Basic Accounting For Non-Accountants (Melanie

BASIC ACCOUNTING
FOR NON-ACCOUNTANTS
Melanie Cloete • Ferina Marimuthu
Third edition
Van Schaik
PUBLISHERS
Published by Van Schaik Publishers
A division of Media24 Books
1059 Francis Baard Street, Hatfield, Pretoria
All rights reserved
Copyright © 2018 Van Schaik Publishers
No part of this publication may be reproduced, stored in a

retrieval system, or transmitted in any form or by any
means – electronic, mechanical, photocopying, recording
or otherwise – without the written permission from the
publisher, except in accordance with the provisions of the
Copyright Act 98 of 1978.
Please contact DALRO for information regarding copyright clearance

for this publication. Any unauthorised copying could lead to civil liability
and/ or criminal sanctions.
Tel: 086 12 DALRO (from within South Africa) or +27 (0)11 712 8000
Fax: +27 (0)11 403 9094
Postal address: PO Box 31627, Braamfontein, 2017, South Africa
http://www.dalro.co.za
First edition 2008

Second edition 2015
Third edition 2018
Third revised edition 2019
ISBN 978 0 627 03626 2

eISBN 978 0 627 03720 7
Commissioning editor Claire Thornton

Production manager Werner von Gruenewaldt
Editorial coordinator Nangamso Phakathi
Copy editor Karin Heydenrych
Proofreader Anneline du Preez and Erika Janse van
Rensburg
Cover design by Gisela van Garderen
Cover image iStock Images
Typeset in 9.5 on 13 pt Caecilia by Pace-Setting &
Graphics, Pretoria
Printed and bound by Creda Communications
eBook conversion by InfoGrid Pacific
Every effort has been made to obtain copyright

permission for material used in this book. Please contact
the publisher with any queries in this regard.
Please note that reference to one gender includes

reference to the other.
Website addresses and links were correct at time of

publication.
About the authors
Melanie Cloete’s qualifications include a Higher Diploma in

Education (Economic Science), a Bachelor’s Degree in
Technology: Cost and Management Accounting and a Master
of Accounting degree. She is currently engaged in research
geared towards a PhD. Melanie has worked in academia,
within the management accounting discipline, since 1996.
What drives her is the support that she receives from her
family and her passion for teaching. She uses innovative
teaching methods and assessments to enhance students’
critical thinking skills. She has published articles in both
accredited and non-accredited journals and has also co-
authored a book titled Cost and Management Accounting:
Operations and Management – a Southern African approach.
Furthermore, she has presented papers on learning, teaching
and assessment to both local and international audiences.
Ferina Marimuthu is a lecturer in management accounting at

the Durban University of Technology and has been involved
in lecturing on the Unisa BCompt and CTA programmes. She
graduated with an MBA at the University of Durban
Westville, where she was also awarded the Outstanding
Management Accounting Student Award and several other
awards for outstanding achievements. She has gained a wealth
of experience in the management accounting field since 1998.
She is the general editor on the books entitled Cost and
Management Accounting – Fundamentals: A Southern African
approach and Cost and Management Accounting: Operations
and Management – A Southern African approach, published
by Juta. She has been a reviewer on several books both locally
and internationally, including the fourth edition of
Management Accounting by Professor Will Seal. Ferina is
passionate about issues related to teaching and learning, with
the latest focus being on ICT in higher education, and has also
presented at international teaching and learning conferences.
Preface
This book is a result of the combined efforts of the authors,

who have consolidated several modules in accounting. It
began to take shape during the merger of two technikons in
2003.
It sought to close a gap that had been identified in the market:

a lack of texts that dealt with both the basics of financial
accounting and cost and management accounting. Numerous
changes distinguish this edition from the earlier editions. This
edition includes, inter alia, more depth on the accounting
cycle, a distinction between the periodic and perpetual
inventory system, and basic financial management, which has
been incorporated into a chapter on capital budgeting.
This book is intended primarily for non-accounting specialists

and is ideal for
students doing a one-year introductory accounting course at

tertiary institutions
short courses, including company in-house training
programmes
practitioners/professionals
individuals who wish to teach themselves.
Each chapter concludes with a variety of tutorial exercises,
including multiple-choice and discussion questions, to test the
student’s knowledge and comprehension. A solutions manual
and a test bank is available from the publisher for instructors
who prescribe the text.
The accounting discipline is constantly changing and is both

stimulating and far-reaching. We hope that this third edition
with its comprehensive and up-to-date coverage would
contribute to a better understanding of the discipline. We
sincerely look forward to the same overwhelming response to
this edition from our readers as to the previous editions.
Acknowledgements
We wish to thank Catherine Du Preez for contributing the

additional questions for each of the chapters. We would also
like to thank all the academics and practitioners at the various
institutions who have prescribed the book. Their valuable
feedback on the second edition is appreciated. We are grateful
to the hard-working team at Van Schaik Publishers that
provided us with the detailed feedback that shaped this
edition.
We dedicate this book to our loving husbands and children for

their unwavering support and patience over the years.
We trust that this book will be enjoyed and used by various

academics and practitioners alike. We welcome constructive
advice and criticism. Please feel free to send us useful
suggestions on how we can improve the book.
With best wishes for a stimulating and positive learning

experience.
Melanie Cloete and

Ferina Marimuthu
June 2017
Table of Contents
CHAPTER 1 Introduction to accounting

1.1 What is accounting?
1.1.1 Definition of accounting
1.1.2 Nature of accounting
1.2 Users of accounting information
1.3 How useful is accounting information?
1.4 The basic business forms found in South Africa
1.4.1 Sole trader
1.4.2 Partnership
1.4.3 Close corporation (CC)
1.4.4 Company
1.5 Types of business activity
1.5.1 Service businesses
1.5.2 Manufacturers
1.5.3 Wholesalers
1.5.4 Retailers
1.6 Considerations before commencing a business
1.7 The accounting field
CHAPTER 2 Financial accounting concepts and
terminology
2.1 How wealthy are you?
2.2 Accounting classifications
2.2.1 Assets
2.2.2 Liabilities
2.2.3 Owner’s equity
CHAPTER 3 The accounting equation

3.1 The basic accounting equation (BAE)
3.2 The effect of transactions on the basic accounting
equation (BAE)
3.2.1 Transactions that affect assets and equities only
3.2.2 Transactions that give rise to income and
expenditure
3.2.3 Transactions involving payments by debtors
CHAPTER 4 Basic financial statements

4.1 Conceptual framework
4.2 The accounting cycle
4.2.1 Transactions
4.2.2 Source documents
4.2.3 Journals
4.2.4 Ledger accounts
4.2.5 Pre-adjustment trial balance
4.2.6 Adjustments
4.2.7 Post-adjustment trial balance
4.2.8 Closing entries
4.2.9 Final trial balance
4.2.10 Financial statements
4.2.11 Analysis and interpretation
4.3 Retailers
4.3.1 Perpetual method of accounting for stock
4.3.2 Periodic method of accounting for stock
CHAPTER 5 Basic financial statements with year-end

adjustments
5.1 Year-end adjustments
5.1.1 Depreciation
5.1.2 Allowance for credit losses
5.1.3 Prepaid expenses
5.1.4 Accrued expenses
5.1.5 Accrued income
5.1.6 Income received in advance
5.2 Closing process
CHAPTER 6 Company financial statements and their

analysis and interpretation
6.1 Introduction
6.2 Company terminology
6.2.1 Share capital
6.2.2 Share premium
6.2.3 Types of share
6.2.4 Reserves
6.2.5 Profits, taxation, reserves and dividends
6.3 Company financial statements (statement of
comprehensive income and statement of financial
position)
6.4 Introduction to analysis and interpretation
6.4.1 The need for comparison
6.4.2 Methods of analysing financial statements
6.5 Liquidity ratios
6.6 Efficiency ratios
6.7 Profitability ratios
6.8 Solvency ratios
CHAPTER 7 Bank reconciliation

7.1 Control over cash
7.1.1 The business’s records
7.1.2 The bank’s records
7.2 Reconciliation process
7.2.1 Steps for bank reconciliation
CHAPTER 8 Value-added tax (VAT)

8.1 Introduction
8.2 Who should be registered as a vendor?
8.3 Rates and exemptions
8.4 The VAT system
8.4.1 Input tax
8.4.2 Output tax
8.4.3 VAT payable/refundable
8.5 Mark-ups on cost price and selling price
8.5.1 Percentage mark-up on cost price
8.5.2 Percentage mark-up on selling price
CHAPTER 9 Cost classification and terminology

