guide. You must read about the topic that you intend to study in the appropriate section

before you start reading the textbook in detail. Ensure that you make your own notes as you work through both the
textbook and this module. In the event that you do not have the prescribed and recommended textbooks/readings,
you must make use of any other source that deals with the sections in this module. If you want to do further reading,
and want to obtain publications that were used as source documents when we wrote this guide, you should look at
the reference list and the bibliography at the end of the Module Guide. In addition, at the end of each Unit there
may be link to the PowerPoint presentation and other useful reading.
H. Study Material
The study material for this module includes tutorial letters, programme handbook, this Module Guide, a list of
prescribed and recommended textbooks/readings which may be supplemented by additional readings.
I. Prescribed and Recommended Textbook/Readings

There is at least one prescribed and recommended textbooks/readings allocated for the module.
The prescribed and recommended readings/textbooks presents a tremendous amount of material in a simple, easy-
to-learn format. You should read ahead during your course. Make a point of it to re-read the learning content in your
module textbook. This will increase your retention of important concepts and skills. You may wish to read more
widely than just the Module Guide and the prescribed and recommended textbooks/readings, the Bibliography and
Reference list provides you with additional reading.
The prescribed and recommended textbooks/readings for this module is:
 Service, C. (2019) Gripping Gaap: Your Guide to International Reporting Standards. Twentieth Edition.
Durban: Lexis Nexis.
 Kolitz, C.L. and Service, C. (2019) Gaap: Graded questions. Eighteenth Edition. Durban: Lexis Nexis.
 Flood, J.M. (2017). Gaap – Interpretation and Application of Generally Accepted Accounting Principles. First
Edition. New York: Wiley.

J. Special Features
In the Module Guide, you will find the following icons together with a description. These are designed to help you
study. It is imperative that you work through them as they also provide guidelines for examination purposes.
Special Feature Icon Explanation
The Learning Outcomes indicate aspects of the particular Unit you have
LEARNING to master.
OUTCOMES
The Associated Assessment Criteria is the evaluation of the students’

ASSOCIATED
understanding which are aligned to the outcomes. The Associated
ASSESSMENT
Assessment Criteria sets the standard for the successful demonstration
CRITERIA
of the understanding of a concept or skill.
A Think Point asks you to stop and think about an issue. Sometimes you
THINK POINT are asked to apply a concept to your own experience or to think of an
example.
You may come across Activities that ask you to carry out specific tasks.
In most cases, there are no right or wrong answers to these activities.
ACTIVITY
The purpose of the activities is to give you an opportunity to apply what
you have learned.
At this point, you should read the references supplied. If you are unable
READINGS to acquire the suggested readings, then you are welcome to consult any
current source that deals with the subject.
PRACTICAL Practical Application or Examples will be discussed to enhance
APPLICATION understanding of this module.
OR EXAMPLES
KNOWLEDGE You may come across Knowledge Check Questions at the end of each
CHECK Unit in the form of Knowledge Check Questions (KCQ’s) that will test
QUESTIONS your knowledge. You should refer to the Module Guide or your
textbook(s) for the answers.
You may come across Revision Questions that test your understanding
REVISION
of what you have learned so far. These may be attempted with the aid
QUESTIONS
of your textbooks, journal articles and Module Guide.

Case Studies are included in different sections in this Module Guide.
CASE STUDY This activity provides students with the opportunity to apply theory to
practice.
You may come across links to Videos Activities as well as instructions
VIDEO ACTIVITY on activities to attend to after watching the video.

Unit
1: Share Capital and
Earnings Per Share

Unit Learning Outcomes
CONTENT LIST LEARNING OUTCOMES
1.1 Introduction  Introduce topic areas for the unit
1.2 Types of Shareholders  Display an understanding of ordinary and preference

shareholders
1.3 Basic Earnings Per Share  Calculate the basic earnings per share and basic number of
shares for a company and interpret the various manners in which
shares can be issued
1.4 Headline Earnings Per Share  Calculate the headline earnings per share for a company
1.5 Diluted Earnings Per Share  Calculate the diluted earnings per share for a company
1.6 Summary  Summarise topic areas covered in unit
Prescribed / Recommended Readings
 Service, C. (2019) Gripping Gaap: Your Guide to International Reporting

Standards. Twentieth Edition. Durban: Lexis Nexis.
 Kolitz, C.L. and Service, C. (2019) Gaap: Graded questions. Eighteenth

Edition. Durban: Lexis Nexis
 Flood, J.M. (2017). Gaap – Interpretation and Application of Generally

Accepted Accounting Principles. First Edition. New York: Wiley.

1.1 Introduction
In order for a business to begin its operations, it will need to obtain the necessary funds required to start and to
ensure continuation of the business activities. In industry today these funds are often obtained from the following
sources:
 Raising the funds from owners of the entity in the form of shares
 The generation of profits
 Borrowing of funds through loans or debentures
For a company, the owners are referred to as shareholders and the shares that are issued to these shareholders
are equity instruments for the entity and assets for the shareholders. The accounting double entry principle for the
issue of shares will be:
Assets Owners’ Equity Liabilities
+ Bank (DR) + Ordinary Share Capital / No entry
Preference Share Capital (CR)
It is important to note that the Memorandum of Incorporation of a company will specify the various classes of shares
and the maximum number of shares that the company will have authorisation to issue to shareholders. Only shares
that have been authorised can be issued.
1.2 Types of Shareholders

1.2.1 Ordinary shareholders and ordinary dividends
 The ordinary shareholders of a company are those persons who buy share for the purpose of earning
dividends as well as ensuring their capital growth. Dividends that are earned fluctuate and are dependent on
the profits and reserves of cash, etc. Ordinary shareholders, however, have less rights than that of
preference shareholders.
 For example: if a company has both ordinary and preference shareholders happens to liquidate, the
preference shareholders will be paid out their portion of the share capital first and if the funds which remain
are sufficient than only will the ordinary shareholders be paid their portion of the share capital due to them.
 Interim dividends on ordinary shares are during the year and the final dividend is generally declared at year
end.
 Due to ordinary shares being equity instruments, the dividends that are distributed on these shares are
considered to be distributions to the shareholders instead of expenses, therefore, these dividends are a
reduction in equity which is presented in the statement of changes in equity.

 The dividends that are paid to shareholders must only be recognised when the obligation to pay the dividend
arises or occurs. A dividend is a present obligation when the appropriate authorisation is given and the
company does not have any discretions regarding the dividend.
 The proposal of dividends is made in a meeting and if the proposal is accepted the dividend is then declared
by the company. Dividend declarations are made when it is publically announced that the payments of the
dividends will be made on a specified future date.
Example - Dividend obligations – proposal vs declaration dates

A company declares two dividends for the financial year ended 28 December 20X12:
 Interim dividend of R200 000 which is proposed and declared on 10 June 2012; and final dividend of
R28 000 which is proposed on 20 November 2012 and declared on 2 January 2013.
Solution
 Only the interim dividend will be recognised during the 2012 financial period as it was the only
dividend declared which created an obligation during 2012.
 The fact that the final dividend was proposed before the end of 2012 does not lead to the rise of an
obligation during 2012
Think Point
What is the difference between proposal and declaration dates and how does this
affect the payment of dividends?
1.2.2 Preference shareholders

o As discussed above, preference shareholders are entitled to more rights than ordinary shareholders and apart
from the preference to capital that they have in the event of liquidation, they are also paid out a dividend that is
fixed in nature every year. The value of the dividend that is paid out to preference shareholders is dependent of
the coupon rate of the shares.
o For example: If the shareholder owns 2 000 preference shares that are valued at R 1 each with a coupon rate
of 20 % can expect the following dividends – R 1 X 2 000 X 20 % = R 400.

o Preference shares can be classified as:

 Pure equity
 Pure liability
 Compound financial instruments (part equity and part liability)
 The above classification is dependent on the assessment of all the aspects of the shares such are whether or
not the capital is redeemable and whether or not the dividends are discretionary (the company make the choice
on whether to pay dividends or not – pure equity) or mandatory (the company has an obligation to pay the
dividend – pure liability).
 A discretionary dividend can only be recognised when the dividends have been declared and it is recognised in
the same manner as an ordinary dividend.
 It is important to note that preference shares can be redeemable or non-redeemable and participating or non-
participating. The table below will illustrate the difference between these types of shares.
Redeemable preference shares Non-redeemable preference shares
Redeemable preference shares indicates that Non-redeemable preferences shares indicates

the shareholders capital will be returned to the that the shareholders capital will not be
shareholder returned to the shareholder
Participating preference shares Non-participating preference shares
A fixed dividend is paid which could be A fixed dividend is paid which could be
mandatory or discretionary and an extra mandatory or discretionary
variable dividend (e.g. % of ordinary dividend)
which is discretionary
Example - Issue of non-redeemable preference shares recognised as equity
On 1 January 2001 (date of incorporation) Blue Blow Limited issued:
 100 000 ordinary shares at R3,50 each.
 50 000 10% non-cumulative, non-redeemable preference shares at R2 each.
 Half of the authorised ordinary and preference shares have been issued. The preference dividends
are discretionary dividends. All preference dividends were declared and paid before yearend with the
exception of 2006, when the preference dividend was declared but not yet paid at 31 December 2006.

Required:
A. Provide all journal entries from the date of issue of the preference shares to 31 December 2006.
Comment: Because the preference shares are non-redeemable, we must first consider the other rights
attaching to the shares when deciding how to classify the shares. The payment of dividends is entirely at the
discretion of Blue Blow Limited. For this reason, the shares are classified as equity.
Solution:
Debit Credit
1/1/20X1
Bank(A) 50 000 x R2 100 000
Preference share capital (Eq) 100 000
Issue of 50 000 10% non-redeemable preference shares at C2

each
31/12/20X1 – 31/12/20X6 *
Preference dividends (distribution to equity holders – negative 10 000

equity)
10 000
Preference shareholders for dividends (L)
Preference dividends *
31/12/20X1 – 31/12/20X5 **
Preference shareholders for dividends (L) 10 000
Bank 10 000
Payment of preference dividend ***
The above journal would be repeated on 31/12/20X2; 31/12/20X3;

31/12/20X4, 31/12/20X5 and 31/12/20X6.

** The above journal would be repeated on 31/12/20X2;

31/12/20X3; 31/12/20X4 and 31/12/20X5 but not on 31/12/20X6,
since the dividends were not paid in 20X6 (presented as a current
liability
Example: Participating dividend

 A company has 1 000 12% non-cumulative, non-redeemable preference shares in issue (all issued
at R2 each).
 The payment of the 12% preference dividends is entirely discretionary.
 These preference shares participate to the extent of 1/5 of the ordinary dividend per share.
 The ordinary dividend declared is R0,10 per share.
 There are 1 000 ordinary shares in issue. The ordinary dividends and preference dividends were
declared on 25 December 2005.
Required: Journalise the ordinary and preference dividends

Solution:
25 December 2005 Debit Credit
Ordinary dividends (Distribution of equity) 1 000 x C0,10 100
Ordinary shareholders for dividends (L) 100
Ordinary dividends declared
Preference dividends (Distribution of equity) 1 000 x C2 x 12% 240
Preference shareholders for dividends (L) 240
Fixed preference dividend owing
Preference dividends (Distribution of equity) 1 000 x C0,10 x 1/ 5 20
Preference shareholders for dividends (L) 20
Participating preference dividend owing
 Preference dividends can be:

 Cumulative – arrear cumulative preference dividends must be paid out prior to paying ordinary dividends
 Non-cumulative – If dividends are not paid in a year the shareholder loses the right to claim those dividends

1.2.3 Changes to share capital

A. Share issue costs
 Share issue costs are cost that the entity incurs when they issue shares and these costs are offset against
the entities equity accounts
 However, if the shares are abandoned the costs then become an expense and are allocated to the profit
and loss account
 IAS does not specifically indicate the equity account to which share issue costs are offset against and
therefore, an entity should choose an account as an accounting policy and consistently apply it
B. Preliminary cost
 Preliminary costs are the costs that an entity occurs when starting up a business and they are accounted for
by being expensed to the profit or loss account
Example: Share issue costs and preliminary costs
Future Limited was incorporated during 2001:
 Preliminary costs (legal costs incurred in connection with the start-up of the company) of R10
000 were paid on 2 January 2001.
 2 000 ordinary no par value shares were issued at R100 each on 5 January 2001.
 Share issue costs of R2 000 were paid on 5 January 2001.
 The draft statement of comprehensive income for 2001, before processing any adjustments for
the above transactions, reflected total comprehensive income for 2001 of R120 000
(components of other comprehensive income: R 0).
Required:
A. Process journals to account for the preliminary costs, share issue and the related share issue costs.
B. Disclose this in the statement of changes in equity for the year ended 31 December 2001.
Debit Credit
02 January 2001
Preliminary cost (E) 10 000
Bank (A) 10 000
Preliminary costs paid are expensed

05 January 2001
Bank (A) 20 000
Ordinary share capital (Eq) 2 000 X R 100
Issue of 2 000 ordinary shares at R100 each 20 000
Ordinary share capital (Eq) 2 000
Bank (A) 2 000
Share issue costs paid deducted from equity
Future Limited
Statement of changes in equity
For the year ended 31 December 2001
Ordinary share capital Retained earnings Total
Opening balance 0 0 0
Ordinary shares issued 200 000 0 200 000
Share issue costs set-off (2 000) 0 (2 000)
Total comprehensive income 0 110 000 110 000
Closing balance 198 000 110 000 0
C. Conversion of shares
Example: Converting ordinary shares into preference shares
 Nate Limited had 1 000 ordinary shares in issue (having been issued at R1,20).
 On 1 January 20X2, 500 of these shares were converted into 12% preference share equity.
Required:
A. Journalise this conversion.
B. Disclose this in the statement of changes in equity for the year ended 31 December 2002
Solution:
Debit Credit
1 January 2001
Ordinary share capital (Eq) 500 X R1.20 600
Preference share capital (Eq) 600
Conversion of ordinary shares into preference shares

Future Limited
Ordinary share Preference Share Retained earnings Total

capital Capital Xxx
Opening balance 1 200 0 xxx
Conversion of ordinary shares (600) 600 0
to preference shares 0 xxx
Total comprehensive income xxx
Closing balance 600 600 xxx
D. Rights Issue
Rights issue is when an entity offers a certain amount of shares to shareholders that already
exist at a price which is lower than the market value.
Example: Rights issue

 A company has 1 000 ordinary shares in issue, each issued at R2,50.
 The company wishes to offer its shareholders 1 share for every 4 shares held at an issue price of R3.
 The current market price immediately before this issue is R4.
 All the shareholders had accepted the offer by the last day of the offer.
Required:
A. Journalise this issue.
B. Disclose this in the statement of changes in equity.
Solution:
W1: Calculations
Number of shares issued - 1 000/ 4 x 1 = 250
Proceeds received - 250 x R3 = R750
Debit Credit
Bank (A) 750
Ordinary Share Capital (Eq) 750
Shares issued to existing shareholders (1:4) at R3 each (market
price: R4)


For the year ended ….
Ordinary share capital Retained earnings Total

2 500
Opening balance (750) xxx Xxx
Issue of shares in terms of a rights issue 750
Total comprehensive income 3 250 xxx xxx
Closing balance xxx xxx
E. Capitalisation issue
Share can be issued to shareholders for no monetary value when the entity needs to make use of the
idle reserves. These shares can be used as a payment of dividends for example.
Example: Capitalisation issue
 At the start of the year, a company has 1 000 ordinary shares in issue (issued at R1,50 each).
 It then issued a further 600 fully paid-up shares to its existing shareholders in proportion to their existing
shareholding at the current market price of R1 each.
 The company had retained earnings of R800 at the beginning of the year and total comprehensive
income of R150 for the year.
Required:
A. Journalise the issue.
B. Disclose the issue in the statement of changes in equity.
Solution:
Debit Credit
Retained earnings (Eq) 600 600
Ordinary share capital (Eq)
Capitalisation issue of 600 ordinary shares to existing shareholders