9.1 The cost concept
9.2 Cost classification in relation to the product or period
9.2.1 Manufacturing costs (product costs)
9.2.2 Non-manufacturing costs (period costs)
9.3 Cost classification in relation to volume of production
(cost behaviour)
9.3.1 Fixed costs
9.3.2 Variable costs
9.3.3 Semivariable, semifixed or mixed costs
9.4 Separating a mixed cost
9.5 Cost classification for control or evaluation
9.5.1 Controllable and non-controllable costs
9.6 Cost classification for decision making
9.6.1 Relevant costs
9.6.2 Irrelevant costs
CHAPTER 10 Materials
10.1 Classification of materials
10.1.1 Direct material
10.1.2 Indirect material
10.1.3 Work in progress
10.1.4 Finished goods
10.1.5 Inventory
10.2 Accounting entries
10.3 Stock control
10.3.1 Carrying costs (holding costs)
10.3.2 Ordering costs
10.3.3 Stock-out costs
10.3.4 Lead time
10.3.5 Economic order quantity (EOQ)
10.3.6 Reorder level (ROL)
10.3.7 Minimum stock level (MinSL)
10.3.8 Maximum stock level (MaxSL)
10.3.9 Average stock level (AveSL)
10.4 Stock valuation methods
10.4.1 The perpetual and periodic inventory control
systems
10.4.2 First-in-first-out method (FIFO)
10.4.3 Weighted average method
CHAPTER 11 Labour
11.1 Classification of labour
11.1.1 Direct labour
11.1.2 Indirect labour
11.2 Remuneration methods
11.2.1 Salaries
11.2.2 Hourly wages
11.2.3 Piecework pay
11.2.4 Basic, gross and net wages
11.2.5 Employer’s contributions
11.2.6 Accounting entries
11.3 Incentive schemes
11.3.1 Halsey bonus scheme
11.3.2 Halsey-Weir bonus scheme
11.3.3 Rowan premium bonus scheme
11.3.4 Taylor’s differential piecework system
11.4 Labour recovery rate
11.4.1 Productive hours
11.4.2 Annual labour cost
11.5 Payroll accounting
11.5.1 Salaries journal
11.5.2 Wages journal
CHAPTER 12 Overheads and job costing

12.1 What are overheads?
12.2 Job costing (absorption costing)
12.2.1 Why do we need to know about overheads?
12.2.2 Steps involved in job costing and accounting
entries
CHAPTER 13 Budgetary control

13.1 Introduction
13.2 Operational budgets
13.2.1 Sales budget
13.2.2 Production budget
13.2.3 Direct materials usage budget
13.2.4 Direct materials purchases budget
13.2.5 Direct labour budget
13.2.6 Manufacturing overheads budget
13.2.7 Sales and administration expenditure budget
13.2.8 Inventory budget
13.3 Flexible budgets
13.4 Cash budgets
CHAPTER 14 Standard costing and variance analysis

14.1 Introduction
14.2 A standard costing system
14.2.1 Advantages of standard costing
14.2.2 Disadvantages of standard costing
14.3 Variance analysis
14.4 Sales variances
14.4.1 Sales price variance
14.4.2 Sales quantity variance
14.5 Production cost variances
14.5.1 Direct materials variances
14.5.2 Direct labour variances
14.5.3 Variable manufacturing overheads variances
14.5.4 Fixed manufacturing overheads variances
CHAPTER 15 Short-term decision making

15.1 Introduction
15.1.1 Manufacturing cost per unit according to
marginal and absorption costing
15.1.2 Income statements according to marginal and
absorption costing
15.2 Decisions using marginal costing
15.2.1 Special order decisions
15.2.2 Dropping a product or department
15.2.3 Choice of products where a limiting factor exists
15.2.4 Make versus buy
CHAPTER 16 Cost-volume-profit (CVP) analysis

16.1 Introduction
16.1.1 Fixed costs
16.1.3 Marginal costing layout
16.2 Assumptions of CVP analysis
16.3 CVP according to the contribution margin approach
16.3.1 Calculation of breakeven point
16.3.2 Calculation of margin of safety
16.3.3 Sales required to achieve expected (target) profit
or return
16.4 Using CVP analysis in decision making
16.4.1 Change in the selling price
16.4.2 Change in the variable cost
16.4.3 Change in the fixed cost
16.5 Summary of formulae needed for CVP analysis
16.5.1 Breakeven point in units
16.5.2 Breakeven point in rands
16.5.3 Sales necessary to make a desired profit
16.5.4 Margin of safety
CHAPTER 17 Time value of money

17.1 Introduction
17.2 Cash flow and other time value of money concepts
17.3 Interest
17.3.1 Simple interest
17.3.2 Compound interest
17.3.3 Nominal rate
17.3.4 Effective rate
17.4 Formulae used in time value of money
17.4.1 Present value of a single cash flow
17.4.2 Present value of an ordinary annuity
17.4.3 Present value of an annuity due
17.4.4 Present value of a perpetuity
17.4.5 Future value of a single cash flow
17.4.6 Future value of an ordinary annuity
17.4.7 Future value of an annuity due
17.4.8 Repayment of loan/annual instalment
17.4.9 Loan amortisation
CHAPTER 18 Capital budgeting

18.1 Introduction
18.2 Capital budgeting process
18.3 Categories of capital budgeting projects
18.4 Why do organisations use investment appraisal?
18.5 Relevant and irrelevant cash flows in investment
appraisal
18.6 Capital budgeting techniques
18.6.1 Payback method
18.6.2 Accounting rate of return
18.6.3 Net present value
18.6.4 Profitability index
18.6.5 Internal rate of return
Index
1 Introduction to accounting
Outcomes
At the end of this chapter students should be able to
define the purpose of accounting

identify the main users of accounting information
explain the difference between financial accounting and cost and
management accounting.
Chapter outline

1.4 The basic business forms found in South Africa
1.4.1 Sole trader
1.4.2 Partnership
1.4.4 Company
1.5.2 Manufacturers
1.5.3 Wholesalers
1.5.4 Retailers
1.6 Considerations before commencing a business

Accounting is a system of
gathering – the bringing together of all financial information that

has an effect on a specific business
analysing – determining how the financial information will affect
the business
recording – inputting the financial information through proper
accounting processes
reporting – summarising all financial information for a given
period of time so that it can be read and understood in a more
condensed format
interpreting – preparing an analysis of the summarised reports to
allow users to make informed decisions about the business.

Accounting is a rapidly changing field, reacting in response to the
changes that occur in the external environment. Accounting is a
means of communication used to convey a message about the
finances of a business. The main purpose of accounting is to provide
its users with both financial and non-financial information that will
assist them in making informed decisions. It is essential that the users
of this information should understand it, otherwise it is of no value.
The users of accounting information can be divided into two groups,

namely internal users (users within the organisation) and external
users (users outside the organisation). The users listed below use
accounting information for different reasons.
Internal users:
Owners – use accounting information to determine whether their

business is profitable and financially viable over a long period of
time.
Managers – use accounting information to ensure that the business
operates efficiently and to solve problem areas highlighted in the
accounting information.
Employees and their representatives – use accounting information
to determine whether their employer is able to provide stable
employment and remuneration.
External users:
Customers – use accounting information to determine whether the

business can provide them with the products that they require for a
long period of time.
Competitors – use accounting information to maintain a
competitive edge.
Lenders – use accounting information to determine whether the
business would be able to repay a loan and the interest on it.
Government – uses accounting information to determine whether
the business should be registered and, if so, how much tax should
be paid.
Suppliers – use accounting information to determine whether the
business is able to make payments for goods purchased on credit.
Investment analysts – use accounting information to determine
whether the business would be a good investment, and to assess the
risk and return on an investment in the business.
This list of potential users is not exhaustive, but these are the most
important.
The four main qualitative characteristics that influence the usefulness

of accounting information are the following:
Comparability – the information must be comparable to the

financial information presented by other organisations and also
various accounting periods within the organisation, so that users
can identify trends in the performance and financial position of the
organisation.
Understandability – the information must be readily
understandable by all users of financial statements.
Relevance – the information reported must be relevant to the needs
of the users. This may involve reporting information that could
influence the economic decisions of the users.
Reliability – the information must not be misleading and should be
free of material error and bias.
It is important to bear in mind that the benefit derived from providing

accounting information should outweigh the costs.
1.4 The basic business forms found in South

Africa
The basic business forms in South Africa are the sole trader,
partnership, close corporation and company.
1.4.1 Sole trader
The business comprises one owner.

The owner will supply the capital for starting the business.
There are no legal formalities other than a licence to trade.
The owner is taxed on business profits in his own hands.
The business is not a distinct legal person, that is, it has no legal
personality.
Advantages:
The owner is independent.

The owner is directly involved with customers / clients and can
supervise staff closely.
Decisions can be taken quickly and the business can be adapted to
take advantage of business opportunities.
Limitations:
Expansion prospects are hampered by the limited access to capital.

The owner is personally liable or has unlimited liability for the
debts of the business, should the business fail to pay its own debts.
Due to the unlimited nature of the liability, creditors can have
access to the owner’s personal assets for the payment of debts of
the organisation.
The owner may not be versatile or skilled enough to do everything
for the entity.
There is no continuity of operations, should the owner die or retire.
1.4.2 Partnership
This is a legal relationship that exists between two to 20 people

carrying on a business for the purpose of making a profit.
Each partner’s profits are taxed in his own hands, similar to a sole
trader.
Advantages:
New partners bring in additional capital and introduce new ideas.