For the year ended…
Ordinary share Retained Total

capital earnings
Opening balance 1 500 2 300
Issue of shares in terms of a rights issue (600) 800 0

Total comprehensive income (600) 150

Closing balance 2 100 150 2 450
350
1.3 Basic Earnings Per Share

Earnings per share (EPS) is a common ratio which is utilised when the financial statements of an entity are being
analysed. The calculation of the earnings which is the numerator and the number of share which is the denominator
is regulated by the International Accounting Standard 33. The calculation of earnings per share will need to be
computed and disclosed for every class of ordinary shares that a company has.
The diagram below is an illustration of the various earnings per share figures that a company can calculate:
EARNINGS PER SHARE
BASIC (BEPs) DILUTED (DEPs) HEADLINE (HEPs) OTHER

IFRS requirement IFRS requirement if Not an IFRS Allowed if given in
the company has requirement addition to BEPs
dilutive potential Required for all and DEPs
ordinary shares companies listed or
wanting to be listed on
the JSE
The basic earnings per share figure is volatile as it is inclusive of all items of income and expenses in the calculation
and for this volatility to be compensated for the headline earnings per share calculation came to existence, as it is
inclusive of all income and expenses that are of a capital nature as well as those that are “highly abnormal”.
Therefore, the headline earnings per share has proven to be a superior indication of the “maintainable earnings” of
a company.
 “The objective of basic earnings per share is a measurement of the interest of each ordinary share of a parent
entity in the performance of the entity over a reporting period”
 Basic earnings per share provide users with information regarding the amount of earnings for a period that
belong to a share
 Basic earnings per share can be provided for all entities but if the entity is part of a group of entities than this
can be only provided for the parent company which is in ultimate control

 The calculation for basic earnings per share is - basic earnings per share is calculated by dividing earnings
attributable to the ordinary shareholders by the weighted average number of ordinary shares in issue during
the year
BEPS = ____EARNINGS_____
NUMBER OF SHARES
 If an entity makes a loss for the period, they will report a loss per share instead
1.3.1 Basic earnings – the numerator

The basic calculation
 When calculating the earnings that are attributed to the ordinary shares we should begin with the profit for the
period which is obtained from the statement of comprehensive income
 The profit for the period less the profit which is attributable to the preference shareholders will give you the
earnings required
 NB – preference dividends are only deducted when they NOT presented as a liability (as this is recognised as
an interest expense which will already be accounted for in the statement of comprehensive income) but rather
as a distribution of equity
 Due to any arrear cumulative preference dividends being due to the preference shareholders before the
ordinary dividends are paid out, any of these undeclared cumulative preference dividends should also be
deducted from the profit for the period
 In summary:
 “If the dividends are non-cumulative, deduct only the preference dividends that are declared in respect of
that period
 If the dividends are cumulative, deduct the total required preference dividends for the period (in accordance
with the preference share’s coupon rate), regardless of whether or not these dividends have been declared
- See IAS 33.14”.
o Where they are only ordinary shares

 The entire profit or loss of the entity belongs to the ordinary shareholders

Example: Ordinary shares only

 Ordinary shares only A company has 10 000 ordinary shares in issue throughout 2001.
 The company earns a profit after tax of C100 000.
Required: Calculate the basic earnings per ordinary share.
Solution:
Basic earnings per share = C10 per ordinary share (W1&W2)
W1: Earnings belonging to ordinary shareholders: R

Profit (or loss) for the year (per the statement of comprehensive income) 100 000
Less fixed preference dividends (0)
Less share of profits belonging to participating preference shareholders (0)
= Earnings belonging to ordinary shareholders 100 000
W2: Earnings per ordinary share:

= Earnings belonging to ordinary shareholders = R100 000 = R10 per ordinary share
Number of ordinary shares 10 000

o Where there are ordinary and non-participating preference shares

 If there are both ordinary and preference shareholders, and if these preference dividends are classified as
equity, a portion will need to be set aside from the profit for the year which belongs to these preference
shareholders (i.e. the portion needed to cover the preference dividend)
 If the dividend has not been declared, it will not be recognised. However, if this dividend is cumulative, we will
still make an adjustment for that year's dividend
 “As mentioned already, some preference dividends represent liabilities rather than equity and thus these
dividends end up being recognised as interest expense rather than as dividends. In these instances, even if
the dividend has not yet been declared as at the end of the reporting period, the dividend will be recognised
as an interest expense. Therefore, since these preference dividends are always effectively taken into account
when calculating the profit for the year, no adjustment is made when calculating the basic earnings”
Example: Ordinary and non-participating preference shares

A company has the following shares in issue throughout 2001:
 10 000 ordinary shares and 10 000 non-redeemable 10% preference shares.
 Preference dividends are discretionary and non-cumulative and based on a deemed value of
R2 per share.
 The company earns a profit after tax of C100 000.
 The company declared the full 2001 dividends owing to the preference shareholders.
Required: Calculate the basic earnings per ordinary share
Solution:
Basic earnings per share = C9,80 per ordinary share (W1&W2)
W1: Earnings belonging to ordinary shareholders:
Profit (or loss) for the year 100 000
Less fixed preference dividends declared (10 000 x C2 x 10%) (2 000)
Less share of profits belonging to participating preference shareholders (0)
= Earnings belonging to ordinary shareholders 98 000
W2: Earnings per ordinary share:
Earnings belonging to ordinary shareholders = R98 000
= R9.80 per ordinary share

o Where there are ordinary and participating preference shares

 In this case the equity of the company belongs to a ratio between preference shareholders and ordinary
shareholders and there are two equity share types in issue.
 This means that there are two types of equity share in issue and when the basic earnings are calculated the
amounts due to the preference shareholders in terms of their fixed dividend are deducted from the profit for
the period. The remaining profit is shared between the ordinary and participating preference shareholders.
 It is important to note that even though there are two equity share types that re in issue the earnings per share
is only calculated for the ordinary shares
Example:
A company has the following shares in issue throughout 2001:
 10 000 ordinary shares, and 10 000 non-redeemable, 10% discretionary, participating
preference shares (at R2 each).
 The company earns a profit after tax of R100 000.
 The preference shares participate to the extent of ¼ of the dividends declared to ordinary
shareholders.
 The total ordinary dividend declared for 2001 was R4 000.
 The company declared the full 2001 dividends owing to the preference shareholders.
Required: Calculate the following:

A. Earnings per ordinary share and indicate if it is disclosable;
B. Earnings per participating preference share and indicate if it is disclosable;
C. The total dividend belonging to the participating preference shareholders; and
D. The total variable dividends in 2001
Solution:
A. Earnings per ordinary share = C7,84 – this is disclosable (W1&W4)
B. Earnings per participating share = C2,16 – this is not disclosable (W1-3&W5)
C. Total dividend to participating shareholders = C3 000 (W6)
D. Total variable dividends = C5 000 (W7)

W1: Earnings belonging to ordinary shareholders:

Profit (or loss) for the year 100 000
Less preference dividends (fixed) declared (10 000 x C2 x 10%) (2 000)
Earnings to be shared 98 000
Less earnings attributable to participating preference shareholders (see W2) (19 600)
Earnings belonging to ordinary shareholders (referred to as: basic earnings) 78 400
W2: Earnings belonging to participating preference shareholders:

Earnings attributable to ordinary and participating preference shares 98 000
- portion belonging to ordinary shareholders (4/5 x C98 000: see W3) 78 400
- portion belonging to participating preference shareholders (1/5 x C98 000: see W3) 19 600
W3: The ratio in which to share earnings:

The ratio in which the earnings are to be shared (4/5 and 1/5) between the two equity share types is
calculated as follows:
Let X = the portion of the earnings belonging to the ordinary shareholders
Then ¼ X = the portion of the earnings belonging to the participating preference shareholders
And therefore:
X + ¼ X = total earnings to be shared
X + ¼ X = 98 000 5/4 X = 98 000
X = 98 000 x 4/5
X = 78 400 (share belonging to ordinary shareholders)
Therefore: ¼ X = ¼ x 78 400 = 19 600 (share belonging to participating preference shares) please note
that the R19 600 may also be calculated as 98 000 x 1/5 or
98 000 – 78 400 = 19 600
W4: Earnings per ordinary share – this is disclosable:

Earnings belonging to ordinary shareholders = R78 400 = R7,84 per ordinary share
W5: Earnings per participating preference share – this is not disclosable:

Earnings belonging to participating preference shareholders R 2 000 + R19 600
Number of participating preference shares 10 000
= R2,16 per participating preference share

Comment:
 Please note that the earnings belonging to the participating preference shareholders are made
up of both the fixed component (dividend based on the coupon rate: 10 000 x R2 x 10%) and the
variable component (share of the ‘after preference dividend profits’: 19 600 (W2)).
 Please also note that this ‘earnings per share’ of R2.16 is not disclosable because these earnings
belong to preference shareholders – the financial statements are produced for general users.
 Also note that, as with the total earnings to be shared, the participating preference shareholders
participate in 1/5 of the ‘total variable’ dividends declared:
W6: Total dividends belonging to preference shareholders:

Fixed dividend (10 000 x C2 x 10%) 2 000
Variable dividend (C4 000 x ¼) 1 000
Total dividend belonging to the participating preference shareholder 3 000
W7: Total variable dividends:

Variable dividend declared to ordinary shareholders (given) 4 000
Variable dividend to participating preference shareholders: (C4 000 x ¼ or C5 000 x 1/5) 1 000
Total variable dividends declared 5 000
1.3.2 Basic earnings – the numerator

 In this section we will discuss the numerator of the earnings per share calculation.
 The number of shares that are used could be the actual number of share, the adjusted number of shares or
the weighted average number of shares
 If there are no movement in the number of shares for the year then the balance of shares at the beginning
of the year is equal to the balance of shares at the end of the year.
 These are the types of share issues that could take place during the year which we are focusing on in this
unit:
 Issue for value – share issued at market price
 Issue for no value – shares are given away
 Decreases in the number of shares could come in the form of:

 share buy-backs: a for-value reduction; and
 reverse share split (i.e. share consolidations): a not-for-value reduction.

o Issue for value

 “When shares are issued for value, we calculate the number of shares to include in the denominator by
weighting the number of shares from the date consideration is receivable. The date on which consideration
is receivable is generally the date of issue of the shares (although some exceptions do apply). See IAS
33.21”
A. Issue at the beginning of the current year

 Shares that are issued for value are sold at their market value. This issue means a rise in capital for an entity
which will also increase the profits.
 The increase in the denominator which is the shares will lead to a parallel increase in the numerator,
therefore, the number of shares will not need to be adjusted.
Example:
 A company has 10 000 ordinary shares in issue during the previous year.
 There was a share issue of 10 000 ordinary shares at market price on the first day of the current
year. The earnings in the previous year were R20 000, and thus the earnings per share in the
previous year was C2 per share (C20 000/ 10 000 shares).
Required: Assuming absolutely no change in circumstances have occurred since the previous year, explain
what the user would expect the profits and earnings per share to be in the current year.
Solution:
Since the capital base doubled, the user would expect the profits to double too. If the profits in the current year
did, in fact, double to R40 000, this would then mean that the earnings per share would remain comparable at R2
per ordinary share (R40 000/ 20 000 shares)
Number of shares Actual Current year (weighted) Prior year
Opening balance 10 000 10 000* 10 000
Issue for value 10 000 10 000** 0
Closing balance 20 000 20 000 10 000
* Opening balance: 10 000 shares for 12 months (10 000 x 12/12) 10 000
**New shares issued: 10 000 shares for 12 months (10 000 x 12/12) 10 000

Earnings per share: Current year Prior year
Earnings R40 000 R20 000 Number

of shares 20 000 10 000
= R2 per share R2 per share
The earnings per share for the current year would then remain comparable at R2 per ordinary share.
B. Issue at the end of the year or during the year

 Shares that are issued on any other day other than the beginning of the year will increase the earning
potential of the entity in the period after the proceeds from the share issue are received.
 To make sure that the earnings per share in the current year is comparable to that of the previous year,
the number of shares is weighted based on time.
 “This weighting should ideally be performed based on the ‘number of days since the share issue’ as a
proportion of the ‘total number of days in the period’ (i.e. usually 365) although months may also be used
if considered a reasonable estimation. See IAS 33.20”
Example: Issue for value at the end of the year
 A company had 10 000 ordinary shares in issue during the previous year.
 There was a share issue of 10 000 ordinary shares at market price on the last day of the current year.
 The earnings in the previous year were R20 000, and thus the earnings per share in the previous
year was R2 per share (R20 000/ 10 000 shares).
Required: Assuming absolutely no change in circumstances since the previous year, explain what the
user would expect the profits and the earnings per share to be in the current year.
Solution:
 Although the capital base doubled in the current year, the user would not expect the current
year’s profits to double since the extra capital was only received on the last day of the current
year with the result that this would not yet have had an effect on the entity’s earning potential
(profits).
 Thus, assume the profits in the current year remained constant at R20 000 (i.e. equal to the
prior year):
 Unless the number of shares (in the earnings per share calculation) is adjusted

 The current year’s earnings per share would incorrectly indicate that the efficiency of
earnings halved to R1 per share during the year (C20 000/ 20 000 shares)
 When the reality is the company earned C2 for every one of the 10 000 shares in issue
during the year.
 Therefore, in order to ensure the comparability of the earnings per share calculation, the
number of shares in the current year should be weighted as follows:
Opening balance 10 000 10 000* 10 000
Issue for value 10 000 10 000** 0
Closing balance 20 000 20 000 10 000
* Opening balance: 10 000 shares for 12 months (10 000 x 12/12) 10 000
**New shares issued: 10 000 shares for 12 months (10 000 x 12/12) 10 000
Earnings R40 000 R20 000

Number of shares 20 000 10 000
= R2 per share R2 per

share
Example: Issue for value during the year
 There was a share issue of 10 000 ordinary shares (at market price) 60 days before the end
of the current year.
 In the previous year: earnings were R20 000, and earnings per share was R2 per share
(R20 000/ 10 000 shares).
Required: Assuming absolutely no change in circumstances since the previous year, explain what the user
would expect the profits and the earnings per share to be in the current year.

Solution:
 Although the capital base doubled, the user could not expect the annual profits to double since the
extra capital was only received 60 days before the end of the year with the result that this extra injection
of capital could only have had an effect on the profits earned during the last 60 days of the period.
 The shareholder could only reasonably expect the earnings in the last 60 days to double.
 He would thus hope that the earnings for the current year totals R23 288 (R20 000 + R20 000 x
60/365).
 Assume that the profits in the current year did total the R23 288 that the shareholders hoped for:
 Unless an adjustment is made to the earnings per share calculation, the current year’s earnings
per share would indicate that the efficiency of earnings decreased during the year (R23 288/ 20
000 shares) to 116,44c per share,
 Despite the reality that the company earned R2 for every one share in issue during the period, as
was achieved in the previous year.
Opening balance 10 000 10 000* 10 000
Issue for value 10 000 1 644** 0
Closing balance 20 000 11 644 10 000
*Opening balance: 10 000 shares for 365 days (10 000 x 365/365) 10 000 (2)
**New shares issued: 10 000 shares for 60 days (10 000 x 60/365) 1 644

= R2 per share R2 per share
o Issue for no value

 Issues for no value is when an entity effectively gives shares away.