Partners can specialise in different areas.
Increased capital and division of labour between partners facilitate
expansion of the business.
Limitations:
Partners are jointly and severally liable, meaning that if the

partnership is unable to pay a debt, then the partners will have to
contribute from their personal assets. In the event that a partner is
unable to contribute his portion, the remaining partners will have to
make up the shortfall.
Ownership by a partner is not easily transferable because a new
partnership must be formed when a partner wants to exit the
partnership.
The continued existence of a partnership is limited as a partnership
ceases to exist when a partner wishes to sell or dies.
The funds available for the activities of the business are limited to
the combined funding of the partners. This can limit expansion or
growth.
This is a legal entity unique to South Africa and was established in

terms of the Close Corporations Act 69 of 1984.
When the Companies Act 71 of 2008 came into effect in May
2011, the registration of new CCs was no longer possible.
CCs that were registered prior to the Companies Act of 2008
coming into effect, are still allowed to operate.
A close corporation is formed when the members lodge a founding
statement (similar to a constitution) with the Registrar of Close
Corporations.
A CC can have between one and 10 members, who are natural
persons.
It is a separate legal entity or juristic person. It can sue or be sued
in its own right.
It is taxed in its own hands (figuratively) at the same rates as
companies, that is, income is not taxed in the hands of members.
Advantages:
Members enjoy limited liability. The liability of the members is

limited to the amount they have contributed to the close
corporation.
A CC enjoys perpetual succession, i.e. it may continue to operate
under its registered name, even if there are changes in its
membership.
Members only become liable when certain rules are breached.
An audit of the books is not required by law. Banks, creditors and
the South African Revenue Service (SARS) may, however, request
audited financial statements.
A CC may acquire shares in a company. Note that a company
cannot acquire membership in a CC, as only natural persons can be
members.
Limitations:
Restriction of the number of members to 10 limits the capital and

possible growth of the business.
A CC is taxed at the same rate as a company, which is a higher rate
than a sole trader or partnership.
In order for a member to leave the CC or be paid out, all members
have to agree to dispose of a member’s interest.
1.4.4 Company
A company is a legal organisation distinct from its “owners”, who

are referred to as shareholders and can be one or more individuals
or organisations.
According to the Companies Act of 2008 that came into operation
on 1 May 2011, all companies fall into one of two broad
categories:
1. Profit companies – companies incorporated for the purpose of

financial gain for their shareholders. These include:
– private companies: to be reflected as "Proprietary Limited" or
"(Pty)Ltd"
– public companies: to be reflected as "Limited" or "Ltd"
– personal liability companies: to be reflected as "Incorporated"
or "Inc".
– state-owned companies: to be reflected as "SOC Ltd"
2. Non-profit companies to be reflected as NPC must be

incorporated by three or more persons and have an objective of
furthering some public benefit or relating to cultural or social
activities.
For the purpose of this book we shall focus on profit companies, in

particular private and public.
A private company is an organisation comprising one or more

persons. Its name ends with the words “Proprietary Limited (Pty
Ltd)”. It is governed by the Companies Act of 2008 and is
incorporated in terms of the Memorandum of Incorporation (MOI).
It is prohibited from offering its shares to the public. This means
that the transferability of its shares is restricted.
A public company is an organisation comprising one or more
persons. Its name ends with the word “Limited (Ltd)”. It is
governed by the Companies Act 71 of 2008 and is incorporated in
terms of the Memorandum of Incorporation (MOI). Securities are
issued through an initial public offering (IPO) and are traded on an
open market such as the Johannesburg Stock Exchange (JSE).
The formation and activities of a company are regulated by the
Companies Act of 2008, making a company much more
complicated and expensive to form than any other form of
business. The registration of a company must be made at the
Companies and Intellectual Property Commission (CIPC).
A company is a distinct and separate legal entity apart from its
shareholders.
Shareholders enjoy limited liability. Unlike a sole trader and a
partnership, the shareholders do not have to pay the company’s
debt if it cannot do so itself.
A company is managed by the board of directors, which is headed
by the chief executive officer.
Advantages:
The limited liability of the shareholders ensures that shareholders

are not responsible for the debts of the company (in the case of
public companies).
There is an improved access to capital which in turn can stimulate
growth.
A company enjoys perpetual succession. The unlimited life of the
company ensures that investors can keep their shares as a long-
term investment.
Table 1.1 The difference between public and private

companies
Private company Public company

Transferability A private company is A public company is
of securities prohibited from allowed to transfer its
offering its shares to securities and offer its
the public and the securities to the public.
transferability of its
shares is restricted.
Private company Public company
Name The name of a private The name of a public
company must end company must end with
with the expression the word “Limited” or its
“Proprietary Limited” abbreviation “Ltd”.
or its abbreviation
“(Pty) Ltd”.
Directors The board of a private A public company
company must requires a minimum of
comprise at least one three directors.
director.
Annual A private company is A public company is
general not compelled to hold required to hold an
meeting an annual general annual general meeting.
meeting.
Notice period A private company is A public company is
for required to give 10 required to give 15
shareholder business days’ notice business days’ notice for
meetings for shareholder shareholder meetings.
meetings.
Disclosure A private company is A public company is
now subject to fewer obliged to comply with the
disclosure and additional transparency
transparency and accountability
requirements than requirements of Chapter
before (old 3 of the Companies Act of
Companies Act of 2008.
1973).
Lodging of A private company is A public company is
financial not required to lodge required to lodge its
statements its annual financial annual financial
statements with the statements with the CIPC.
CIPC.
Table 1.2 Comparison of the characteristics of each
business form
Sole Partnership Close Company

trader corporation
What are Owners Partners Members Shareholders
owners
called?
How many 1 owner 2–20 1–10 1 or more
owners? partners members persons
Legal None Voluntary Founding MOI
requirements agreement statement represents
between lays down the founding
partners. the legal document in
requirements terms of the
in terms of Companies
the CCs Act. Act of 2008.
Type of Unlimited Unlimited Limited Limited
liability: if the liability. liability. liability. A liability.
business The Partners are CC is a Shareholders
goes owner is jointly and separate are not liable
bankrupt, liable for severally legal person. for the debts
who is held all debts liable for the unless the
responsible? in his debts. MOI or
personal Companies
capacity. Act of 2008
states
otherwise.
Is the Does not Does not According to "Notice of
business have to have to be the Incorporation
required to be registered Companies and signed
register with registered with an Act of 2008, MOI should
an external with an external no further be filed with
body? external body. registration the Notice of
body. of CCs. Incorporation
at CPIC.
Sole Partnership Close Company
trader corporation
Continuity: Entity Partnership Unlimited. Unlimited.
what ceases to terminated The CC The duration
happens if exist. on death or operates of a
an owner withdrawal separately company is
dies / of one of the from perpetual,
retires? partners. members, except if
therefore limited in
enjoys terms of its
perpetual founding
continuation. statement.
Transfer of The Transfer is Can be Private: the
ownership owner complicated transferred act restricts
can unless to an the
transfer, stipulated in individual if transferability
sell or the all members of shares.
close partnership agree. Public:
down at agreement. unlimited and
any time. free transfer
of shares.
How are Profits Profits are Taxed as Subject to
business are taxed taxed in the company double
profits in the hands of the tax. Subject taxation on
taxed? hands of partners. to double the taxable
the taxation on income and
owner. the taxable Secondary
income and Tax on
Secondary Companies
Tax on (STC)
Companies payable on
(STC) declared
payable on dividends.
declared
dividends.
The various types of business activity include service businesses,

manufacturers, wholesalers and retailers.