 Examples of this include capitalisation issues (bonus issues or stock dividends) and share splits.
Capitalisation issues frequently occur when a company has a shortage of cash with the result that shares
are issued instead of paying cash dividends to the shareholders.
 Since there has been no increase in capital resources (there is no cash injection), a corresponding
increase in profits cannot be expected.
 If the earnings in the current year are the same as the earnings in the prior year and there is an increase
in the number of shares in the current year, the earnings per share in the current year will, when compared
with the earnings per share in the prior year, indicate deterioration in the efficiency of earnings relative to
the available capital resources.
 Comparability would thus be jeopardised unless an adjustment is made. The adjustment made for an
‘issue for no value’ is made to the prior year and current year, (note: an ‘issue for value’ is adjusted for in
the current year only).
 This adjustment has the effect that it appears that the shares issued in the current year had already been
in issue in the prior year.
 This adjustment is thus a retrospective adjustment
Example: Issue for no value

 There was a capitalisation issue of 10 000 ordinary shares during the current year.
 The earnings in the previous year were R20 000, and thus the earnings per share in the
previous year was R2/ share (C20 000/ 10 000 shares).
Required: Assuming absolutely no change in circumstances since the previous year, explain what the
user would expect the profits and the earnings per share to be in the current year.
Solution:
 The number of shares doubled in the current year due to the capitalisation issue but there has been
no increase in resources and so the shareholders could not reasonably expect an increase in profits.
 By way of explanation:
 Assume that the profits in the current year did, in fact, remain constant at R20 000.
 Without an adjustment to the earnings per share calculation, the earnings per share in the current
year would appear to halve to R1/ share (R20 000/ 20 000 shares), indicating to the user that the
entity was in financial difficulty.
 The reality, of course, is that the profitability has neither improved nor deteriorated since the
previous year and thus the earnings per share should reflect this stability.

 The need for comparability between the earnings per share for the current year and the prior year
requires that the number of shares be adjusted. This is done by making an adjustment to the prior
year’s number of shares in such a way that it seems as if the share issue took place in the prior year.
 This means that the prior year’s earnings per share has to be restated; and
 the fact that the prior year’s earnings per share figure has been changed (restated) must be made
quite clear in the notes.
 The earnings per share in the current year will be disclosed at R1 (R20 000/ 20 000 shares) and the
earnings per share in all prior periods presented will be restated: the prior period will be disclosed at
R1 (R20 000/ 20 000 shares).
 Comment:
 Please notice that the adjustment is not time-weighted.
 Therefore ‘issues for no value’ made during the year, (as opposed to at the beginning or end of the
year), are all dealt with in the same way (by adjusting the prior year number of shares)
o Share buy-back
 A share buy-back is the involvement of a reduction of the capital base (i.e. fewer issued shares will exist after
the buy-back) and a reduction in the money/ resources of the entity (this is because the entity will be required
to pay the shareholders for the shares).
 The entity pays the shareholders for their shares, the share buy-back is a for-value that is reduced. The
treatment of a for-value reduction is very similar to that of a for-value issue with the exception that the number
of shares involved is subtracted rather than added.
Example: Share buy-back

Bell Ltd had 10 000 ordinary shares in issue during 2002 and had a share buy-back in 2003:
 of 5 000 ordinary shares (at market price)
 60 days before the end of the current year (year-end: 31 December 2003). The basic earnings
in 2002 were R20 000 and were C17 000 in 2003.
Required: Calculate the earnings per share in 2003 and 2002
Solution:
Basic earnings per share (W1&W2): 2003: R1,85 per share 2002: R2,00 per share

W1: Denominator: number of shares Actual 2003 2002

Opening balance: 1/1/2002 10 000 10 000 10 000
Reduction for value: 1/11/2003 (5 000) (822) 0
(2003: 5 000 x 60/ 365);
(2002: 5 000 x 0/12)
Denominator for 2003 financials 5 000 9 178 10 000
W2: Earnings per share for inclusion in 2003 financial statements
Earnings per share for inclusion in 2003 financial statements 2003 2002
= R1.85 per share R2 per
share
o Reverse share split (share consolidation)

 An entity might perform a share split if they believe that their share price is too low (by reducing the number
of shares, the demand for the share should push the market price up).
 This transaction will require none of an entity’s resources and will be treated as not-for-value reduction.
 Treatment of a not-for-value reduction is very similar to that of a not-for-value issue with the exception that
the number of shares involved is subtracted rather than added.
Example: Reverse share split (share consolidation)

 A company had 10 000 issued ordinary shares during 2002.
 It then consolidated its shares in 20X3 such that every 2 shares were consolidated into 1 share, 60
days before the end of the current year (year-end: 31 December 2003).
 Basic earnings were C20 000 (2002) & C17 000 (2003).
Required: Calculate the earnings per share in the 20X3 financial statements.
Solution:
Earnings per share (W1&W2): 2003: R3,40 per share 2002: R4,00 per share
W1: Denominator: number of shares Actual 2003 2002

Opening balance: 1/1/2002 10 000 10 000 10 000
Reduction for value: 1/11/2003 (5 000) (5 000) (5000)
(20X3: 5 000 x 10 000/ 10 000);

(20X2: 5 000 x 10 000/ 10 000)

Denominator for 2003 financials 5 000 5 000 5 000
W2: Earnings per share for inclusion in 2003 financial statements
Earnings per share for inclusion in 2003 financial statements 2003 2002
Basic Earnings R17 000 R20 000
= R3,40 per share R4 per share
* The 2002 financial statements would have reflected earnings per share of R2 (R20 000/ 10 000) for 2002.
Comment: Since the share consolidation is not for value, the reduction is not weighted but is rather
retrospectively adjusted
1.4 Headline Earnings Per Share

 Headline earnings per share is not a requirement of IAS 33 but is a requirement for companies wishing to
be/remain listed on the South African Johannesburg Securities Exchange (JSE)
 The history of headline earnings per share, stems from:
 The source of the basic earnings per share figure;
 Price-earnings ratio as a tool for analysing financial statements
 Since basic earnings are derived from the profit for the year, it may be inclusive of the re-measurement of
assets and liabilities, some of which:
 May relate to capital platform-related items (e.g. capital transactions)
 May relate to operating activities (e.g. inventories)
 The price-earnings ratio is a frequently used tool in the analysis of financial statements and the need for
headline earnings developed from the notion that the price of shares is:
 More likely to be driven by earnings from operations;
 Less likely to be driven by earnings from re-measurements of certain non-current assets making up the
company’s capital-platform (e.g. property, plant and equipment)
 The headline earnings per share therefore simply separates the basic earnings into:
 The earnings that relates to operating/ trading activities (included in HEPS);
 The earnings that relates to the capital platform of the business (excluded from HEPS)

1.4.1 Headline earnings – the numerator

 Headline earnings is a reflection of the entity’s operating performance. We calculate basic headline earnings
by taking the basic earnings figure (as per IAS 33) and making an adjustment
 This basic earnings figure (calculated in terms of IAS 33) is:

 Adjusted for any re-measurement of an asset or liability that constitutes part of the platform of the business
(e.g. re-measurement of property, plant and equipment): these are excluded from the earnings figure; and
conversely,
 Not adjusted for any re-measurements of assets and liabilities related to the business operations (e.g. re-
measurement of inventories): these are included in headline earnings.
 When calculating diluted headline earnings, we start with the basic diluted earnings figure (per IAS 33), and
adjust it for the same headline earnings adjustments as above
 The following are examples of some items that would be excluded from earnings when calculating ‘headline
earnings’ per share:
 Profits or losses on the sale of non-current assets
 Profits or losses on the full or partial sale of a business (i.e. sale of disposal groups)
 Impairments (and reversals thereof) of non-current assets or businesses
 Foreign exchange loss on the translation of a net investment in a foreign operation
 Gain on an available for sale financial asset that is reclassified on disposal (this type of financial
asset will not exist if the company has adopted IFRS 9)
 The following are examples of some items that would not be excluded from earnings (i.e. would be included
in earnings) when calculating ‘headline earnings per share’:
 Depreciation of plant
 Amortisation of intangible assets
 Write-down of inventory (remember that this relates to a current asset)
 Increase in a deferred tax expense due to the effect of an increase in the tax rate on a deferred tax
liability
 Foreign exchange loss due to the effect of the weakening of the local currency on an amount payable
by the entity
 Gain on the initial recognition of a deferred tax asset
1.4.2 Headline earnings – the denominator

 The number of shares to be used in calculating the headline earnings per share must be the same as the
number of shares used to calculate basic earnings per share. Similarly, the number used to calculate the

diluted headline earnings per share must be the same as that used to calculate diluted earnings per share.
See Circular 04/2018.24 & IAS 33.7
Example: Headline earnings per share

The following information relates to Kin Limited’s year-ended 31 December 2002:
 The statement of comprehensive income shows profit for the year of R100 000.
 The calculation of this profit included the following income and expenses: Impairment
of building: R35 000 (before tax: R50 000)
 Profit on sale of plant: R22 400 (before tax: R32 000)
 Inventory write-down: R10 000 (before tax: R15 000)
 The statement of changes in equity reflected preference dividends of R2 000.

Required: Calculate the basic earnings and the headline earnings.
Solution:
Basic earnings C
Profit for the year 100
000 Preference dividends (2
000) Basic earnings 98
000
Headline earnings
Basic earnings 98
000 Adjusted as follows:
Add impairment of building 35
000 Less profit on sale of plant (22
400) Headline earnings 110
600
1.4.3 Disclosure of headline earnings per share

 If an entity presents headline earnings per share in its financial statements, IAS 33 requires that both the
basic headline earnings per share and the diluted headline earnings per share are calculated and presented
and where these two variations of the headline earnings per share and presented with equal prominence.
 An ‘earnings per share note’ must be included in the financial statements and must include:
 the headline earnings per share

 a reconciliation between the basic earnings and headline earnings

 comparatives for all such disclosures. Circular 04/2018.25 & .27 & IAS 33.73
 This reconciliation must be provided in a long-form, meaning that the amounts that have been excluded from
the basic earnings must be shown:
 gross (before tax) and
 net (after tax and after non-controlling interests). Circular 04/2018.28
Example:
Use the same information as was provided in the example above and that there were 10 000 shares in issue
throughout the year.
Required: Disclose headline earnings per share for the year-ended 31 December 2002.
Solution:
Company name
Notes to the financial statements (extract)
Earnings per share 2002 2001

Headline earnings per share HE: 110 600/ Shares: 10 000 R11,06 per share xxx
Headline earnings per share

The calculation of headline earnings per share is based on earnings of R 110 600 (2004 R XXX) and 10 000
(2004 xxx) ordinary shares outstanding during the year.
Reconciliation of earnings: Profit – basic earnings – headline earnings

2002 2001
Gross Net Gross Net
Profit/(loss) for the period 100 000 xx
Preference dividend (2 000) (xx)
Basic earnings 98 000 xx
Add: back: Impairment of building 50 000 35 000 xx xx
Less: Profit on sale of plant (32 000) (22 400) xx
Headline earnings 110 600 xx

1.5 Diluted Earnings Per Share

 Dilution means to make thinner or less concentrated.
 With regard to earnings per share, dilution would occur if the same earnings have to be shared amongst
more shareholders than are currently in existence
 Many entities at year-end have potential shares outstanding, which, if converted into shares, may or may
not dilute the earnings per share
 Diluted earnings per share shows the lowest earnings per share possible assuming that all dilutive
potential ordinary shares were no longer potential but had resulted in the issue of ordinary shares
 In other words, the diluted earnings per share shows users the maximum potential dilution of their
earnings in the future (i.e. the worst-case scenario) assuming the dilutive potential shares currently in
existence are converted into ordinary shares in the future
 It logically follows that diluted earnings per share can never be higher than basic earnings per share.
 Diluted earnings per share is calculated for both basic and headline earnings per share
Revision Question:
“a) Define an equity instrument.
b) Name two classes of shares that a company may issue and briefly explain the
difference between them.
c)Describe how to recognise an issue of ordinary shares and the related dividend
declarations.
d)An issue of ordinary shares is always recognised in the same way as an issue of
preference shares. True or false? Briefly justify your answer.
e) The holder of a cumulative preference share is entitled to a distribution every year.

True or False? Briefly justify your answer.
f) IFRSs prohibit the existence of par value shares. True or false? Briefly justify your
answer.
g) Identify four different ways in which a company could increase its number of issued
shares.
h) Explain in what way a share consolidation and a share buy-back are similar and
explain what each involves.

i) The Companies Act No. 71 of 2008 refers to a solvency and liquidity test: briefly
outline what this test involves.
j) Briefly compare the accounting treatment of share issue costs with the accounting
treatment of preliminary costs. Required: Provide brief answers to each of the
questions posed above.
Solution:
a) Equity instruments are defined as ‘any contract that evidences a residual interest in
the assets of an entity after deducting all of its liabilities’. IAS 32.11
b) Two classes of shares include: ordinary shares and preference shares.

 The main differences between ordinary and preference shares relate to the
dividend entitlement of the shareholders.
 The holders of ordinary shares are not guaranteed to receive dividends
because ordinary dividends are dependent on both the profitability of the
company and its cash flow.
 The holders of preference shares can receive or be owed dividends based on
whether the dividends are discretionary or non-discretionary. If the preference
dividend is discretionary, the dividend is only recognised once it has been
declared. If the dividend is non-discretionary the company has created a
liability for all future preference dividends on the day, the preference share is
issued.
c) An issue of ordinary shares is recognised by increasing assets (cash) and increasing

equity (share capital). Ordinary dividends declared are recognised as a decrease in
equity (dividends / retained earnings) with a corresponding increase in liabilities
(dividends payable).
d) False:
 Although the issue of ordinary shares is always recognised as equity, the issue
of preference shares may be recognised as equity or a liability depending
on the circumstances.
 If the preference shares issued are:
- compulsorily redeemable; or
- redeemable at the option of the shareholder; or

- non-redeemable however their dividends are non-discretionary (i.e.

mandatory);
 then the issue of preference shares will be recognised as a liability and the
dividends will be recognised as a finance cost using the effective interest rate
method.
 If the preference shares issued are:
- redeemable at the option of the issuer; or
- non-redeemable and their dividends are discretionary;
 then the issue of preference shares will be recognised as equity and the
dividends will be recognised as a distribution of equity.
e) True.
 When a company issues ‘cumulative preference shares’ it commits itself to the
payment of preference dividends until either the company is wound up or the
preference shares are redeemed. This means that the company creates a
present obligation on the date of issue: a liability equal to all the future
preference dividends. The holder of this share is therefore irrevocably entitled
to a distribution every year (or other period specified by the contract).
f) False.
 The IFRSs do not prevent the issue of par value shares and, in fact, the IFRSs
prescribe how to account for both par value and no par value shares.
However, the national legislation of certain countries (e.g. South Africa) may
prohibit the issue of par value share whereas the national legislation of other
countries (e.g. the UK) may permit the issue of par value shares.
g) A company could increase the number of its issued shares as set out below, provided
that the share issue is within the limits of its authorised number of shares that it can
issue:
 The company could issue shares at market price;
 The company could issue shares to existing shareholders at a price lower than
market price (i.e. a rights issue);
 The company could issue shares to existing shareholders for free by
converting reserves into equity (i.e. a capitalisation issue);
 The company could perform a share split (existing shareholder’s shares are
split into one or more shares: this does not reflect a transaction of commercial
substance from the entity’s perspective and thus no journal is processed).

h) A share consolidation and a share buy-back both result in fewer issued shares. They
both thereby affect the disclosure of the number of issued shares in the ordinary or
preference share capital notes to the financial statements, and also affect the
calculation of the company’s earnings per share and related disclosure.
 A share consolidation involves the conversion of, say two shares into one
share, in which case the number of issued shares will halve. No journal entry
is processed for a share consolidation.
 A share buy-back involves a company buying back its own shares: the
purchased shares become what are referred to as treasury shares. These
treasury shares are not deemed to be held by the company, rather, they are
deemed to be ‘authorised and unissued’. In other words, the treasury shares
are available to be re-issued.
i) A company satisfies the solvency and liquidity test if:

 The assets of the company, fairly valued, equal or exceed its liabilities, fairly
valued; and
 It appears that the company will be able to pay its debts as they become due
in the ordinary course of business for a period of 12 months after the date on
which the test is considered or in the case of a distribution, 12 months
following that distribution.
j) Share issue costs (also referred to as transaction costs) must be set-off against the
equity account (e.g. share capital account) unless the issue of shares is abandoned,
in which case the share issue costs will be expensed in profit or loss. See IAS 32.37
Preliminary costs (also called start-up costs) must be expensed in profit or loss. See
IAS 38.69
Question
You have recently been appointed the accountant of Castile Limited. The company
wishes to acquire Princess Limited and has requested your help in the acquisition. Your
task was to perform a ratio analysis of Princess Limited using its annual financial
statements for the year ended 31 December 20X9, including calculating its earnings
and dividends per share. Having reviewed your analysis, the financial director seeks
the following information from you: A detailed explanation of all the circumstances
under which comparative figures for earnings per share should be restated and why

this would be necessary. An explanation of why Princess Limited’s profit on sale of

investments was included in the earnings figure used to calculate earnings per share.
An explanation as to why earnings per share is a better performance indicator than
dividends per share and profit for the year.
Required: Write an email to the financial director to address each of his queries.
Solution:
Subject Earnings per share
header: queries
Dear FD
You have identified three very important questions, each of which I will address below:
Question 1: When should comparative earnings per share be restated:
 The following situations will result in comparatives for earnings per share to be
restated:
A capitalisation issue or a share split (i.e. a not for value issue)
A change in accounting policy or a correction of an error
 With a capitalisation issue or a share split no new cash resources are available
to the company. The number of shares increases resulting in a decrease in the
EPS.
 Therefore, the comparative EPS must be restated to ensure that comparability is

not lost. This adjustment applies not only to the prior period but to the figures of all
previous periods that are presented as comparatives as well.
 A change in accounting policy or a correction of an error gives rise to a prior

year adjustment in terms of IAS 8.
 With a prior year adjustment, it is necessary to restate the previous year’s

comparatives and the retained earnings at the beginning of the year. If the
adjustment has an impact on the ‘earnings’ used for the earnings per share
calculation, it will therefore be necessary to restate the earnings per share figure
for the previous year.

Question 2: Why the profit on sale of investments is included in earnings per

share:
 IAS 33 requires earnings per share to be based on basic earnings, which is
defined as the profit or loss for the period attributable to ordinary shareholders
after deducting preference dividends. In terms of IAS 8, profit for the period
should include all items of income and expense recognised in a period.
 The profit on sale of investments should be included in profit for the period and
therefore should be included in basic earnings as well.
Question 3: Why earnings per share a better indicator of performance than profit
for the year and dividends per share
 The dividend per share depends on the dividend payout policy of a company,
and not necessarily on the size of its profits.
 It is not possible to judge a company’s performance on its dividends declared.

In new or expanding companies, for example, it would be irresponsible to adopt
too high a dividend payout ratio.
 A low dividend per share in such cases would not necessarily reflect poor
performance - management may just be retaining the profits in order to re-invest
in the business.
 Earnings per share, on the other hand, is based on profit earned by the business
regardless of whether such funds are being paid out to the owners or are being
re-invested to increase the value of the business.
 Profit after tax on its own does not tell shareholders the extent of the return on
their investment.
 For example, if two companies both reflect profit after taxation for the year of
C100 000 but company A has 1 000 shares and company B has 2 000 shares,
it cannot be said that a shareholder with one share in each of the companies
has earned the same amount on each investment, even though the profits
earned by each company are the same.
 The one share held in company A has yielded a C100 return whereas the one
share in company B has only yielded a C50 return once the profits have been
shared out amongst the owners.

 It is therefore more meaningful to look at earnings per share than at total

earnings.
I hope this has helped you, please feel free to email or call if you have any further
questions.
Regards
Question
Your employer has approached you to advise him as to whether or not he is correct in
his understanding of IAS 33:
a) All entities must present diluted earnings per share on the face of the statement of
comprehensive income.
b) We must present the basic and diluted earnings per share from continuing operations
separately from the basic and diluted earnings per share from discontinued
operations.
c) Only anti-dilutive potential ordinary shares are used in calculating diluted earnings per
share.
d) Potential ordinary shares are weighted for the period outstanding.
e) In the case of a debenture liability that may be settled in cash or by way of conversion
into an ordinary share, and where this choice of settlement is at the option of the entity,
settlement in ordinary shares is always assumed.
f) Options are the least dilutive of all the possible potential ordinary shares. Required:
State whether the above statements are true or false. Briefly justify your answer.
Solution:
a) True.
 Basic and diluted EPS must be presented on the face of the Statement of
Comprehensive Income and must be presented with equal prominence. See
IAS 33.15

b) True.
 Where the profit or loss for the year is constituted by profit or loss from a
continuing operation and a profit or loss from a discontinued operation, we must
present and disclose the diluted EPS (and also the basic EPS) from the
continuing operations separately from the diluted EPS (and also the basic EPS)
from the discontinued operation. See IAS 33.66 & .68
 The diluted EPS (and also the basic EPS) from the continuing operations must
be presented separately from the diluted EPS (and also the basic EPS) from
the entire operation. See IAS 33.66
c) False.
 Only dilutive potential ordinary shares are used in calculating diluted EPS.
d) True.
 Potential ordinary shares are weighted for the period they are outstanding. This
means, for example, that:
potential ordinary shares that are cancelled or allowed to lapse during the period
are included in diluted earnings per share only for the part of the period during
which they were outstanding; and
potential ordinary shares that are converted into ordinary shares during the period
are in diluted earnings per share only up to the date of conversion.
 Potential ordinary shares are included in the calculation of diluted earnings per
share:
weighted from the beginning of the year, or
if the potential ordinary share was issued during the year, then from the date of the
issue.
e) True.
 Where, for example, an instrument (e.g. a debenture) may be settled by
converting it into ordinary shares or redeeming it for cash, whether this choice
of settlement is to be made by the entity or the holder of the instrument, we
always assume that the settlement will be made by way of a conversion into
ordinary shares. As a result, these potential ordinary shares are included in the
diluted earnings per share computation.

f) False.
Options are the most dilutive of potential ordinary shares.
Question:
You are a new member of the financial reporting team at Perseverance Limited, charged
with the responsibility of ensuring that the equity and liabilities section of the statement
of financial position is fairly presented.
The following information is relevant:
 100 000 ordinary shares were issued on 1 January 20X1 at C1 each.
 300 000 redeemable preference shares with a coupon rate of 10% were issued
on 1 January 20X3 at C1 each. These shares are compulsorily redeemable on
31 December 20X5 at a premium of C0,10 per share. The effective interest rate
is 12,937%.
 The preference dividends are declared and paid on 31 December each year
and are nondiscretionary.
 The directors are satisfied that the company’s assets, fairly valued, exceed its
liabilities and that the company will be able to pay its debts as they become due.
 All amounts are considered to be material.
Required:
a) Using the Conceptual Framework definitions of the elements of the financial
statements, discuss whether the issue of the preference shares on 1 January 20X3
should be recognised as equity or as a liability.
b) Using the Conceptual Framework definitions of the elements of the financial
statements, discuss whether the redemption of the preference shares on 31 December
20X5 should be recognised as an expense.
Solution:
a) Issue of the preference shares
 Definitions
 Liability:
a present obligation of the entity
to transfer an economic resource
as a result of past events
 Equity:

The residual interest in the assets of the entity after deducting all its liabilities.
Application of the above definitions on the initial issue of preference shares:

 Liability:
Since Perseverance Limited’s preference shares are compulsorily
redeemable, the entity has a present obligation to redeem the preference
shares.
The settlement of this obligation will result in a transfer of economic resources
in the form of cash of C420 000 (in respect of the issue price of the shares:
C300 000, the premium: C30 000 and the annual dividends: C30 000 x 3 years
= C90 000).
The past event is the issue of these shares on 1 January 20X3.
 The preference shares therefore meet the definition of a liability.
b) Redemption of the preference shares
 Definitions
 Expense:
A decrease in assets, or
An increase in liabilities
That result in decreases in equity, other than those relating to distributions to
holders of equity claims.
 Application of the above definitions on the redemption of preference

shares:
 Expense:
There is a decrease in assets: being the cash outflow of redeeming the preference
shares on 31 December 20X5.
Resulting in a decrease in equity, other than a distribution to equity participants:
- Since the issue of the preference shares represents a liability, none of the payments
to the preference shareholders represent distributions to equity participants.
- Since the issue price of the shares and premium on redemption are both committed
to on the date that the preference shares are issued and are thus recognised as
liabilities, the repayment of each represents a decrease in assets (decrease in the
bank account) and a decrease in this preference share liability balance, with the result
that there is no impact on the equity. These repayments are therefore not expenses.
- The C300 000 paid is a settlement of the original liability.

- The C30 000 paid is a settlement of the premium that accrued over the 3 years.
- Both the above payments thus decrease liabilities and, at the same time, decrease
the assets (bank) with the result that the payments do not represent expenses.
Question
 Future Limited had basic earnings for 2005 of R500 000.
 This basic earnings figure was equal to its profit for the year. It had no
components of other comprehensive income.
 Future Limited had 1 200 000 ordinary shares in issue throughout 2005. There
were 300 000 options in issue at 31 December 2005 (granted to the directors for
no value).
Required:
A. Calculate basic and diluted earnings per share for the year ended 31 December 2005.
B. Disclose basic and diluted earnings per share for the year ended 31 December 2005.
Solution:
A.
Basic earnings per share (W1): R0, 4167
Diluted earnings per share (W2): R0, 3333
W1: Basic earnings per share: 20X5
Basic Earnings R 500 000
Number of shares 1 200 000
= R0.4167 per share
W2: Diluted earnings per share: 20X5

Basic Earnings R500 000
Weighted average number of shares + potential shares (1 200 000 + 300 000)
=R0.3333 per share
B.
Future Limited
Statement of comprehensive income
2005 2004
Profit for the year 500 000 xxx
Other comprehensive income 0 xxx
Total comprehensive income 500 000 xxx
Basic earnings per share 0.4167 x

Diluted earnings per share 0.3333 x
Future Limited
Notes to the financial statements (extracts)
Earnings per Share

Basic earnings per share Basic earnings per share is based on earnings of R500 000
(2004: RX) and a weighted average of 1 200 000 (2004: X)
ordinary shares in issue during the year.
Dilutive earnings per share Dilutive earnings per share is based on dilutive earnings
of R500 000 (2004 RX) and a weighted average of
1 500 000 (2004 X) ordinary shares during the year”
Kolitz, C.L. and Service, C. (2019) Gaap: Graded questions. Eighteenth Edition. Durban:
Lexis Nexis
1.6 Summary
Students should have knowledge of the different types of shareholders that exist in an entity, basic earnings per
share, headline earnings per share and diluted earnings per share are calculated for entity’s that operate on share
capital. This chapter looks at the financial treatment of shares from an entities perspective and concentrates on
the manner in which a company acquires funds and manages these funds through their shareholders.

Unit
2: Statement of Cash Flows

2.1 Introduction to Cash Flow  Display an understanding of cash flow statements

Statements
2.2 Calculating and Presenting Cash  Compute and present cash flows according to IFRS
Flows
2.3 Cash and Cash Equivalents  Display and understanding of cash and cash equivalents
2.4 Interest, Dividends and Taxation  Display an understanding of interest, dividends and tax
included in cash flow statements




2.1 Introduction to Cash Flow Statements

According to IAS 1 the statement of cash flows is one of the 5 financial statements that make up the ‘set of annual
financial statements’ for an entity. The statement of cash flows analyses the bank account of an entity and other
accounts which can be considered as cash equivalents.
Think Point
Provide a definition of cash equivalents with relevant examples.
The statement of cash flows is prepared with the purpose of adding to the usefulness of financial statements as it
classifies the total inflows and outflows of cash, for a period, into the following areas:
 Operating activities
 Investing activities
 Financing activities
Benefits of preparing a statement of cash flows:

 The statement provides information which is useful regarding the assessment of liquidity of an entity.
 It helps with the identification of the main sources of cash and their uses
 The subjectivity and judgements that are essential in other statements do not have any influence on the
figures that are in the statement of cash flows
 Cash budget requirements and movements of cash can be carefully monitored
 Future cash flow predictions can be made as records of cash flows that already exist will be available
which is important as the present value of an entities cash flows is a reflection of the value of the entity
Drawbacks of relying on a statement of cash flows:

 The volatility of cash flows is a hazard as they are influenced by external factors such as changes in the
economy
 Due to the elimination if the accrual basis of accounting when preparing statements of cash flows, credit
transactions of future cash inflows and outflows can be undermined

The following is a basic outline of the statement of cash flows. Inflows of cash are shown without brackets
(positive) whereas outflows are shown in brackets (negative)
Company name
Statement of cash flows
Note 2002
Cash flows from operating activities 2000

Cash flows from investing activities (1 000)
Cash flows from financing activities 4 000
Net cash (outflow)/ inflow 5 000
Cash and cash equivalents: opening balance (per statement of financial position) .. 2 500
Cash and cash equivalents: closing balance (per statement of financial position) 7 500
2.2 Calculating and presenting Cash Flows

2.2.1 Presenting cash flows
A. Operating activities
 The cash flows that an entity generates from their operating activities are the main activities that they take
part in to generate their revenue
 They are often defined as ‘principle revenue producing activities’ and exclude any activities that are
investments or financing activities
 Operating activities are involved with the generation of revenue and their recognition is made in the profit
or loss account
 Exceptions to this rule are activities such as profit/loss on the sale of plant, for example, which are not
considered to be operating activities but investing activities even though they are included in the profit/loss
calculations
 The original intention when purchasing an asset is to use it in the entity and not for the generation of
revenue
B. Investing activities
 This is the cash flows that an entity generates from the purchasing and selling of long term assets and is
a reflection how much cash the entity invested with the intention of generating cash flows in the future
 In order for a transaction to be classified as an investing activity, an outflow from the asset must be
recognised in the entities statement of financial position

C. Financing activities
 An entity’s equity and borrowings form part of their cash flows from financing activities and the net cash flows
from these activities are a reflection of the extent that 3rd parties can claim against the cash resource of the
organisation
2.2.2 Calculating cash flows

 The reconstruction of ledger accounts is generally the easiest way to calculate the amounts that should be
included in a statement of cash flows. This can be done if the statement of financial positon, statement of
comprehensive income and statement of changes in equity for an entity is made available
 Items that have been recognised in the financial statements on the accrual basis will have to be converted
into items that are recognised on the cash basis for example, the conversion of revenue into cash that has
actually been received from debtors
 These conversions will need adjustments to be made to the changes in working capital balances for example,
the balances on the trade accounts receivable
 Non-cash flow items such as profit/loss on disposal of assets, impairment of assets and depreciation will need
to be adjusted
o Movements in working capital

 The working capital of an entity makes reference to its current liabilities and assets
 When making the conversion it is imperative to remember that items that have been recognised in the financial
statements on the accrual basis will have to be converted into items that are recognised on the cash basis.
Therefore, when doing a conversion of income and expense accounts into cash the effects of selling and
buying on credit will need to be removed
Example: Movements in working capital: cash received from customers

The following are extracts from Sam Limited’s financial statements:
 Statement of comprehensive income: Revenue is R 200 000.
 Statement of financial position: Trade receivable balances:

- Opening balance: R 60 000
- Closing balance: R 210 000
Required: Calculate the ‘cash receipts from customers’ to be disclosed in the ‘Statement of cash flows