This business provides a service for which it charges a fee. The fees
received for the services rendered are called fee income. Examples
include plumbers, attorneys, accountants, architects, electricians and
computer repair persons.
1.5.2 Manufacturers
These businesses buy raw materials that they then transform into a
finished product. The raw materials are not always raw material in
their true sense and may be items that have already undergone some
manufacturing. For example, a furniture manufacturer would use
wood, while a car manufacturer would use car seats, tyres and so on
manufactured by someone else. The manufacturer physically makes
or produces the goods and sells them to wholesalers and retailers.
1.5.3 Wholesalers
Wholesalers are often termed the middlemen, because they buy in
bulk from the manufacturer and then supply the goods in a slightly
smaller quantity to the retailer. In a few instances, wholesalers may
sell to the public.
1.5.4 Retailers
Retailers buy goods from the wholesalers or manufacturers and then
sell these goods at a mark-up to the general public (consumer). The
cost price of the product plus the mark-up gives the selling price. In a
broader context retailers can also be viewed as organisations that
provide services. This is because they:
bring goods within reach of the consumer

allow the consumer to buy on credit
pay attention to the needs of their consumers
sell goods in small quantities
make consumers aware of new products on the market
offer convenience shopping.
1.6 Considerations before commencing a

business
The following are considered to be some significant issues which

must be addressed before a business enterprise can be launched with
any hope of success:
The type of business activity – where the market does not offer a
particular product or service, an individual may identify an
opportunity to provide that product or service in such a way that
the potential consumer will benefit and a profitable business with
growth potential can be maintained. Some experience or
specialised knowledge is usually required, but a goal-directed
entrepreneur could arrange that this be provided by employees. At
this stage the entrepreneur usually engages in a strategy known as a
SWOT analysis in which careful consideration is given to the
strengths and weaknesses of the business as well as to the
opportunities for and threats to the business. This analysis provides
information with which the probable success of the business can be
assessed. There is virtually no business opportunity which does not
have a risk of failure. It is this risk which must be assessed and
weighed up against the potential for providing a return on the
capital which will be invested.
The entity form – the different entity forms have been discussed in
an earlier section. This is a significant decision because of the
impact on continuity and control of the business, as well as factors
such as taxation and regulatory responsibilities.
The location of the business – it is sometimes difficult to choose
the geographical location of a business, particularly in the case of a
manufacturing business. Relative transport costs must be
considered when deciding either to locate close to the source of
raw materials or close to the market which will purchase the goods.
The availability of suitable premises and the proximity of
appropriate employees for the business will all contribute towards
the probable success.
Capital requirements – virtually all types of business require
capital in order to purchase the assets, which are required for the
business to function. These assets include furniture, equipment,
vehicles and inventory of goods. In addition, the credit facilities
customers will be allowed will determine the amount of capital
required to commence business. Furthermore, funds for daily
expenses and the payment of wages and salaries are needed. Once
the amount of capital required has been determined, a plan or
budget of future revenue and expenses is drafted.

Accounting must accumulate financial data for two widely different
objectives:
1. External reporting to meet the needs of those who have an interest

in the business but who do not participate in the running of the
business
2. Internal reporting to meet the needs of those who are actively

engaged in the management of the business
This is where the two branches of accounting, namely financial

accounting and management accounting, play a role:
Financial accounting is the process of recording financial

information and reporting that information to external users.
Financial accounting is governed by Generally Accepted
Accounting Practices (GAAP), which consist of external standards
which must be adhered to, thereby ensuring the comparability of
accounting information between organisations. The rules for
communicating in accounting language are set out in detail in the
International Financial Reporting Standards (IFRS).
Management accounting, on the other hand, is the reporting of
financial information to internal users such as the managers of the
business. Financial information is provided for specific purposes,
which managers can use in their decision making, and which leads
to the attainment of the objectives of the organisation. A field
within management accounting is cost accounting.
Table 1.3 The major differences between financial

accounting and management accounting
Basis of Financial accounting Management

comparison accounting
1. Who is External users, i.e. Internal users, i.e.
information people outside the people within the
prepared organisation. organisation.
for?
2. What type General purpose reports, Specific purpose

of reports concerning the company reports, concerning a
are as a whole. specific department /
prepared? unit or branch.
3. How much Reports provide users Reports provide

detail is with a broad overview of managers with
provided in the performance of the considerable detail to
the business for a specific assist them in making
reports? period. operational decisions.
4. Are there Financial reports must be Reports are tailored to

specific produced according to a meet the needs of
formats specified format, as laid specific managers, i.e.
that must down by law (GAAP) and the format of financial
be the accounting reports is not governed
complied profession. by law.
with?
5. How often Reports must be Reports are produced

must produced at least once a as the need arises, i.e.
reports be year. when required by
prepared? management.
6. Is the Provides information Provides information

information concerning the past concerning the future
past or performance of the performance of the
future business. business.
orientated?
7. What type Reports contain only Reports contain
of information that can be financial and non-
information quantified in monetary financial information,
is terms. e.g. the measures of
contained physical quantities of
in the stock.
reports?
TUTORIAL EXERCISES
Exercise 1
Match the items that appear to be most appropriate:
1.1 Sole trader a. jointly and severally liable
1.2 Partnership b. membership limited to shares

1.3 Private c. enjoys entire profit of the business
company
1.4 Public d. income is not taxable in the hands of
company members
1.5 Close e. maximum of 50 shareholders
corporation
Exercise 2
Multiple-choice questions
2.1 A dentist is an example of a

a. retailer
b. manufacturer
c. wholesaler
d. service business
2.2 The internal users of financial information are
a. investors
b. employees
c. the government
d. suppliers
2.3 In management accounting

a. reports are prepared for external users
b. reports must be produced at least once a year
c. historical information is used
d. information is provided about the future performance of
the business
2.4 Which of the following statements about financial accounting

are incorrect?
a. Reports are prepared for external users.
b. Reports must be produced at least once a year.
c. It uses historical information.
d. It provides information about the future performance of the
business.
2.5 Which of the following is not an example of a retail store?

a. A store selling motorcar spares
b. A general dealer business
c. A self-service business
d. A clothing boutique
2.6 The following is not a qualitative characteristic of accounting

information:
a. Comparability
b. Understandability
c. Profitability
d. Relevance
2.7 Which of the following is not an example of a type of

business found in South Africa?
a. Private company
b. Sole trader
c. Public corporation
d. Public company
2.8 Which one of the following sentences does NOT explain the
distinction between financial accounts and management
accounts?
a. Financial accounts are primarily for external users and
management accounts are primarily for internal users.
b. Financial accounts are normally produced annually and
management accounts are normally produced monthly.
c. Financial accounts are more accurate than management
accounts.
d. Financial accounts are audited by management, whereas
management accounts are audited by external auditors.
Exercise 3
Read through the following statements. Answer true or false. If
false, give a reason.
3.1 A sole trader has limited liabilities.
3.2 A partnership has a minimum of one partner and a maximum
of 50 partners.
3.3 A public company has to have a minimum of seven directors
to run the company.
3.4 A private company lacks continuity.
3.5 A partnership has unlimited liabilities.
Exercise 4
4.1 Give five examples of service businesses and state how they
derive their income.
4.2 Explain the major cost items that a service business will
incur.
Exercise 5
Jack and Jill are partners in a partnership. They are considering
whether they should continue with their partnership or rather trade
as a company. Name the advantages that should be taken into
account when evaluating the option to change the form of the
organisation to a company.
Exercise 6
The objective of financial statements is to provide information
about the financial position and financial performance of an
enterprise that is useful to users in making economic decisions. It
is important for financial information to be comparable,
understandable, relevant and reliable. Describe what each of
these characteristics means in the context of financial information.
Give examples of problems which may prevent financial
information from fulfilling all of these characteristics.
Exercise 7
Two sisters are operating similar businesses in neighbouring
towns near Mpumalanga. Senayshia has been operating a
hardware business as a sole trader for the past five years with no
prior tertiary qualification. Camishka, who recently completed her
MBA in Stellenbosch, has been running a similar store for the past
two years. Camishka has contacted Senayshia to see if she would
be interested in going into a partnership with her. She believes
that there could be several advantages to running the two stores
in partnership, such as trade discounts for a larger business.
The sisters meet over coffee to discuss the business proposal.
Camishka suggests that, as the stores are of similar size and have
the same profit level, the profits of the partnership should be split
evenly. Camishka assures Senayshia that there is very little of the
administrative form-filling you get with starting up a company, so
start-up will be a breeze.
Senayshia approaches her uncle, a small business adviser, for
some advice on the proposal. She is not quite clear on the legal
status of a partnership, and wonders what formalities would be
involved in setting up the partnership.
Advise Senayshia on the pros and cons of setting up a partnership
with Camishka.
2 Financial accounting
concepts and terminology
Outcomes
At the end of this chapter students should be able to classify

items as assets, liabilities or owner’s equity.
Chapter outline
2.2.1 Assets
2.2.2 Liabilities
Some people are considered wealthier than others. Your

wealth is determined by what you have, that is, your
possessions less what you owe (your debts). In essence wealth
is what you are worth, that is, your net worth. It is your
financial position at a particular point in time.
Possessions – Debts = Wealth (net worth)
ILLUSTRATIVE EXAMPLE
Draft a statement of financial position for Bheki Zwane, a

student at the Durban University of Technology, who wants
to know how much he is worth as at 31 December 20x1.
Statement of financial position of Bheki Zwane as at 31
December 20x1
Possessions Debts
R1 University
Cellphone R500
500 fees
R2
Clothing Dad R250
000
R3
iPod
000
R5
Net worth
750
R6 R6
500 500
TUTORIAL EXERCISE Statement of financial

position
Exercise 1
Draft your personal statement of financial position at this
point in time. (Use the worksheet provided below.)
Statement of financial position of ________ as at
_____________
Possessions (assets) Debts (liabilities)
Net worth (owner’s equity)
From a personal perspective it is acceptable to use terms such

as wealth, possessions and debts. However, from a business
perspective we would have to use the following terminology:
Possessions= Assets
Debts = Liabilities
Net worth = Owner’s equity
Each of the above terms will be explained under accounting
classifications below.
It is very important to be familiar with the following

definitions as you will be using them continuously throughout
financial accounting.
2.2.1 Assets
Assets are resources controlled by an entity resulting from
past events out of which future economic benefits will flow.
There are two categories of assets:
2.2.1.1 Non-current assets