Solution:
Trade Receivables (A)
Balance b/f (Opening) 60 000 Bank (Balancing) 50 000

Revenue 200 000 Balance c/f 210 000
260 000 260 000
Balance b/f (Closing) 210 000
“In order to convert the revenue line-item (from the SOCI) into the cash receipts from customer’s line item
(in the SOCF presented on the direct method), we will need to be able to reconstruct the trade
receivables
account (i.e. debtors)” – by reconstructing this ledger account the cash received from our customers’ can
be banked at R 50 000.
Example: Movements in working capital: cash paid for inventory

The following are extracts from Gamgee Limited’s financial statements:
 Statement of comprehensive income: Cost of sales is R 70 000.
 Statement of financial position: Trade payables balances:
- Opening balance: C60 000
- Closing balance: C40 000
 Statement of financial position: Inventory balances:
- Opening balance: C50 000
- Closing balance: C80 000
Required: Calculate the cash paid for inventory to be included in ‘cash payments to suppliers and employees’.
Solution:
Inventory (A)
Balance b/f (Opening) 50 000 Cost of sales 70 000

Trade payables (purchases - balancing 100 000 Balance c/f 80 000
150 000 150 000

Trade Payables (L)
Bank (payments – balancing) 120 000 Bank (Balancing) 60 000

Balance c/f 40 000 Inventory (Purchases) 100 000
160 000 160 000
“In order to convert the cost of sales line-item (from the SOCI) into the cash paid for inventory to be included as
part of the cash payments to suppliers and employees line-item (in the SOCF presented on the direct method), we
will need to be able to reconstruct the trade payables account (i.e. creditors) as well as the inventory account” - by
reconstructing these ledger accounts bank is balanced to the cash paid to suppliers of the inventory: R 120 000.
Example: Non-cash flow items: depreciation and profit on sale

The following are extracts from Greyjoy Limited’s financial statements:
 Statement of comprehensive income: Depreciation is R20 000.
 Statement of comprehensive income: Profit on sale of plant: R15 000.
 Statement of financial position: Plant cost:
- Opening balance: R110 000
- Closing balance: R160 000
 Statement of financial position: Plant accumulated depreciation:
- Opening balance: R70 000
- Closing balance: R78 000
 Additional information: plant with a cost of R22 000 was sold during the year.
 Required: Calculate the cash flows relating to plant

Solution:
Plant: Cost (A)
Balance b/f (Opening) 110 000 Asset disposal 22 000

Bank (balancing) 72 000 Balance c/f 160 000
182 000 182 000
Plant: Accumulated depreciation (-A)
Asset disposal (balancing) 12 000 Balance b/f (opening) (given) 70 000

Balance c/f (given) 78 000 Depreciation (given) 20 000
90 000 90 000
Balance b/f (closing) 78 000
Asset disposal: profit on sale
Plant: cost (given) 22 000 Plant: Acc Dep (see Acc Dep account) 12 000
Profit or loss 15 000 Bank (balancing) 25 000
37 000 37 000

Example 4: Calculating and disclosing cash flows

An inexperienced accountant at Futuresmart Limited has been having difficulties in calculating the relevant cash
flows and therefore he has troubles in preparing the statement of cash flows. He has asked you to assist him in
compiling the statement and has provided you with the following notes to the statement of financial position and
comprehensive income:
Notes:
1. Profit before tax includes:
 sales - R800 000
 cost of sales - R350 000
 profit on sale of plant - R 10 000
 total depreciation of R50 000
 impairment loss on vehicles - R10 000
 other operating, distribution and administration costs - R60 000
 interest expense of R20 000.
2. Plant with a carrying amount of R80 000 was sold during the year.
3. All purchases and sales were paid for in cash.
4. There was a capitalisation issue at a market price of R10 000 - retained earnings.
5. There was an issue of ordinary shares during 2003 at a market price of R4 each.
4. A loan of R20 000 was repaid to Talas Bank in 2003. No other repayments were made.
5. Dividends of R40 000 were declared during the year.
Futuresmart Limited
For the year ended 31 December 2003 (extract)
Profit before tax (see note 1) 320 000
Income tax expense 110 000
Profit for the year 210 000
Other comprehensive income for the year 0
Total comprehensive income for the year 210 000

Futuresmart Limited
Statement of financial position
As at 31 December 2003’
ASSETS 2002 2001

Non-current assets
Property, plant and equipment 350 000 300 000
Current assets
Trade receivables 40 000 30 000
Expense prepaid 8 000 10 000
Inventory 120 000 100 000
Bank 152 000 10 000
EQUITY AND LIABILITIES

Owners’ equity
Share capital (note 3) 90 000 60 000
Retained earnings (note 5) 460 000 300 000
Liabilities
Loans (note 4) 60 000 50 000
Shareholders for dividends (note 5) 30 000 2 000
Expenses payable 5 000 6 000
Trade payables 10 000 20 000
Current tax payable: Income tax 15 000 12 000
Required:
A. Ignoring deferred tax, calculate and disclose as many cash flows as is possible from the information
presented.
Solution:
Cash receipts from customers W1 790 000
Cash payments to suppliers & employees: R 380 000 + R 59 000 W2 439 000
Interest paid W3 20 000
Plant purchased for cash W4 190 000
Plant sold for cash W4 90 000
Proceeds from share issue W5 20 000
Loan repaid W6 20 000

Loan raised W6 30 000

Tax paid W7 107 000
Dividends paid W8 12 000
W1: Cash receipts from customers: debtors and sales

In order to convert the sales figure, (which is part of the profit before tax in the statement of comprehensive
income), into a cash amount to be shown in the statement of cash flows using the direct method: ‘cash receipts
from customers’, one must reconstruct the trade receivables account:
Trade Receivables (A)
Balance b/f (Opening)* 30 000 Bank (Balancing)**** 790 000

Revenue** 800 000 Bad debts *** 0
Balance c/f* 40 000
830 000
830 000
Balance b/f (Closing)* 40 000
Revenue (I)
Trade Receivables ** 800 000
Bank (A)
Trade Receivables **** 790 000
Steps: The steps followed are highlighted above with *:

* Complete in the opening and closing balances per the statement of financial position.
** Insert the revenue figure into the trade receivables account (additional information).
*** Insert the bad debts figure into the trade receivables account
**** Balance the trade receivables account to the amount received during the year.
W2: Cash paid to suppliers & employees: creditors, inventory, cost of sale & other expenses
The line item ‘cash paid to suppliers and employees’ includes payments for wages and salaries (payments to
employees) and payments for many other supplies, split into two categories:
 suppliers of inventory items (which involves numerous interrelated accounts)
 suppliers of non-inventory items and services (e.g. electricity, telephone, water, rent and consultation
services).

The following interrelated accounts will need to be reconstructed:
Inventory (A)
Balance b/f (Opening)* 100 000 Cost of sales (given)** 350 000
Trade payables *** 370 000 Balance c/f* 120 000
470 000 470 000
Trade Payables (L)
Bank (payments – balancing)**** 380 000 Bank (Balancing)* 20 000

Balance c/f* 10 000 Inventory (Purchases)***
370 000
390 000 390 000
Cost of Sales
Inventory** 350 000
Bank (A)
Trade payables **** 380 000

* Complete in the opening and closing balances per the statement of financial position.
** Insert the cost of sales figure into the inventory account.
*** Balance the inventory account to the value of inventory purchased: insert this entire amount into the trade
payables account. It makes no difference if some of the purchases were paid for in cash: by taking the movement
in the opening and closing balance of the trade accounts payable account, we will balance to the amount paid
in cash.
**** Balance the trade payables account to the amount paid during the year.
Payments to non-inventory related suppliers and employees may be calculated by reconstructing the
other expenses and related accrual accounts in the balance sheet

Expenses prepaid (A)
Balance b/f (Opening)* 10 000 Expenses** 10 000

Expenses**** 8 000 Balance c/f* 8 000
18 000
18 000
Expenses payable (L)
Expenses*** 6 000 Balance b/f (Opening)* 6 000

Balance c/f* 5 000 Expenses***** 5 000
11 000
11 000
Operating, distribution and administration expenses (E)
Expenses prepaid o/bal** 10 000 Expenses prepaid c/bal** 8 000

Expenses payable c/balance***** 5 000 Expenses payable o/balance*** 6 000
Bank******* 59 000 Profit or loss****** 60 000
74 000 74 000
Bank (A)
O, D & A expenses ******* 59 000


*Fill in the opening balances per the statement of financial position
**Reverse the opening balance of expenses prepaid to the expense account
***Reverse the opening balance of expenses payable to the expense account
****Insert closing balance of expense prepaid by crediting the expense account
*****Insert closing balance of expense payable by debiting the expense account
******Insert total expenses taken to the statement of comprehensive income
*******Balance back to the amount paid for in cash
The total paid to suppliers and employees:

Cash paid to suppliers of inventory = 380 000
Cash paid to employees and other suppliers (non-inventory related suppliers) = 59 000
= 439 000
W3: Interest prepaid and interest expense (interest paid)
Interest Expense
Bank*** 20 000 Profit or loss ** 20 000
Bank (A)
Interest expense *** 20 000

* Fill in the opening and closing balances of interest prepaid or interest payable per the statement of financial
position. There were no such balances in this example, but the same principles as those used when calculating
the amount paid to suppliers and employees are applied here (W2)
** Fill in the related expense per the statement of comprehensive income.
*** Balance to the amount paid in cash (since there was no interest payable or prepaid at either the beginning
or end of the year, the actual interest expense must have been paid).

W4: Property plant and equipment and depreciation (plant purchased or sold for cash)
Plant: Carrying amount (A)
Balance b/f (Opening)* 300 000 Depreciation (per SOCI) ** 50 000

Impairments (per SOCI)** 10 000
Bank **** 190 000 Asset disposal (given)*** 80 000
Balance c/f* 350 000
490 000 490 000
Depreciation Expense
PPE (per SOCI)** 50 000
Impairment Expense
PPE (per SOCI)** 10 000
Asset disposal: profit on sale
Plant (carrying amount) (given)*** 80 000 Bank ****** 90 000

Profit or loss ***** 10 000
90 000 90 000
Bank (A)
Asset disposal ****** 90 000 Plant: cost **** 190 000


**Fill in the depreciation and impairment expenses per the statement of comprehensive income
***Fill in the carrying amount of the disposals
****Balance the PPE account back to the purchases (either the disposals figure or the purchases figure will need
to be known and the remaining unknown figure will be the balancing figure: this question gave the disposals
figure, but not the purchases figure)
*****Insert profit on sale of plant
******Balance the Asset disposal account back to the proceeds received on disposal
W5: Share capital (proceeds from share issue)
Share capital (Eq)
Balance b/f (Opening)* 60 000

Issue – retained earnings** 10 000
Balance c/f* 90 000 Issue – bank*** 20 000
90 000 90 000
Retained earnings
Share capital ** 10 000Balance b/f (Opening)* 300 000
Dividends declared **** 40 000
Balance c/f* 460 000Profit or loss 210 000
510 000 510 000

Bank (A)
Share capital*** 20 000

** Insert the capitalisation issue and any other issue not for cash (R 20 000: given - at market price
*** Balance to the share movements made for cash
**** Closed off from the dividends declared account to the retained earnings account

W6: Liabilities (liabilities raised and liabilities repaid)
Liabilities
Repaying of loan – bank** 20 000 Balance b/f (Opening)* 50 000

Balance c/f* 60 000 Raising of a loan – bank** 30 000
80 000 80 000
Bank (A)
Liabilities - raised** 30 000 Liabilities – repaid** 20 000

** Either the repayment or the raising of any liability will need to be known (in this case, the repayments are
given as R 30 000 and so the amount of the loans raised is the balancing figure).
W7: Current tax payable and Income tax expense
Current tax payable: income tax (L)
Bank**** 107 000 Balance b/f (Opening)* 12 000

Balance c/f* 15 000 Income tax expense*** (E) 110 000
122 000 122 000
Income tax (E)
Current tax payable: income tax*** 110 000 Deffered tax*** 0

Profit or loss 110 000
110 000 110 000

Bank (A)
Current tax payable: income tax*** 107 000

** Insert the income tax expense per the statement of comprehensive income.
*** Balance the income tax expense account in order to calculate the current tax charge in the statement of
comprehensive income and insert this into the current tax payable account. In this example we were told to
ignore deferred tax and therefore the entire income tax expense is the tax owing to the tax authorities in respect
of the current year. Please note, however, that if deferred tax was not ignored, it is important to remember to
separate the deferred tax into its elements that relate to ‘profit or loss’ and those that relate to ‘other
comprehensive income’. The amount relating to ‘other comprehensive income’ will not be included in the tax
expense ledger account.
**** Balance the current tax payable account to the amount paid to the tax authorities.
W8: Shareholders for dividends and dividends declared

Shareholder for dividends (L)
Bank**** 12 000 Balance b/f (Opening)* 2 000

Balance c/f* 30 000 Dividends declared** 40 000
42 000
42 000
Dividends declared (equity distribution)
Shareholders for dividends** 40 000 Retained earnings***** 40 000

Bank (A)
Shareholders for dividends****
12 000

* Fill in the opening balances.
** Insert the dividend/s declared for the year (crediting shareholders for dividends). Dividends declared will
appear in the Statement of Changes in Equity.
*** Insert closing balance
**** Balance back to the amount paid for in cash.
***** The dividends declared account closed off to the retained earnings account at year end.
W9: Retained earnings account

Reconstructing the retained earnings account is not compulsory but can be of assistance in ensuring that all the
movements have been reconciled.
Retained earnings
Share capital *** 10 000Balance b/f (Opening)* 300 000
Dividends declared *** 40 000 Profit and loss account** 210 000
Transfers*** 0
Balance c/f* 460 000
510 000 510 000

* Fill in the opening balances.
** The profit for the year will be transferred to the retained earnings account at year-end.
*** Dividends paid to shareholders, capitalisation issues and transfers to other reserve accounts would need to
be adjusted for, although, in this example there were no transfers. The retained earnings account is in balance.
Disclosure of cash flows – direct method

Cash flows from operating activities 212 000
Cash receipts from customers W1 790 000
Cash paid to suppliers and employees (see comment 1) W2 (439 000)
Cash generated from operations 351 000
Interest paid W3 (20 000)
Dividends paid W8 (12 000
Income tax paid W7 (107 000)

Cash flows from investing activities (100 000)

Disposal of plant W4 90 000
Additions to plant –replacement W4 (190 000)
Cash flows from financing activities 30 000

Loans repaid W6 (20 000)
Proceeds from loans raised W6 30 000
Proceeds from share issue W5 20 000
Net cash (outflow)/ inflow 142 000
Cash and cash equivalents: opening balance (per SOFP) 10 000
Cash and cash equivalents: closing balance (per SOFP) 152 000
2.3 Cash and Cash Equivalents

2.3.1 What is a cash equivalent?
 A statement of cash flows should be presented by all entities as users of these statements will need to
be concerned with the manner in which an entity utilities and generates their cash and cash equivalents
 A cash equivalent can be identified as an investment that an entity uses to meet ‘short term
commitments’
 The most imperative characteristic of a cash equivalent is that it should readily convertible into cash
for example a 3 month fixed deposit and the conversion should be for a known amount of cash
 Borrowing money from a bank generally falls into financing activities, however, it can be included in an
entities cash and cash equivalents. This scenario occurs when the overdraft is ‘payable on demand’
and it is an ‘integral to the entity’s cash management’ which means its balance has to be fluctuating
between a positive and negative
Example: Bank overdrafts

Hats Limited ran at a loss of R40 000 for the year ended 31 December 2003.
 Revenue – R200 000 less expenses of R240 000.
 All transactions conducted in cash.
 In order to be able to pay the expenses during 2003 the entity had made an arrangement for an overdraft
facility.
 Its bank balances were:
 Savings account at R140 000 – (31 Dec 2003), R110 000 (1 January 2003)
 Bank overdraft payable - 31 December 2002: R 70 000 (1 January 2003: 0).
 There were no other transactions during 2003 other than those referred to above.