A non-current asset is an item of value with a lifespan of more
than one year, for example buildings and vehicles. This
includes property, plant and equipment, intangible assets and
financial assets.
2.2.1.2 Current assets

A current asset is an item of value with a lifespan of less than
one year, which is easily converted to cash, for example cash
in the bank and debtors.
2.2.2 Liabilities
Liabilities are present obligations resulting from past events,
the settlement of which leads to decreases in economic
benefits. There are two categories of liabilities:
2.2.2.1 Non-current liabilities

These are obligations of the business which are payable over a
period of more than one year, for example a bond from the
bank on a property.
2.2.2.2 Current liabilities

These are obligations of the business which are payable within
one year, for example bank overdraft and creditors.
Net asset value = Total assets – Total liabilities

This is the interest of the owner in the business, for example
capital contribution and drawings.
Income – Expenses = Net profit
The net profit belongs to the owner of the business and so also
falls under owner’s equity.
2.2.3.1 Income
Income consists of receipts by a business for its normal
operations, for example sales, fees earned, rent received and
interest received. These increase economic benefit within a
current period.
2.2.3.2 Expenses
Expenses are amounts spent by a business during its normal
operations (but excluding capital expenses), for example rent
paid, advertising, salaries and insurance. These decrease
economic benefit within a current period.
TUTORIAL EXERCISES Accounting

classification
Exercise 2
Below are lists of statements. Indicate whether each of
these statements is true or false. If the statement is false,
then rephrase the statement in order to make it true.
2.1 Financial position and net worth are one and the
same thing.
2.2 The main purpose of accounting is to provide
information on the business entity’s financial position
and financial results.
2.3 A business is regarded as a separate entity from its
owners.
2.4 A business will make a profit when its income is less
than its expenditure.
2.5 The net profit is the owner’s return for the capital that
he or she has invested in the business.
2.6 Expenses are incurred in order to generate income.
2.7 Net asset value represents the portion by which the
total liabilities exceed the total assets.
2.8 Assets and liabilities are the elements that are used to
measure the financial position of an entity.
2.9 Income and expenditure are the elements that are
used to measure the financial results of an entity, i.e.
profitability.
Exercise 3
3.1 Discuss the concept of financial position.
3.2 Discuss the concept of net profit.
3.3 Describe the characteristic of assets, equity and
liabilities.
3.4 When applying for a loan to start your own business,
what accounting information will the bank require?
3.5 What are the two main sources of financing?
Exercise 4
Classify each of the following items as either a non-current
asset (NCA); current asset (CA); non-current liability
(NCL); current liability (CL); owner’s equity (OE); income
(I) or expense (E):
NCA CA NCL CL OE I E
a) Capital
b) Delivery
vehicle
c) Weekly wages
d) Sales
e) Trading stock
f) Mortgage loan
g) Telephone
account
h) Debtors (trade
receivables)
i) Computer
j) Interest
received
k) Creditors (trade
payables)
l) Interest paid
m) Property
n) Discount
allowed
o) Discount
received
p) Depreciation
q) Stationery used
r) Stationery
unused
(stationery on
hand)
s) Bank overdraft
t) Drawings
u) Photocopy
machine
v) Shop fittings
Exercise 5
Classify each of the following items as either a non-current
asset (NCA); current asset (CA); non-current liability
(NCL); current liability (CL); owner’s equity (OE); income
(I) or expense (E).
a) Capital
b) Drawings
c) Equipment
d) Vehicles
e) Accumulated
depreciation of
equipment
f) Accumulated
depreciation of
vehicles
g) Trading stock
h) Loan from XYZ
bank
i) Bank
j) Petty cash
k) Cash float
l) Receiver of
Revenue
m) Sales
n) Cost of sales
o) Rent paid
p) Rent received
q) Stationery
r) Packing
material on hand
s) Interest on loan
t) Electricity and
water
u) Telephone
v) Salaries and
wages
w) Repairs
x) Bad debts
y) Bad debts
recovered
Exercise 6
Gail is a qualified hairdresser who has set up a
hairdressing salon at her home. She is not certain about
the accounting classifications. You are required to assist
her in correctly classifying the following items. You must
view all transactions from the salon’s point of view. Classify
each of the following items as either an asset (A); liability
(L); income (I) or expense (E).
6.1 Money borrowed from her husband to set up the salon
6.2 Receipts from customers
6.3 Stock of shampoo, conditioners, colour rinses and
treatments
6.4 Water and electricity used in the salon
6.5 Wages of her assistant
6.6 Amounts owed to the suppliers of stock
6.7 Hairdryers, flat irons and other equipment bought for
the salon
6.8 Amount owed to Gail by customers
6.9 Call charges for the telephone used in the salon
6.10 Amount paid for tea, coffee, sugar and milk for the
clients
Exercise 7
Megacity is a business which sells clothing. The business
rents shops in various shopping centres from which it sells
its merchandise.
Indicate whether each of the following items is an asset, a
liability, an income or an expense. You must view all
transactions from Megacity’s point of view.
Asset Liability Income Expense

a) The
monthly rental
paid for the
shops
b) A loan
raised from
Bee Bank
Asset Liability Income Expense
c) Amounts
owed to
Megacity by
customers
d) Petty cash
on hand
e) The stock
of clothes on
hand in each
shop
f) Amounts
owed by
Megacity to its
suppliers of
stock
g) Warehouse
owned by
Megacity used
for storing
stock
h) Wages paid
to the shop
assistants
i) Receipts
from
customers for
the sale of
clothes
j) Cash in the
bank
3 The accounting equation
Outcomes
At the end of this chapter students should be able to show the effect of
various transactions on the basic accounting equation (BAE) of both a
service organisation and a retail organisation.
Chapter outline
3.2 The effect of transactions on the basic accounting equation (BAE)
3.2.2 Transactions that give rise to income and expenditure
From a large corporation to the local hairdresser, every business

transaction will have an effect on an organisation’s financial position. The
financial position is measured by the following items:
1. Assets (what it owns)

2. Liabilities (what it owes)
3. Owner’s equity (the difference between assets and liabilities)
The accounting equation offers us a simple way to understand how these

three items relate to each other.
The three main elements of accounting fit together in the following way:
Assets (A) = Owner’s equity (OE) + Liabilities (L)
The right-hand side of the equation is owner’s equity + liabilities. This

represents all the money that is available to the business in the long term
from the owner and from outsiders. What happens to this money? It is used
to purchase assets.
In other words, the money raised from the owner and from outsiders
(loans) is converted into assets. Therefore, the left-hand side of the
equation equals the right-hand side of the equation.
ILLUSTRATIVE EXAMPLES
Example 1
Mr Hayne, the owner of Prima Innovations, invests R140 000 in order to
start his business. Owner’s equity is therefore R140 000. He also
approaches a bank that lends him R100 000. Liabilities are therefore
R100 000.
Owner’s equity (R140 000) + Liabilities (R100 000) = R240 000
What happens to this R240 000?
It will be used to purchase assets:
e.g. Building R120 000

Vehicle R50 000
Machinery R30 000
R200 000
Bank (cash) R40 000
R240 000
Therefore, Assets (R240 000) = OE (R140 000) + Liabilities (R100 000)

The basic accounting equation (BAE) and its components are
summarised as follows:
Assets = Owner’s equity + Liabilities

Non-current Owner’s Income Expenses Non-current
assets funds liabilities
Land and Capital Sales Purchases Long-term loans
buildings
Add: Net Fees Rent paid Mortgage bond
Furniture
profit earned
Less: Rental Salaries Current
Equipment
Drawings income and wages liabilities
Interest Interest Creditors
Motor vehicles income paid (accounts
payable)
Commission Stationery VAT
Fixed deposit
received used
Discount Telephone Bank overdraft
Current assets
received
Debtors Water and
(accounts electricity
receivable)
Trading stock Bank
(inventory) charges
Bank Repairs
Petty cash Advertising
Petrol and
oil
Discount
allowed
Example 2
The assets of Beauty Salon amount to R50 000 and its liabilities
(creditors) to R10 000.
Required
Calculate the owner’s equity.
Solution
A = OE + L
OE = A – L
OE = R50 000 – R10 000
= R40 000
Example 3
K. Masondo is the owner of Mars Services, which offers a carpet
cleaning service. As at 31 March, Mars Services owns equipment
amounting to R120 000, clients owe R50 000 for services rendered and
Mars Services owes R25 000 to a supplier for parts purchased. Mars
also has R8 000 cash in the bank.
Required
Complete the BAE for Mars and determine the owner’s equity.
Solution
Step 1 Identify the assets:

Equipment R120 000
Debtors R 50 000
Cash at bank R 8 000
Step 2 Identify the liabilities:
Creditors R 25 000
Step 3 Substitute these values in the BAE and solve:
A = OE + L
OE = A – L
OE = (R120 000 + R50 000 + R8 000) – R25 000
= R178 000 – R25 000
= R153 000
TUTORIAL EXERCISES
Exercise 1
An undertaking called Quick Enterprises was formed on 3 January
20x1, on which date the owner invested R50 000 in the business and
borrowed R80 000 from Strand Bank. During the month of January
20x1 the enterprise acquired the following assets:
Cash at bank R40 000 and a motor vehicle that cost R90 000.
1.1 What was the total value of the assets on 31 January 20x1?
1.2 What was the total value of the liabilities on 3 January 20x1?
1.3 What was the owners’ capital on 3 January 20x1?
1.4 Compile an accounting equation to reflect Quick Enterprises’
financial position on 31 January 20x1.
Exercise 2
In any undertaking, for each of the circumstances given, calculate the
following:
2.1 The liabilities if the assets and owner’s equity total R40 000 and
R10 000 respectively
2.2 The assets if the liabilities and owner’s equity total R172 000 and
2.3 The owner’s equity if the assets and liabilities total R72 000 and
2.4 The liabilities if it possesses assets of R40 000 and reflects
owner’s equity of R24 000
2.5 The assets when liabilities of R60 000 and owner’s equity of R36
000 are reflected
2.6 The owner’s equity when assets and liabilities are reflected as R80
000 and R44 000 respectively
Exercise 3
In each of the following independent situations determine the following:
3.1 The assets of a business which has owner’s equity of R20 000 and
liabilities of R10 000
3.2 The owner’s equity of a business which has assets of R50 000 and
liabilities of R32 000
3.3 The liabilities of a business which has assets of R120 000 and
owner’s equity of R90 000
3.4 The owner’s contribution during the year, if a business has assets
of R60 000, liabilities of R15 000 and owner’s equity (excluding
capital contributed by the owner during the year) of R25 000
Exercise 4
Calculate the missing figures using the BAE.
R
4.1 Bank = 20 000
Vehicles = 25 000
Equipment = 35 000
Capital = ?
4.2 Capital =750 000
Mortgage loan=250 000
Bank = ?
Machinery =900 000
Debtors = 50 000
4.3 Bank = 25 000
overdraft
Debtors = 75 000
Buildings =500 000
Furniture =200 000
Creditors =250 000
Capital = ?
3.2 The effect of transactions on the basic

accounting equation (BAE)
Every financial transaction, however simple or complex, affects the BAE.

3.2.1.1 Capital contributions
T. Zondo has decided to open a mobile motor vehicle repair and service
unit called Prima Innovations. He has withdrawn R50 000 from his
personal savings account and deposited it in the Prima Innovations bank
account.
Let us examine the effect of this transaction:
A separate entity, Prima Innovations, has been established.

The business, Prima Innovations, now has an asset: cash in the bank of
R50 000.
The owner, T. Zondo, has provided Prima Innovations with funds and
increased his interest in that business. The owner’s equity (capital) is
now R50 000.
Assets = Owner’s equity +

Liabilities
Bank Capital
R R R
Previous balances 0 0 0
This transaction +50 000 +50 000 0
New balances 50 000 = 50 000 + 0
Remarks:
In an enterprise that has not yet entered into any transaction, the
elements of the BAE will always be 0.
The terms “bank” and “capital” in the analysis are actually names of
accounts.
Capital may be contributed in the form of cash or any other asset (e.g.
equipment). Equipment instead of bank will then increase.
3.2.1.2 Loans
Prima Innovations has borrowed R30 000 with a payback period of three
years. The R30 000 was paid into the business’s bank account.
The asset, bank, increases by R30 000.

A liability, namely loan, has now been created.

Bank Capital Loan
R R R
Previous balances 50 000 50 000 0
This transaction + 30 000 + 30 000
New balances 80 000 = 50 000 + 30 000
Remarks:
The result of the previous transactions forms the previous balance and is
carried forward in this transaction.
Liabilities arise when another party or institution supplies funds (makes
a loan to the business).
The borrowed amount of R30 000 is added to both sides of the BAE,
since the money received will increase the bank account and a liability
(loan) has also been created.
3.2.1.3 Purchase of assets for cash

Prima Innovations has purchased tools for R40 000 and issued a cheque for
this amount.
The asset, bank, decreases by R40 000.

The asset, equipment, increases by the same amount of R40 000.
Owner’s
Assets = + Liabilities
equity
Equipment Bank Capital Loan
R R R R
Previous 0 80 50 000 30 000
balances 000
+ 40 000 – 40 0 0
This transaction
000
40
New balances 40 000 = 50 000 + 30 000
000
Remarks:
There are two assets now, namely equipment and bank.

The effect is on one side of the equation, that is, the asset side. One asset
is replaced by another asset.
3.2.1.4 Buying assets on credit (creating a debt)

Prima Innovations has bought a vehicle for R100 000 on credit (account)
from GM Motors. R20 000 was paid as deposit. The balance is to be paid
in equal instalments within one year.
The asset, vehicle, increases by R100 000.

A liability, creditor, comes into being.
The amount owing to GM Motors, the creditor, stands at R80 000 (R100
000 – R20 000).
The asset, bank, decreases by R20 000 because of the deposit paid.
The bank balance now stands at R20 000.
There are now three assets – equipment, bank and vehicles.

Vehicles Equipment Bank Capital Loan Creditors
R R R R R R
Previous balances 0 40 000 40 000 50 000 30 000
This transaction + 100 000 – 20 000 +80 000
New balances 100 000 40 000 20 000 = 50 000 + 30 000 80 000
Remarks:
The transaction is recorded when it is entered into and not when the
payment is made.
Both sides of the BAE increase.
3.2.1.5 Payments to creditors

Prima Innovations has issued a cheque of R8 000 to GM Motors for the
first instalment.

The liability (the amount owing to the creditor) also decreases by R8
000.
Owner’s
equity
Vehicles Equipment Bank Capital Loan Creditors
R R R R R R
Previous 100 000 40 000 20 000 50 000 30 000 80 000
balances
This – 8 000 – 8 000
transaction
New
100 000 40 000 12 000 = 50 000 + 30 000 72 000
balances
Remarks:
Both sides of the BAE decrease.
3.2.1.6 Withdrawals by owner

T. Zondo has withdrawn R1 000 from the business to pay part of a private
loan.

T. Zondo’s capital (equity) in Prima Innovations decreases by R1 000.
Owner’s
equity
Vehicles Equipment Bank Loan Creditors
R R R R R R
Previous 100 000 40 000 12 000 50 000 30 000 72 000
balances
This – 1 000 – 1 000
transaction
New
100 000 40 000 11 000 = 49 000 + 30 000 72 000
balances
Remarks:
Withdrawals (referred to as drawings) are the opposite of capital

contributions and these reduce capital. NB: withdrawals are not
expenditure.
Both sides of the BAE are reduced.
3.2.2 Transactions that give rise to income and expenditure

3.2.2.1 Income (cash)
Prima Innovations has provided services for a client and has received a
cheque of R2 500.

The fee that Prima Innovations earned is regarded as income.
This income belongs to the owner.
Owner’s equity therefore increases by R2 500.
Owner’s
equity
Vehicles Equipment Bank Loan Creditors
R R R R R R
Previous 100 000 40 000 11 000 49 000 30 000 72 000
balances
This + 2 500 +2 500
transaction
New
100 000 40 000 13 500 = 51 500 + 30 000 72 000
balances
Remarks:
It is the objective of the enterprise to earn income.

Income increases owner’s equity.
3.2.2.2 Income (credit)

Prima Innovations has supplied repair services for S. Cele’s taxis and bills
him for R4 500.
The asset, debtor, comes into being and increases by R4 500.

Fees earned is an income item.
Owner’s equity increases by R4 500.
Owner’s
equity
Vehicles Equipment Debtors Bank Loan Creditors
R R R R R R R
Previous 100 000 40 000 0 13 500 51 500 30 000 72 000
balances
This +4 500 0 +4 500 0 0
transaction
New balances 100 000 40 000 4 500 13 500 = 56 500 + 30 000 72 000
Remarks:
Prima Innovations has rendered services to S. Cele, who does not pay
immediately.
S. Cele is therefore a debtor.
A debtor arose from a credit transaction.
The income is earned when the service is rendered and not when the
cash is received.
3.2.2.3 Expenditure (cash)

Prima Innovations issues a cheque of R1 800 for wages.

Wages are an expenditure item.
An expenditure item has a negative effect on owner’s equity.
Owner’s equity decreases by R1 800.
Owner’s
equity
R R R R R R R
Previous 100 000 40 000 4 500 13 500 56 000 30 000 72 000
balances
This –1 800 –1 800 0 0
transaction
New balances 100 000 40 000 4 500 11 700 = 54 200 + 30 000 72 000
Remarks:
An expenditure is incurred and decreases income.