 Ignore any finance charges.
Required:
A. Explain whether the overdraft is a ‘cash and cash equivalent’, assuming the overdraft often fluctuates
between positive and negative balances and any balance owing to the bank is payable within 30 days.
B. Present the statement of cash flows assuming the overdraft is not a cash equivalent.
C. Present the statement of cash flows assuming the overdraft is a cash equivalent.
Solution:
A. The overdraft facility is used by the entity as its cash management strategy, however, it does not
meet both the criteria as discussed above. Even though it does fall under the entities cash
management, the overdraft facility is only payable after a period of 30 days, therefore it does not
meet the criteria which states it should be repayable on demand.
B.
Cap Limited
For the year ended 31 December 20X3
Cash flows from operating activities

Cash receipts from customers 200 000
Cash payments to suppliers and employees (240 000)
Cash outflow from operations (40 000)
Cash flows from financing activities

Bank overdraft raised 70 000
Cash and cash equivalents: net inflow 30 000

Cash and cash equivalents: opening balance - savings account 110 000
Cash and cash equivalents: closing balance -savings account 140 000
C.
Cap Limited
For the year ended 31 December 20X3

Cash receipts from customers 200 000

Cash payments to suppliers and employees (240 000)
Cash and cash equivalents: net inflow (40 000)

Cash and cash equivalents: opening balance - savings account 110 000
Cash and cash equivalents: closing balance -savings account (140 000 – 70 000 – 0/draft) 70 000
2.4 Interest, Dividends and Taxation

2.4.1 Interest and dividends
 Interest received and paid must have a separate disclosure and the same concept applies for dividends
received and paid
 These cash flows cannot be presented on a net basis (setting them off against each other)
 Interest and dividends can be classified as cash flows from operating activities or financing activities.
The most common practice in financial institutions is to make a disclosure under operating activities
 The classification that an entity chooses must be consistently applied on an annual basis
2.4.2 Taxation
“IAS 7.35 and 7.36 state that where it is possible to ‘specifically identify’ the tax cash flows resulting from an income,
then this tax (paid or received) should be classified under the same heading that that specific income is classified
under (e.g. investing, operating or financing activities). However, if, as is often the case, calculating the tax cash
flow that relates specifically to another transaction is impracticable, then that tax cash flow should be classified
under operating activities instead”.
Think Point
Why should interest received and interest paid be disclosed separately and not set-off against
each other?

Revision Question
“Question 1
Meow Cat Limited manufactures cat treats. All necessary statements and trial balances are
presented below.
Meow Cat Limited

Revenue 3 150 000

Cost of sales (2 152 500)
Gross profit 997 500

Distribution expense (210 000)
Administration expense (354 750)
Finance cost (17 250)
Profit before tax 415 500
Income tax expense (124 650)
Profit for the period 290 850
Other comprehensive income 0
Total comprehensive income 290 850
Meow Cat Limit
Trial balance (extract) at 31 December 2003
2003 2001
Inventories 238 500 219 000
Accounts receivable 312 000 291 750
Prepaid distribution expenses 18 000 0
Cash and cash equivalents 53 250 18 750
Accounts payable (279 750) (240 000)
Current tax payable: income tax (22 650) (15 400)
Accrued administrative expenses (33 750) (53 250)
Accrued finance costs (12 000) (10 500)

Additional information:
The administrative expenses include:
A gain on the disposal of non-current assets amounting to R3 750.
Bad debts written off during the year amounting to R12 750.
Cost of sales includes depreciation of R161 250.
Assume that all transactions are for cash unless otherwise indicated.
Required:
a) Prepare the statement of cash flows of Woof Limited for the year ended 31
December 2002, showing the cash from operating activities only.
Solution 1:
Meow Cat Limit
For the year ended 31 December 20x2

Cash receipts from customers W3 3 117 000
Cash paid to suppliers and employees W4, 5 & 6 (2 564 250)
Interest paid W1 (15 750)
Taxation paid W2 (117 400)
Net cash generated from operating activities 419 600
W1 Interest paid R
Opening balance: accrued interest 10 500
Statement of comprehensive income 17 250
Closing balance: accrued interest (12 000)
15 750
W2 Taxation paid R
Opening balance: current tax payable 15 400
Statement of comprehensive income 124 650
Closing balance: current tax payable (22 650)
117 400

W3 Cash receipts from customers R

Opening balance: accounts receivable 291 750
Sales 3 150 000
Bad debts (12 750)
Closing balance: accounts receivable (312 000)
3 117 000
W4 Calculation of purchases
Opening inventory + Purchases – closing inventory = COS - Depreciation
219 000 + 2 010 750 – 238 500 = 2 152 500 – 161 250
W5 Cash payments to suppliers R

Opening balance: accounts payable 240 000
Purchases 2 010 750
Closing balance: accounts payable (279 750)
1 971 000
W6 Other cash flows / removal of non-cash flows R

Distribution 210 000
Administration 354 750
Gain on disposal Bad debts written off 3 750
Opening balance: administration expenses accrued (12 750)
Closing balance: administration expenses accrued 53 250
Closing balance: prepaid distribution expenses (33 750)
18 000
593 250
Total = R1 971 000 (W5) + R593 250 (W6) = R2 564 250
Question 2
Pop Limited is a manufacturer of flasks. The statement of comprehensive income and
statement of changes in equity of Pop Limited for the year ended 31 December 2008, as well
as the statement of financial position of the company at 31 December 2008, are shown below:
Pop Limited

Sales 300 000

Cost of sales (200 000)
Gross profit 100 000
Operating expenses (26 000)
Selling expenses 10 000
Administration expenses 7 000
Loss on disposal of equipment 1 000
Depreciation 8 000
Profit before tax 74 000
Income tax expense (29 600)
Profit for the period 44 400
Share capital Retained earnings Total
Balance 01/01/08 100 000 10 000 110 000

Profit for the period 44 400 44 400
Dividends (20 000) (20 000)
Issue of share capital 10 000 10 000
Balances: 31/12/08 110 000 34 400 144 400
Pop Limited
As at 31 December 2008
ASSETS 2008 2007

Non-current assets
Equipment 85 000 80 000
Current assets 109 800 70 500
Inventory 60 000 40 000
Trade receivables 12 000 20 000
Selling expenses paid in advance 1 200 1 500
Bank 36 600 9 000
194 800 150 500

Owners’ equity
Share capital 110 000 100 000

Retained earnings 34 400 10 000

Non- current liabilities
Loans 10 000 20 000
Current liabilities
Admin expenses payable 800 500
Current tax payable: Income tax 19 000 10 000
194 800 150 500
The following information is relevant:

Equipment costing C15 000 was purchased during the year when certain other equipment
was traded in as part of the purchase price.
Required:
a) Prepare a statement of cash flows of Pop Limited for the year ended 31 December 20X6
using the direct method.
Solution 2:
POP LIMITED
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED 31 DECEMBER 2008

Cash receipts from customers (20 000 + 300 000 - 12 000) 308 000
Cash paid to suppliers and employees W1, W2 & W3 (225 800)
Taxation paid (10 000 + 29 600 – 19 000) (20 600)
W4
Dividends paid (20 000)
Net cash generated from operating activities 41 600
Cash flows from investing activities
Purchase of equipment (15 000)
Sale of equipment W5 1 000
Net cash utilised in investing activities (14 000)
Cash flows from financing activities
Proceeds from issue of shares 10 000
Repayment of long-term loan (10 000)
Net cash generated from financing activities 0

Net inflow in cash and cash equivalents 27 600

Cash and cash equivalents at the beginning of 9 000
period
W1 Calculation of purchases
Opening inventory + Purchases – closing inventory = COS
40 000 + 220 000 – 60 000 = 200 000
W2 Cash payments to suppliers 209 400

Opening balance: accounts payable 10 000
Purchases 220 000
Closing balance: accounts payable (20 600)
W3 Other cash flows / removal of non-cash flows 16 400

Selling expenses 10 000
Administration expenses 7 000
Opening balance: administration expenses payable 500
Closing balance: administration expenses payable (800)
Opening balance: selling expenses paid in advance (1 500)
Closing balance: selling expenses paid in advance 1 200
Total = C209 400 (W5) + C16 400 (W6) = C225 800

W4 Taxation
Current tax payable: income tax (L)
Bank 20 600 Balance b/f (Opening) 10 000

Balance c/f 19 000 Income tax expense (E) 29 600
39 600 39 600
W5 Equipment
Plant: Carrying amount (A)
Balance b/f (Opening)* 89 000 Disposal (1) 4 000

Bank 15 000 Balance c/f* 100 000
104 000 104 000
Equipment: accumulated depreciation (-A)
Disposal (2) 2 000 Balance 9 000

Balance 15 000 Depreciation 8 000
17 000 17
000
Loss on disposal of equipment (E)
Equipment 4 000 Accumulated depreciation 2 000

Loss 1 000
Bank (3) 1 000
4 000 4 000
Step 1: Calculate the cost of the equipment disposed of by reconstructing the equipment account
Step 2: Calculate the accumulated depreciation of the equipment disposed of by reconstructing the
accumulated depreciation account
Step 3: Calculate the proceeds on trade-in by balancing the disposal account.”
Kolitz, C.L. and Service, C. (2019) Gaap: Graded questions. Eighteenth Edition. Durban: Lexis Nexis

2.5 Summary
In this chapter the student will obtain an understanding of how the cash flow operations of an entity are dealt with,
namely: operating, investing and financing activities. Students will also be able to reconcile and calculate the overall
cash flow of an entity for a financial year.

Unit
3: Ratio Analysis

CONTENT LIST LEARNING OUTCOMES:
3.2 Users of financial statements  Demonstrate an understanding of and explain the individuals
3.3 Weaknesses of financial statements and entities that utilise financial statements
3.4 Analysis of ratios  Compute and provide relevant explanations for each relevant
ratio
 Service, C. (2019) Gripping Gaap: Your Guide to International

Reporting Standards. Twentieth Edition. Durban: Lexis Nexis.
 Kolitz, C.L. and Service, C. (2019) Gaap: Graded questions.

Eighteenth Edition. Durban: Lexis Nexis
 Flood, J.M. (2017). Gaap – Interpretation and Application of

Generally Accepted Accounting Principles. First Edition. New York:
Wiley.

3.1 Introduction
The financial statements of an entity are unable to present a factual picture of the business regardless of the rich
information that they contain. This leads to an in-depth analysis and interpretation of these statements which will
be a true reflection of the business. The types of financial analysis that is performed is dependent on the user, their
needs and the information that is available to them.
3.2 Users of financial statements

The following persons and entities will be considered as users of financial statements:
 Bank managers and entities that provide a business with finance
 Tax authorities for tax payment purposes
 Employees for job security
 Directors and management for decision making, budgeting, errors and fraud
 Investors such as shareholders to make an evaluation of the level of returns they can receive
 Merger and acquisition analysts who make an analysis on the risk vs return when a merger is considered
 Auditors for the purpose of providing a fair presentation of financial statements
3.3 Weaknesses of financial statements

It is important to note that for a reasoned analysis and interpretation to be performed, awareness with regard to the
limitations of financial information being analysed is imperative.
The 5 inherent weaknesses in financial statements are:

 Historical figures – these figures can be over or understated due to inflation effects. This weakness is reduced
by the performance of asset revaluations or inflation adjustments being made to the statements.
 Limited predictive value – financial statements are a reflection of history and transactions that have occurred
in the past which may have no influence on future events.
 Limited qualitative information – information such as changes in technology and market trends are useful to
users of statements, but they are not included in financial statements.
 Risks are not reported – identifying all risks is a difficult process and even though certain risks are reported in
financial statements, the analysis of finances assists in the identification of other unreported risks.
 Limited comparability - comparing financial information from one company to another and from one year to
another is comprisable as there may be different accounting policies implemented or seasonal fluctuations.

Think Point
What impact can weakness in financial statements have on the users of financial information?
3.4 Analysis of ratios

The following activity will assist in understanding the various types of ratio analysis which exists.
Mineral Man Limited
2003 2002
ASSETS
Non-current assets 5 075 000 3 850 000
Property, plant and equipment 3 150 000 1 575 000
Investments at cost 1 925 000 2 275 000
Current assets 5 264 000 2 353 750
Inventory 2 625 000 656 250
Trade receivables 2 625 000 612 500
Cash 14 000 1 085 000
10 339 000 6 203 750
Owners’ equity
Issued share capital and reserves 4 747 750 3 395 000
Non-current Labilities
Non-current loan 3 500 000 1 400 000
Debentures 1 050 000 1 050 000
Deferred tax 700 000 183 750
Current liabilities
10 339 000 6 203 750

Mineral Man Limited

Ordinary share Preference share Retained Total
capital capital earnings
Opening balance - 1 January 2002 875 000 – R3.50 525 000 612 500 2 012 500
Total comprehensive income 1 470 000 1 470 000
Less dividends declared:
Preference dividends (52 500) (52 500)
Ordinary dividends (35 000) (35 000)
Opening balances: 1 January 875 000 525 000 1 995 000 3 395 000
2003 1 347 500 1 347 500
Total comprehensive income
Less dividends declared: (61 250) (61 250)
Preference dividends (21 000) (21 000)
Ordinary dividends 87 500 87 500
Preference share issue 875 000 612 500 3 260 250 4 747 750
Closing balances: 31 December
2003
Mineral Man Limited

2003 2002
Revenue from sales 8 750 000 5 250 000
Cost of sales 5 250 000 2 625 000
Gross profit 3 500 000 2 625 000
Total other expenses 1 400 000 507 500
Profit before finance charges 2 100 000 2 117 500
Finance charges (all relating to non-current liabilities) 175 000 17 500
Profit before tax 1 925 000 2 100 000
Taxation expense 577 500 630 000
Profit for the year 1 347 500 1 470 000
Other comprehensive income 0 0
Total comprehensive income 1 347 500 1 470 000
Market share price 1.25 1.00
Using the information above calculate all possible ratios.

3.4.1 Probability ratios

 This ratio calculates the profitability of an entity by utilising the line-items of a statement of comprehensive
income and can be inclusive of the analysis of profitability by using items in the statement of financial position
 These items can include the amount of capital that an entity has invested in assets and the sources used to
generate their capital
 Analysing profitability in relation to the capital that an entity invests in assets can provide an idea of how
effectively management utilises the available funds
 Analysing profitability in relation to an entity sources of finances can provide an idea if profitability is sufficient
in relation to the cost of capital
Profitability ratios include:

A. Gross profit percentage / margin
 Ratio for gross profit can be fluctuated due to changes in mark-up, stock thefts, incorrect inventory counts
and inconsistent valuation of inventory.
2003 2002
Gross profit X 100 3 500 000 X 100 2 625 000 X 100
Net sales 8 750 000 5 250 000
= 40% = 50%
B. Net profit percentage/margin

 Net profit should be calculated prior to tax and interest being taken into account and idealistic should
exclude non-operating incomes such as investment income.
 Items that may impact on the net profit percentage can include changes which impact the gross profit
percentage and changes that are made to an entities operating expenses and other income included in
the calculation.
2003 2002
Profit before finance charges and tax X 100 2 100 000 X 100 2 625 000 X 100
Net sales 8 750 000 5 250 000
= 24% = 40%
C. Return on capital employed

 The return of capital employed ratio provides information with regard to the return that can be offered to
persons who supply the entity with capital or long-term finance.
 The numerator is the profit before long term interest and tax figure and the denominator is the capital
employed figure.

The capital employed figure is made up of – issued share capital and reserves (i.e retained earnings)
+ interest bearing liabilities
 The accuracy of the ratio is achieved by added the opening and closing balances and dividing them by
2.
2003
Profit before finance charges and tax X 100 2 100 000 X 100
Average capital employed (9 297 750 + 5 845 000)/2
= 27.74%
Capital employed C/B = 4 747 750 + 3 500 000 + 1 050 000 = 9 297 750
Capital employed O/B = 3 395 000 + 1 400 000 + 1 050 000 = 5 845 000
D. Return on owner’s equity

 The return on owners’ equity ratio is of importance to all ordinary shareholders that want to receive a
return that is relative to the risks that are involved with making an investment in the entity.
 The objective is to calculate the returns that are owed to ordinary shareholders and thus must reflect the
entities profits after the deduction of preference dividends and tax.
 Preference dividends are deducted as the ratio only deals with ordinary shareholders.
 The average ordinary shareholder’s equity is calculated by deducting any preference share balances for
the year
2003
Profit after tax - preference dividends X 100 1 347 500- 61 250 X 100
Average ordinary shareholder’s equity (4 747 750 – 612 500 + 3 395 000 – 525 000)/2
= 36.7%
E. Return on assets
 The return on assets ratio is a reflection of how effectively management uses the entities assets.
2003
Profit before finance charges and tax X 100 2 100 000 X 100
Average total assets (10 339 000 + 6 203 750)/2
= 25.4 %

F. Earnings per ordinary shares

 Similar to calculation for return on ordinary shareholder’s equity. The only difference is that this ratio is
calculated as a value per ordinary share and not a percentage of the capital value.
2003 2002
Profit after tax - preference dividends X 100 1 347 500- 61 250 1 470 000- 52 500
Number of ordinary shares (875 000 / 3.5) (875 000 / 3.5)
(Value of shares / share price) = no. of shares =5.15 =5.67
G. Dividends per share

 This ratio assists in calculating the amount that has been declared to ordinary shareholders
2003 2002
Ordinary (or preference) dividends X 100 21 0000 . 35 0000 .
Number of ordinary (or preference) shares (875 000 / 3.5) (875 000 / 3.5)
=0.08 =0.14
H. Ordinary dividend pay-out ratio

 A calculation of the % off earnings that belong to the ordinary shareholder which are actually being
distributed to the shareholders.
2003 2002
Dividends per share OR Dividends 0.08 0.14
Earnings per share Earnings 5.15 5.67
= 0.016: 1 = 0.025: 1
I. Price earnings ratio

 The ratio is an indication of the amount that an investor is will to pay in comparison to the profits that an
entity makes.
2003 2002
Market price per ordinary share 1.25 1.00
Earnings per ordinary shares 5.15 5.67
= 0.24: 1 = 0.81 :1

J. Earnings yield
 Earnings are calculated as a % of each R1 of the profit that is reported.
2003 2002
Earnings per ordinary share X 100 5.15 X 100 5.67 X 100
= 412 % = 567 %
K. Dividend yield
 Dividends are calculated as a % of each R1 that is invested.
 A higher ratio can be a result of a payout that is high or a low share price which indicate a possibility of the
company having a limited future.
2003 2002
Dividends per share X 100 0.84* X 100 X 100 0.14 X 100 X 100
= 6.7 % = 14 %
*875 000 / 3.50 = 250 000 shares *875 000 / 3.50 = 250 000 shares
21 000 (OD) / 250 000 = 0.84 cents 35 000 (OD) / 250 000 = 0.14 cents
per share per share
NB – Multiply by 100 to convert

into rands
3.4.2 Liquidity ratios

 Liquidity ratios are an indication of the ability of a company to repay their debt with a period of 12 months
/ short-term debt.
A. Current ratio
 Indication of the ability to repay current liabilities using the current assets.
 Normal acceptable ratio – 2:1
2003 2002
Current assets 5 264 000 2 353 750
Current liabilities 341 250 17 500
= 15.4: 1 = 13.45: 1

B. Acid test ratio

 Similar to the current ratio but does make a provision for the fact that inventories can be a difficult asset
to easily convert into cash.
 Normal acceptable ratio – 1: 1
2003 2002
Current assets - inventories 5 264 000 – 2 625 000 2 353 750 – 656 250
Current liabilities 341 250 175 000
= 7.73: 1 = 9.7: 1
C. Working capital ratio

 This ratio is an indication of the total assets that are liquid.
 Normal acceptable ratio – 1: 1
2003 2002
Working capital (current assets – 5 264 000 – 341 250 2 353 750 – 175 000
current liabilities) 10 339 000 6 203 750
Total assets = 0.48: 1 = 0.35: 1
D. Debtors collection period

 This ratio is an indication of the average amount of time that it would take a debtor to pay for the goods
that they buy on credit
2003
Average debtors balance X 365 (2 625 000 + 612 500) / 2 X 365
Net credit sales 8 750 000
= 67.525 days
*Calculated using the assumption that all sales were made on a credit
basis
E. Debtors’ turnover
 This ratio measures the effectiveness of a company’s ability to extend its credit and collect its debts.
2003
Net credit sales OR 365 8 750 000 .
Average debtors balance debtors collection period (2 625 000 + 612 500) / 2
= 5.41 times
*Calculated using the assumption that all sales
were made on a credit basis

F. Days’ supply (or inventory) on hand

 Ratio is an indication of the number of days that an entities balance of inventory on and will last them.
 An over or under investment in inventory will be highlighted by this ratio.
2003
Average inventory balance X 365 (2 625 000 + 656 250) / 2 X 365
Cost of sales 5 250 000
= 114.063 days
*Calculated using the assumption that all sales were made on a credit
basis
G. Inventory turnover
 This ration is an indication of how rapidly inventory is sold for the year or how liquid it is. A low rate of
turnover could mean that an entity is stocking too many goods and a high turnover could mean that have
a shortage of stock on hand.
2003
Cost of sales OR 365 . 5 250 000 .
Average inventory balance Days inventory on hand (2 625 000 + 656 250) / 2
= 3.2 times
H. Creditors payment period

 This ratio is an indication of the amount of time it takes an entity to pay its creditors and extended periods
of payment could mean that an entity is experiencing cash flow problems.
 An entity must be off extended credit terms as this may result in the loss of discounts that are offered by
the suppliers.
2003
Average creditors balance X 365 (341 250 + 175 000) / 2 X 365
Credit purchases (5 250 000 + 2 625 000 – 656 250*)
= 13.05 days
*The closing balance of inventory for the previous year is deducted
as it was not bought in the current year and therefore will not fall
under the current year’s credit purchases.

I. Creditors turnover
 This ratio is an indication of the amount of times that an entity pays its creditors for the year
2003
Credit purchases . (5 250 000 + 2 625 000 – 656 250*)
Average creditors balance (341 250 + 175 000) / 2
= 27.97 times
*The closing balance of inventory for the previous year is deducted
as it was not bought in the current year and therefore will not fall
under the current year’s credit purchases.
3.4.3 Solvency / structure ratios

 Solvency or structure ratios of an entity help provide an indication of the entities ability to meet their long
term obligations in the future.
A. Equity ratio
 The equity ratio is an indication of the amount of the entities asset base that is financed by the owners. It
can be assumed that entities who have a high equity ratio fund the business largely with personal
investments.
2003 2002
Total equity 4 747 750 3 395 000
Total assets 10 339 000 6 203 750
= 0.46: 1 = 0.55: 1
B. Debt ratio
 This ratio is an indication of the amount of the entities asset based which is financed by parties that are
external to the organisation.
2003 2002
Total debt (10 339 000* – 4 747 750) (6 203 750 – 3 395 000)
Total assets 10 339 000 6 203 750
= 0.54: 1 = 0.45: 1
*Total debt = total equity and liabilities –
equity.

C. Solvency ratio
 The solvency ratio is the inverse of the debt ratio and is an indication of the amount of liabilities that are
covered by the assets.
 This essentially means that this ratio is an indication of the entities ability to repay their debts in the long
term.
2003 2002
Total assets 10 339 000 . 6 203 750 .
Total debt (10 339 000* – 4 747 750 (6 203 750 – 3 395 000)
= 1.85: 1 = 2.21: 1
equity.
D. Debt to equity ratio

 This ratio is an indication of the how much of the company’s finances come from internal shareholders
on the form of capital and how much of the finances are from enteral parties in terms of borrowings.
2003 2002
Total debt (10 339 000 - 4 747 750) (6 203 750 – 3 395 000)
Total equity 4 747 750 6 203 750
= 1.18: 1 = 0.83: 1
E. Borrowing ratio
 This ratio is relatively similar to the debt equity ratio but does however include any debt that is an
expense to the entity is terms of interest
2003 2002
Interest bearing debt (3 500 000 + 1 050 000 + 341 250) (1 400 000 + 1 050 000 + 175 000)
Shareholders’ equity 4 747 750 3 395 000
= 1.03: 1 = 2.21: 1
equity.

Revision questions
“Question 1
a) Explain the purpose of financial statement analysis.
b) Describe horizontal financial statement analysis.
c) How can the current ratio be used to evaluate a company?
d) What is the purpose of the debtors’ collection period ratio?
e) Explain the debt ratio and its use in analysing a company's performance.
f) Explain how to calculate total asset turnover and explain what it reveals about a
company's financial condition.
g) Explain how to calculate dividend yield and explain how it is used in analysis of a
company's financial condition.
h) Discuss briefly the price earnings ratio with particular reference to the shares of
companies with high or low ratios
Solution:
1. The purpose of financial statement analysis is to assist users to improve the quality
of business decisions. The common goals of financial statement users are to
evaluate a company's past and current performance, current financial position,
future performance and risk.
2. Horizontal analysis is a tool to evaluate changes in financial statement data across

time. Comparative statement analysis and trend analysis are two components of
horizontal analysis. Comparative statements show amounts for two or more
successive periods, and may show changes in both absolute currency amounts or
in percentages. Trend analysis is used to reveal important changes occurring from
one period to the next or over successive financial periods.
3. The current ratio is used to evaluate a company's ability to pay its current debts
with the amount of current assets available.
4. The debtor’s collection period is used to estimate how much time is likely to pass
before a firm receives cash receipts from its debtors. The measure is also valuable
for analysis in comparing ratios from other companies in the same industry and as
a means to compare current with prior years' performance.

5. The debt ratio is calculated by dividing total liabilities by total assets. It reveals the
percentage of the company's assets that are financed by debt financing. The
higher the ratio, the more risk a company has in repaying the debt.
6. Total asset turnover is calculated by dividing net sales by average total assets.
The result is interpreted as the amount of net sales generated by each Rand / Euro
/ Dollar of assets. Thus the ratio measures a company's ability to use its assets to
generate sales.
7. Dividend yield is the ratio of cash dividends per share divided by the market price
per share. The resulting dividend yield represents the rate of cash return investors
earn from an investment in a company's shares. Dividend yield can be compared
to other companies and other types of investments.
8. The price-earnings ratio is calculated by dividing the share's market price by the
company's earnings per share. The price-earnings ratio represents the market's
expectations of a company's future performance. Some analysts view a high PE
ratio as an indication that a share is overvalued. A low ratio may indicate that a
share is undervalued.
Question 2
Fairy-tale land Limited consists of a number of companies and their financial director
requires assistance from you with the calculation of the following ratios for the year
ended 31 December 2007.
1. Sleeping beauty Limited has a profit after tax of R300 000, ordinary share capital
of R300 000 (2006: R200 000), reserves of R800 000 (2006: R520 000) and
preference share capital of R200 000. The preference dividend was R20 000.
What is the return on equity?
2. Rapunzel Limited reported sales of R 2 500 000, cost of sales of R 1 500 000 and
equity of R500 000. What is the gross profit margin for the period?
3. Fiona Limited has current assets and current liabilities at the end of 2007 of R 3
000 000 and R 1 200 000 respectively. Current assets include inventories of R900
000. What is the current ratio and acid-test ratio for 2007?

4. Elsa Limited has inventory of R 5 000 000 at the end of 2006 and R 6 000 000 million
at the end of 2007. Sales for the 2007 period are R 20 000 000 million and the gross
profit is R 10 000 000. What is the inventory holding period for the 2007 year?
5. Sofia Limited has trade receivables of R 6 000 000 (2006 – R 300 000) and trade
payables of R 8 000 000 (2006 – R 7 000 000) at the end of 2007. Credit sales and
credit purchases for 2007 are R 100 000 000 and R 70 000 000 respectively. What
is the debtors’ collection period and the creditors’ payment period for 2007?
6. Cinderella Limited reported a low price/earnings ratio during 2007. In general, is a

low price/earnings ratio viewed more favourably than a high price/earnings ratio?
7. Anna Limited reported a profit after tax of R 20 000 000 million in 2007. The issued
share capital balance is R 26 000 000 at 31 December 2007 and consists of shares
which were all issued at R 1,30 each. The company has no preference share capital.
A total dividend of R 5 000 000 was paid during 2007 and the market value of the
company is R 50 000 000 at 31 December 2007. What is the earnings yield and
dividend yield for the 2007 year?
Solution:
1. Return on equity:
Profit after tax – preference dividends X 100
Average ordinary shareholder’s equity
= 300 000 – 20 000 .
(300 000 + 200 000 + 800 000 + 520 000) / 2
= 280 000
910 000
= 30.8 %
2. Gross profit margin

Gross profit X 100
Net sales
= 2 500 000 – 1 500 000
2 500 000
= 1 000 000
2 500 000
= 40 %

3. Current ratio
Current assets
Current liabilities
= 3 000 000
1 000 000
= 2.5: 1
Acid test ratio

Current assets - inventories
Current liabilities
= 3 000 000 – 900 000
1 200 000
= 1.75: 1
4. Inventory holding period

Average inventory balance X 365
Cost of sales
= (5 000 000 + 6 000 000) / 2 X 365
(20 000 000 – 10 000 000)
= 5 500 000 X 365
10 000 000
= 201 days
5. Debtors collection period

Average debtors balance X 365
Net credit sales
= (6 000 000 + 3 000 000) / 2 X 365
100 000 000
= 4 500 000 X 365
100 000 000
= 16 days
Creditors payment period

Average creditors balance X 365
Credit purchases
= (8 000 000 + 7 000 000) / 2 X 365
100 000 000
= 7 500 000 X 365

100 000 000

= 39 days
6. No. In general, the higher the P/E ratio, the more the market is willing to pay for
each currency of annual earnings. Investing in companies with high P/E ratios
means that the market has high expectations of the companies and is expecting
high growth.
Investing in companies with low P/E ratios means that the market has lower
expectations of the companies and expect lower growth as compared to
companies with high P/E ratios.
7. Dividend yield
Dividends per share X 100
Market price per ordinary share
= 5 000 000 / 20 000 000

2.50
= 10%”
Kolitz, C.L. and Service, C. (2019) Gaap: Graded questions. Eighteenth Edition. Durban:
Lexis Nexis.
3.5 Summary
At the end of this unit students should possess the ability to analysis and interpret financial statements. They should
be able to calculate all ratios which are relevant to an entity and to the users of financial information as it will assist
in them in decision making processes.