The negative effect is transferred to owner’s equity.
Therefore we say that an expenditure item decreases owner’s equity.
Both sides of the BAE decrease.
3.2.2.4 Expenditure (credit)

Prima Innovations has received a billing from Ethekwini Municipality for
water and electricity amounting to R700. This amount has not yet been
paid.
A credit expenditure gives rise to creditors. Ethekwini Municipality is

therefore a creditor.
The liability, creditors, increases by R700.
Electricity and water is an expenditure.
Owner’s equity decreases by R700.
Owner’s
equity
R R R R R R R
Previous 100 000 40 000 4 500 11 700 54 200 30 000 72 000
balances
This – 700 0 + 700
transaction
New balances 100 000 40 000 4 500 11 700 = 53 700 + 30 000 72 700
Remarks:
Expenditure may also be incurred on credit.

An expenditure is incurred when it takes place and not when it is paid.
The right-hand side of the BAE increases and decreases.
No effect is experienced on the left-hand side of the BAE.

Prima Innovations has received a cheque of R3 000 from S. Cele as part
payment of his account.

The asset, debtors, decreases by R3 000.
Owner’s
equity
R R R R R R R
Previous 100 000 40 000 4 500 11 700 53 500 30 000 72 700
balances
This –3 000 +3000 0 0 0
transaction
New balances 100 000 40 000 1 500 14 700 = 53 500 + 30 000 72 700
Remarks:
This transaction affects the assets only.

The left-hand side of the BAE increases and decreases.
Payment by a debtor indicates a settlement/part settlement of his
financial obligation and not a creation in income.

Vehicles Equipment Debtors Bank Capital Income/Expense Loan Creditors
R R R R R R R R
+ +
50 000 50 000
+ +
30 000 30 000
+ 40 000 –
40 000
+ – + 80 000
100 000 20 000
– 8 000 –8 000
– 1 000 – 1 000
+ 2 500 + 2 500
+ 4 500 + 4 500
– 1 800 – 1 800
– 700 + 700
– 3 000 + 3 000
100 000 40 000 1 500 14 700 = 49 000 4 500 + 30 000 72 700
Assets = R156 200
Owner’s equity + Liabilities = (R53 500 + R102 700) = R156 200
How much profit has the business generated and what is the financial
position of the business?
The accounting equation does not answer these questions, and therefore
has to be adapted into a statement of comprehensive income (which
indicates the profit) and a statement of financial position (which indicates
the financial position).
Here are the basic formats of these financial statements. This will be
covered in more depth in Chapter 4.
Statement of comprehensive income of Prima Innovations
Income R R
Fee income (R2 500 + R4 500) 7 000
Less: Expenses 2 500
Wages 1 800
Water and electricity 700
Net income 4 500
Statement of financial position of Prima Innovations
Assets R R
Non-current assets 140 000
Vehicles 100 000
Equipment 40 000
Current assets 16 200
Debtors 1 500
Bank 14 700
156 200
Equity and liabilities
Owners equity 53 500
Capital 50 000
Less: Drawings 1 000
Add: Net income 4 500
Liabilities 102 700

Non-current liabilities 30 000
Loan 30 000
Current liabilities 72 700
Creditors 72 700
156 200
TUTORIAL EXERCISES
Exercise 5 (excluding debits and credits)
T. Gordon starts a new business known as Super Deliveries on 1
January 20x1.
On 1 January 20x1 he deposits R15 000 in the bank to commence
business and the following transactions take place during January 20x1:
2 Purchases a delivery van on credit for R60 000 from X Ltd and
pays a deposit of R6 000 by cheque, the balance to be paid by
the end of March.
3 Pays rental for premises for January R2 000.
10 Receives R15 000 cash for delivery services rendered.
12 Buys stationery costing R500 by cheque.
14 Borrows R20 000 cash from Strand Bank at 15% per annum,
interest is payable with effect from 1 January 20x1 (refer to 28
January).
15 Invoices Brown Ltd for delivery of services rendered R10 000.
17 Withdraws R3 000 from the business for his own use.
20 Receives an account from Z Motors for petrol bought R800.
24 Pays salaries and wages R1 500 by cheque.
26 Receives a cheque from Brown Ltd for R8 000.
28 Issues a cheque in favour of Strand Bank for the interest payable
for January 20x1.
31 Issues a personal cheque for R75 000 to purchase another delivery
vehicle.
Required
Enter the above transactions on the accounting equation.
Exercise 6 (excluding debits and credits)

The following transactions appeared in the books of Sencam Traders
for the month of June 20x1:
1 Bought a sanding machine for R2 800 on credit.
2 Bought stationery from CNA and paid by cheque R110.
3 Bought varnishes and paintbrushes on credit R1 100.
5 Rendered services on credit R6 000.
6 Paid R200 to have motor vehicle serviced.
7 Received R8 400 cash from debtors.
8 Drew a cheque for R1 200 to pay creditors.
9 Owner invested a further R4 000 into his business.
11 Cash received for services rendered R2 600.
12 Returned furniture costing R1 200 to the supplier, as it was
defective. The supplier granted full credit for the return.
13 Owner took a cheque for his personal use R300.
Required
Enter the transactions on the accounting equation.
DOUBLE ENTRIES (DEBITS/CREDITS)
As we have discovered, each transaction has a dual effect on the
accounting equation. This is known as the double-entry system. The
dual effect is also reflected by using debit and credit entries. The debit
and credit entries take place in the general ledger, which follows a T-
account system. The left-hand side is the debit side and the right-hand
side is the credit side.
You must learn the following rules for debit and credit as shown below.
Remember every debit entry must have an equal and corresponding
credit entry.
Assets Owner’s equity Liabilities

+ – – + – +
debit credit debit credit debit credit
The three main groups of accounts may be illustrated as follows:
Assets Liabilities Owner’s equity accounts:

Capital and drawings
Income accounts
Expense accounts

Dr Asset Dr Capital Cr Dr Liabilities
accounts Cr accounts Cr
+ – – + – +
Increases Decreases Decreases Increases Decreases Increases
on the on the on the on the on the on the
debit side credit side debit side credit side debit side credit
Normal Normal side
balance balance = Normal
= debit credit balance
balance balance = credit
balance
Dr Drawings Cr
+ –
Increases Decreases
on the on the
debit side credit side
Normal
balance =
debit
balance
Dr Income
accounts Cr
– +
Decreases Increases
on the on the
Normal
balance =
credit
balance
Dr Expense
accounts Cr
+ –
Increases Decreases
on the on the
Normal
balance =
debit
balance
ILLUSTRATIVE EXAMPLE Debits and credits
1. T. Zondo decided to open a mobile motor vehicle repair and service

unit called Prima Innovations. He withdrew R50 000 from his
personal savings account and deposited it in Prima Innovations’
bank account.
2. Prima Innovations borrowed R30 000 with a payback period of three
years. The R30 000 was paid into the business’s bank account.
3. Prima Innovations purchased tools for R40 000 and issued a
cheque for this amount.
4. Prima Innovations bought a vehicle for R100 000 on credit (account)
from GM Motors. R20 000 was paid as deposit. The balance is to be
paid in equal instalments within one year.
5. Prima Innovations issued a cheque of R8 000 to GM Motors, being
the first instalment.
6. T. Zondo withdrew R1 000 from the business to pay towards a
private loan.
7. Prima Innovations provided services for a client and received a
cheque of R2 500.
8. Prima Innovations provided repair services to S. Cele’s taxis and
billed him for R4 500.
9. Prima Innovations issued a cheque of R1 800 for wages.
10. Prima Innovations received a billing from Ethekwini Municipality for
water and electricity amounting to R700. This amount has not yet
been paid.
11. Prima Innovations received a cheque of R3 000 from S. Cele as part
payment of his account.
12. The business wants to establish a petty cash float of R500 using
money withdrawn from its bank account.
Date Assets OE + Liabilities Account debit Account