Unit
4: Intangible Assets

4.2 Recognition and Initial Measurement  Demonstrate an understanding of the criteria applicable for
of Intangible Assets recognising intangible assets
4.3 The Basics of Initial Measurement  Demonstrate an understanding of the basics of the initial
measurement and compute the costs for an intangible asset
 Display knowledge of and compute the effect of the method

of acquisition on recognition and initial measurement
4.4 Goodwill  Explain the concept of goodwill and compute relevant

calculations


4.1 Introduction
An intangible item is something that cannot be touched or physically seen and this chapter will assist in
understanding assets that do not have any physical substance to them.
The following are examples of items that have no physical substance:
 Research and development
 Software
 Trademarks, patents, designs and copyrights
 Brands
 Cost of training employees
 It is very difficult to prove that intangible items are actually assets as their existence is doubtful, even though
they are beneficial to an entity
 Intangible items are interesting because although we may know they exist and may know they are beneficial
to the entity, the fact that we can’t see or touch them sometimes makes it difficult to prove that they are assets
 IAS 38 deals with these assets that have no physical substance and are referred to as intangible assets
4.2 Recognition and Initial Measurement of Intangible Assets

An intangible asset will need to meet the definition and recognition criteria as set in IAS38 before it is recognised
as such and the initial measurement will be done at cost which can be relatively difficult to establish for an asset of
this nature.
4.2.1 Definition and recognition criteria

A. Definition
 The definition of an intangible asset is “identifiable, nonmonetary asset without physical substance’’. By
making reference to the term asset the item will be defined as “a resource controlled by an entity as a result
of past events, and from which future economic benefits are expected to flow to the entity’’
 It is important to note that the general assets definition makes provision for there to be ‘’future economic
benefits’’ to arise from the use of such asset, however, with regards to an intangible asset it is difficult to
determine what future economic benefits may arise as the asset cannot be seen or touched and therefore
making it difficult to control
B. Recognition criteria
 Along with the definitions discussed above the asset must meet the recognition criteria in order for it be
recognised as an intangible asset

 The recognition criteria, according to IAS 38 states that “the expected inflow of future economic benefits from
the asset must be probable; and the cost must be reliably measured”
 The greatest difficulty that is experienced when dealing with the recognition criteria for an intangible asset is
to determine and prove that the cost of the asset can be ‘reliably measured’
Difficulties in meeting the definitions:

The following difficulties will be experienced when deciding if the asset meets the definition:
 The item must not have any physical substance:

The judgment of a professional will need to be used when making an assessment on assets and a decision
will be made as to which aspect of the asset, tangible or intangible, is of more significance and the IAS
standard will be applied accordingly
Example 1: Physical substance and fishing licences

A fishing licence was purchased by company X and the directors of the company are determined to recognise
the licence as a physical asset as it is written on a paper.
Do you agree with the decision made by Company X?
Solution:
 Even though the fishing licence may be in a form that is physical in nature in terms of the documentation,
it will be considered as an intangible asset as the ability to fish is one of the most significant aspects as
compared to the documentation
Example 2: Physical substance and software Fee

A machine was acquired by Dee Limited which needs a specialised software in order to operate.
Explain if the entity should recognise the software as tangible or intangible.

Solution:
 The tangible machine is the most significant aspect and the software forms as an integral part of the
machine
 The software is however part of the machine and it has no value as a stand-alone asset. It will hence be
considered as part of the machine and will be accounted for under property, plant and equipment in the
financial statements
 If the software had value as a stand-alone asset and did not need the machine to become operational, it
would be considered and accounted for as an intangible asset

Example 3: Physical substance and a prototype

Bee Limited has been conducting research and development for a wallet which can be connected to an
individual’s bank account balance. It will be programmed to set off an alarm when you try to remove a card that
has exceed its limit. A prototype has been successfully developed
Explain if the entity should recognise the prototype as tangible or intangible
Solution:
 Despite the prototype having a physical form, it is a result of years of research and development and an
embodiment of knowledge which is separate from its physical form.
 The prototype will therefore be accounted for as an intangible asset
 The item must be identifiable

 ‘An asset is identifiable if either it: is separable; or arises from contractual or other legal rights. For something
to be separable, it must be: capable of being separated or divided from the entity, and sold, transferred,
licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or
liability, regardless of whether the entity intends to do so’- IAS 38
 Identifiability can be proved if a contract or legal rights to the assets exist and these rights should be taken
into consideration even if they cannot be transferred or separated from the entity and any other obligations
 ‘If we cannot prove that an individual asset is identifiable, we must not recognise it as a separate asset.
Instead, we account for it as goodwill. However, there are two kinds of goodwill: Acquired goodwill: this is
recognised as an asset. It arises during business combinations and reflects the synergies of all those assets
acquired but which were not separately identifiable and thus not able to be separately recognised. Internally
generated goodwill: this is recognised as an expense. It arises from the synergies of the assets within a
business but where the costs involved in creating it are so similar to the general running costs of a business,
that they are expensed. In other words, these costs were not considered ‘separable’ from the costs of just
running the business’
Example 4: Identifiability
Mariah Limited had incurred a cost of R 250 000 on the marketing and promotion of a new product and the
accountant of the firm wants to capitalise the cost that were incurred.

Explain if these cost can be identifiable or not.

Solution:
 It is impossible to separate the costs that an entity incurs when advertising for a product and it cannot be
sold or transferred to another entity.
 The campaign for advertising has no contractual or legal rights attached to it.
 These costs will not be identifiable and they cannot be recognised as an intangible asset.
 Due to the fact that they are created internally, it will be recognised as goodwill and should be expensed.
 The item must be controllable

 ‘Intangible asset definition’ refers to an ‘asset’, which IAS 38 defines as being a ‘resource controlled by the entity
as a result of past events and from which an inflow of future economic benefits is expected’. This means that
for something to meet the ‘intangible asset definition’, it will need to be controlled by the entity
 Having control over an asset can be difficult to prove by the entity unless the entity has the ability to place a
restriction on how accessible the asset is by others and to obtain power over the assets future economic benefits
 ‘An asset’s future economic benefits can be controlled through legally enforceable rights (e.g. copyright) but
legal rights are not necessary to prove control; it is just more difficult to prove that control exists if legal rights
do not exist’ – IAS38
Example 6: Control
Aladdin limited paid an expense of R 340 000 which related to the provision of specialised training to a team of
its employees. The company’s accountant would like to capitalise this cost.
Explain if these costs can be recognised as an asset
Solution:
 Even if this training can be linked to an expected increase in future economic benefits, the training cost is
unlikely to be recognised as an intangible asset as, despite permanent employment contracts, it is difficult
to prove that there is sufficient control over both the employees (who can still resign) and the future
economic benefits that they might generate
 If we cannot prove control, the item is not an asset – and if the item is not an asset, it automatically cannot
be an intangible asset either

4.3 The Basics of Initial Measurement

 ‘Intangible assets are initially measured at cost. This cost is broken down into: the purchase price; and any
directly attributable costs. The purchase price must be calculated after: Deducting: discounts, rebates,
refundable taxes and interest included due to the payment being deferred beyond normal credit terms; Adding:
import duties and non-refundable taxes
 Costs are considered to be directly attributable costs, if: they were necessary to bring the asset to a condition
that enables it to be used as intended by management
 Only those costs that were necessary are capitalised to an intangible asset. Which means income and
expense which arise from incidental operations occurring before or during the development or acquisition of
an intangible asset may not be included in the cost of the recognised asset (i.e. they must be recognised as
income or expenses in profit or loss instead)
 The necessary costs that may be capitalised are those that bring the asset to a particular condition that
enables it to be used as management intended. Thus, capitalisation of costs ceases as soon as the asset has
been brought to that condition.
 IAS 38 lists examples of directly attributable costs:

 professional fees arising directly from bringing the asset to its working condition;
 cost of employee benefits arising directly from bringing the asset to its working condition; and
 cost of testing whether the asset is functioning properly
Example 7: Recognition and initial measurement

 Tea Limited discovered that it had been manufacturing a product illegally because this product was patented
and yet Bee did not have the necessary rights. Bee immediately shut down its factory and hired a firm of
lawyers to act on its behalf in the acquisition of the necessary rights to manufacture this product
 Legal fees of R60 000 were incurred during July 2007. The legal process was finalised on 31 July 2007, when
Tea was then required to pay R900 000 to purchase the rights, including R90 000 in refundable VAT
 During the July factory shut-down: - overhead costs of R50 000 were incurred; and - significant market share
was lost with the result that Tea’s t total sales over August and September was R30 000 but its expenses were
R60 000, resulting in a loss of R40 000
 To increase market share, Bee spent an extra R35 000 aggressively marketing their product. This marketing
campaign was successful, resulting in sales returning to profitable levels in October.

 The accountant wishes to capitalise the cost of the patent at: Purchase price: R900 000 + Legal fees: R60
000 + Overheads during the forced shutdown in July: R50 000 + Operating loss in Aug & Sept: R40 000 +
Extra marketing required: R35 000 = R 1 085 000
Explain if the costs identified can be capitalised
Solution:
 The purchase price should be capitalised, but this must exclude refundable taxes. 900 000 – 90 000 = 810
000.
 Legal costs: This is a directly attributable cost. Directly attributable costs must be capitalised = 60 000
 Given Overhead costs: This is an incidental cost not necessary to the acquisition of the rights (the shutdown
was only necessary because Bee had been operating illegally) = 0
 Incidental costs may not be capitalised Operating loss: The operating loss incurred while demand for the
product increased to its nor mal level is an example of a cost that was incurred after the rights were acquired
=0
 Advertising campaign: The extra advertising incurred in order to recover market share is an example of a cost
that was incurred after the rights were acquired. Furthermore, advertising costs are listed in IAS 38 as one of
the costs
 IAS 38 also includes a list of examples that may never be capitalised to the cost of an intangible asset.
These include costs related to:
 introducing a new product or service (including advertising or promotions);
 conducting business in a new area or with a new class of customer (including staff training); and
 administration and other general overheads.
4.4 Goodwill
 Goodwill is described as the synergy between the identifiable assets or individual assets that could not be
recognised as assets.
 There are two distinct types of goodwill: purchased goodwill (covered by IFRS 3); and internally generated
goodwill (covered by IAS 38)
 ‘Internally generated goodwill is never capitalised since: it is not identifiable (i.e. is neither separable from
the business nor does it arise from contractual rights); it cannot be reliably measured; and it is not
controllable (e.g. can’t control customer loyalty)’ - IAS38

 ‘Purchased goodwill arises on the acquisition of another entity. It is measured as follows: Amount paid for
the entity Less net asset value of the entity = goodwill*’ – IAS38
Positive Goodwill:
 ‘Positive goodwill arises if the amount paid for the acquirer’s assets exceeds the value of those assets. This
is: always capitalised; never amortised; and tested annually for impairments
 With regard to the testing of goodwill for impairment:

 The test may occur at any time, as long as it is done at the same time every year;
 Any impairment loss written off against goodwill may never be reversed
 Thus, purchased positive goodwill is:

 recognised as an asset,
 presented in the statement of financial position and
 measured at a carrying amount that reflects ‘cost less accumulated impairment losses’ – IFRS 3.32
Example: Positive purchased goodwill: asset

Purchase price of business R 150 000
Net asset value of business R 95 000
Required: Journalise the acquisition

Solution:
DEBIT CREDIT
Goodwill: cost 55 000
Net asset: cost 95 000
Bank 150 000
The recoverable amount of this goodwill must be assessed at year-end and, if found to be less than C20 000,
this goodwill will need to be impaired.
Negative Goodwill:
 When the value of the assets acquired exceeds the amount paid for these assets, we have what is referred to
as a gain on a bargain purchase, also called purchased negative goodwill
 A bargain purchase gain is immediately recognised as income, and presented in profit or loss

 Negative goodwill sounds like a ‘bad thing’ and yet it is treated as income. It will make more sense if you
consider some of the situations in which negative goodwill arises (the first two situations are ‘win situations’
for the purchaser and should help to understand why it is considered to be income):
 the seller made a mistake and set the price too low, or
 the selling price is a bargain price, or
 the entity that was purchased was sold at a low price since it is expected to make losses in the
future
 In the third situation above, the negative goodwill is recognised as income in anticipation of the future losses
(i.e. over a period of time, the negative goodwill income will be eroded by the future losses)
Example: Negative purchased goodwill: Income

Purchase price of business R 200 000
Net asset value of business R 950 000
Required: Journalise the acquisition
Solution:
DEBIT CREDIT
Net assets: cost 950 000
Bank 200 000
Gain on purchase 750 000
Negative goodwill is a gain made on the purchase and is thus recognised as income immediately.
4.5 Summary
At the end of this unit students should demonstrate an understanding of the criteria applicable for recognising
intangible assets and the student should be able to apply said criteria to applicable accounting situations. The
student should also have an understanding of the basics of the initial measurement and compute the costs for an
intangible asset and explain concept of goodwill with the computation of relevant calculations.

References List
 Flood, J.M. (2017). Gaap – Interpretation and Application of Generally Accepted Accounting Principles.
First Edition. New York: Wiley.
 Kolitz, C.L. and Service, C. (2019) Gaap: Graded questions. Eighteenth Edition. Durban: Lexis Nexis
 Service, C. (2019) Gripping Gaap: Your Guide to International Reporting Standards. Twentieth Edition.
Durban: Lexis Nexis.


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Bachelor of Commerce

Unit 1: Share Capital and Earnings Per Share ........................................................................................................ 9

Unit 2: Statement of Cash Flows ........................................................................................................................... 50

Unit 3: Ratio Analysis ............................................................................................................................................ 80

Unit 4: Intangible Assets ....................................................................................................................................... 98

References List ................................................................................................................................................... 108

We hope you enjoy the module.

1 MANCOSA – Bachelor of Commerce: Accounting

C. Exit Level Outcomes and Associated Assessment Criteria of the Programme

 Appropriate processes are selected and

 Complex administrative problems are identified,

 Display knowledge of management in  Knowledge of key management terms and concepts

 Components of fundamental and specialised

 Context and systems in general management are

 Evidence – based solutions and theory driven

 Ethics and professional practice is considered and

MANCOSA – Bachelor of Commerce: Accounting 2

to remain current in this regard

 Key change management principles are applied in

 Make appropriate use of information  Accessing, processing and managing information

 Information technology applied to independently

 Appropriate information technology is utilised to

 Method and procedure in solving operational

 Key concepts, principles, knowledge, skills and

3 MANCOSA – Bachelor of Commerce: Accounting

 Prescribed ethical codes of conduct, values and

 Develop the functional competence of a  Scope of knowledge with respect to management

 Management decisions are discussed to apply

D. Learning Outcomes and Associated Assessment Standards of this Module Guide

LEARNING OUTCOMES OF THE MODULE ASSOCIATED ASSESSMENT CRITERIA OF THE

MANCOSA – Bachelor of Commerce: Accounting 4

E. Learning Outcomes Units

F. Notional Learning Hours

Notional Learning Hour Table for the Programme

Lectures/Workshops (face to face, limited or technologically mediated) 10

Tutorials: individual groups of 30 or less 5

Practical workplace experience (experiential learning/work-based learning etc.) 0

Independent self-study of specially prepared materials (case studies, multi-media, etc.) 20

G. How to Use this Module

5 MANCOSA – Bachelor of Commerce: Accounting

I. Prescribed and Recommended Textbook/Readings

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

MANCOSA – Bachelor of Commerce: Accounting 6

Special Feature Icon Explanation

The Associated Assessment Criteria is the evaluation of the students’

PRACTICAL Practical Application or Examples will be discussed to enhance

APPLICATION understanding of this module.

7 MANCOSA – Bachelor of Commerce: Accounting

Case Studies are included in different sections in this Module Guide.

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

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

MANCOSA – Bachelor of Commerce: Accounting 8

9 MANCOSA – Bachelor of Commerce: Accounting

Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES

1.1 Introduction  Introduce topic areas for the unit

1.2 Types of Shareholders  Display an understanding of ordinary and preference

1.6 Summary  Summarise topic areas covered in unit

Prescribed / Recommended Readings

 Service, C. (2019) Gripping Gaap: Your Guide to International Reporting

 Kolitz, C.L. and Service, C. (2019) Gaap: Graded questions. Eighteenth

 Flood, J.M. (2017). Gaap – Interpretation and Application of Generally

MANCOSA – Bachelor of Commerce: Accounting 10