=R R R credit
1 + 50 + 50 0 Bank Capital
000 000
2 + 30 0 + 30 000 Bank Loan
000
3 + 40 0 0 Equipment
000
– 40 0 0 Bank
000
4 + 100 0 + 80 000 Vehicle Creditors
000
– 20 0 0 Bank
000
5 – 8 000 0 – 8 000 Creditors Bank
6 – 1 000 –1 0 Drawings Bank
000
7 + 2 500 +2 0 Bank Fee
500 income
8 + 4 500 +4 0 Debtors Fee
500 income
9 – 1 800 –1 0 Wages Bank
800
10 0 – 700 + 700 Water and Creditors
electricity
11 + 3 000 0 0 Bank
– 3 000 0 0 Debtors
12 + 500 0 0 Petty cash
– 500 0 0 Bank
TUTORIAL EXERCISES
Excercise 7
Cami opened a training centre in January 20x1 under the name Shay —
Active. Choose the correct accounting entry for each of the statements
listed below.
7.1 Cami transferred R10 500 from her personal bank account to the
bank account of Shay — Active training.
Account Account A= OE + L
debit credit
A Bank Capital + R10 + R10 0
500 500
B Capital Bank + R10 + R10 0
500 500
C Bank Capital – R10 – R10 0
500 500
D Bank Capital + R10 0 + R10
500 500
7.2 The owner took R1 000 from the business for her personal use.
debit credit
A Bank Drawings – R1 – R1 0
000 000
B Drawings Bank – R1 – R1 0
000 000
C Drawings Creditors – R1 0 – R1
000 000
D Creditors Drawings – R1 0 – R1
000 000
7.3 Received R5 000 from the customers who were trained during the
month.
debit credit
A Sales Bank + R5 + R5 0
000 000
debit credit
B Creditors Sales + R5 + R5 0
000 000
C Bank Service fees + R5 + R5 0
000 000
D Bank Sales + R5 + R5 0
000 000
7.4 Computers were purchased from Icona Ltd for R10 000 on credit.
Account Account A= OE L
debit credit +
A Loan Equipment + R10 0 + R10
000 000
B Equipment Loan + R10 0 + R10
000 000
C Equipment Creditors + R10 0 + R10
000 000
D Creditor Equipment + R10 0 + R10
000 000
7.5 Paid R2 750 to Icona Ltd to settle the account.
debit credit
A Creditors Bank – R2 + R2 0
750 750
B Bank Debtors – R2 0 – R2
750 750
C Bank Creditors – R2 0 – R2
750 750
D Creditors Bank – R2 0 – R2
750 750
7.6 The secretary’s monthly salary was paid in cash, R500.

debit credit
A Bank Salary + + 0
R500 R500
B Salary Bank + – 0
R500 R500
C Salary Creditors 0 – –
R500 R500
D Debtors Salary 0 + +
R500 R500
7.7 Bought stationery on credit for R800 from Regent Stationers.
debit credit
A Bank Stationery – – 0
R800 R800
B Stationery Creditors 0 – +
R800 R800
C Creditors Stationery 0 + +
R800 R800
D Stationery Bank – + 0
R800 R800
Required
Record the above transactions in the accounting equation, clearly
stating which accounts are debited and credited.
Exercise 8
Dr Dan has decided to open up his own dental practice, operating under
the name of Fluoride Dental Practice. The following transactions took
place during October 20x6, his first month of business.
2 Dr Dan invested R40 000 into a bank account, which he opened up
in the name of the business.
4 He bought R75 400 worth of dental equipment from dental
suppliers. An amount of R22 000 was paid immediately and the
balance will be paid off over the next few months.
7 R30 000 was acquired as a loan from DTU Bank.
10 Dr Dan contributed a vehicle valued at R60 000 to the business.
14 Cash fees of R3 670 were collected from clients.
16 R120 was paid to hire a computer.
18 Provided services for clients amounting to R4 580 on credit.
20 Dr Dan took R250 out of the business bank account to buy his wife
a birthday present.
25 Rent of R1 200 was paid.
27 Telkom was paid R180 for telephone use.
29 Dr Dan paid R3 200 to dental suppliers (see 4 October above) and
R1 000 to DTU Bank to reduce the loan.
30 Paid R260 interest on the loan.
31 Received payments from debtors amounting to R580.
Required
Record the above transactions in the accounting equation.
Exercise 9
You have been employed as a bookkeeper for Nyathi Marketing
Consultants. The following are the transactions that took place during
February 20x6, being the first month of business.
1 Mr Zama, the owner, introduced his contribution of R50 000 cash
and furniture and equipment costing R29 000 into a business.
Cash was then deposited into the business bank account.
5 Paid R1 000 by cheque for rent.
7 Bought stationery on credit from AB Stationers; invoice issued R2
500.
10 Rendered a service and charged Miss Shozi R3 500. She
would pay in the following month.
12 Bought a vehicle costing R90 000; Mr Zama paid R30 000 deposit
and the balance was payable over four years in equal monthly
instalments.
15 Received cash of R5 200 for services rendered.
25 The physical stock count revealed that unused stationery amounted
to R500.
28 Paid the first instalment on the vehicle, R1 250. Mr Zama withdrew
cash of R1 600 for personal use.
Required
Record the transactions on the accounting equation for the month of
February 20x6.
Exercise 10
Shavik Singh decided to open up his own taxi repair and service unit
called Scoundrel Enterprises. The following transactions took place
during August 20x1, his first month of business.
1. Mr Singh invested R150 000 of his own cash into the business
banking account.
3. Acquired a loan of R50 000 from White Diamond Bank.
4. Mr Singh purchased equipment and tools for R38 000 cash.
8. Provided services for his first client and received a cheque of R8
400.
10. Bought a motor vehicle on credit for R100 000. He paid R50 000
deposit from the bank account and the balance is payable over
two years in equal monthly instalments.
12. Mr Singh withdrew R1 800 to buy an expensive gift for his wife.
15. Provided services for SK’s taxis and billed it R3 800.
19. Issued a cheque for wages R2 900.
22. Paid R550 interest on the loan from White Diamond Bank.
27. Received a cheque for R2 800 from SK’s taxis.
Required
Record the above transactions in the accounting equation, clearly
stating which accounts are debited and credited.
Exercise 11
Mahi Ltd commenced business in October 20x1. The following
information represents the transactions for the first month of business:
DATE
1 The owner, Mahi Singh, deposited an amount of R200 000 in
ABSA Bank as her capital contribution.
2 Purchased inventory from Lumber Ware Ltd for R50 000 on credit.
4 Paid electricity deposit of R8 000 by cheque.
6 Sold inventory to Kay Kay (Pty) Ltd for R1 500 on credit.
12 Paid Lumber ware Ltd R25 000 by cheque.
14 Kay Kay (Pty) Ltd returned inventory at value of R300; was not
according to order.
25 Paid wages of R80 000 to office personnel by cheque transfer into
their bank accounts.
26 Kay Kay (Pty) Ltd paid R1150 in full settlement of amount owing.
29 Paid telephone account of R800 by cheque to Telkom.
30 Paid Lumber Ltd a further R10 000 on account; the balance to be
paid in November.
Required
Record the above transactions in the ledger journal of Mahi Ltd and
present your answer in the following format:
Account debited Account credited Amount
Exercise 12
You have been employed as a bookkeeper for Tiara-Leigh Consulting
(Pty) Ltd.
The following are the transactions that took place during August 20x1
being the first month of business:
1 Ms Tiara-Leigh, the owner, introduced her contribution of R100 000
cash, and furniture and equipment of R30 000 into a business.
2 Paid R12 000 by cheque for rent.
5 Bought a vehicle costing R90 000 from BMW. Ms Tiara-Leigh paid
R30 000 deposit and the balance is payable over four months in
equal instalments.
7 Ms Tiara-Leigh drew cash of R1 600 for personal use.
10 Paid first instalment on the vehicle R1 250.
12 Bought stationery on credit from CNA stationers, invoice issued:
R2 800.
15 Rendered a service and charged Mr Jenaid-Reid R2 500; he will
pay in the following month.
26 Received cash of R5 200 for services rendered.
29 Paid salaries and wages of R4 000.
Required
Record the transactions in the accounting equation for February 20x1.
4 Basic financial statements
Outcomes
At the end of this chapter students should have an understanding of the

accounting cycle and be able to
calculate cost of sales

prepare basic financial statements of a sole trader using both the periodic and the
perpetual methods of stock valuation.
Chapter outline

4.2.1 Transactions
4.2.3 Journals
4.2.6 Adjustments
4.3 Retailers
This is a brief introduction to a conceptual framework of basic accounting because at this

stage of your studies an in-depth discussion is not necessary. The conceptual framework
identifies four principal qualitative characteristics of accounting, namely understandability,
relevance, reliability and comparability:
Understandability. This is defined as the ability of the users to understand the information
contained in the financial statements. This is dependent on how the information has been
prepared, as well as the level of financial sophistication of the users.
Relevance. This is defined as the ability of financial information to make a difference in a
decision by helping users to form predictions about the outcomes of past, present and
future events.
Reliability. Information contained in the financial statements must represent faithfully the
transactions and other events and be neutral, that is, free from bias.
Comparability. This characteristic attempts to introduce a common language into the
presentation of financial statements, so that users can compare information about the
enterprise for different time periods, or with information from other enterprises.
Fundamental accounting concepts include the concepts of going concern, matching,

consistency and prudence.
Going concern concept. This concept implies that the business will continue to operate for
a long time (in the foreseeable future), and there is no intention to cease operations.
Matching concept. Revenue and costs are recognised as they are earned or incurred
irrespective of the timing of the receipt of cash or its payment, and matched with one
another, that is, all revenue earned is matched with all expenses incurred in earning that
revenue during the relevant accounting period.
Consistency concept. Items can be recorded in a number of different ways. Therefore, each
business should try to choose the method that gives the most reliable picture of the
business. This cannot be done if one method is used in one year and another method is
used in the next year and so on. Constantly changing the method would lead to misleading
profits being calculated from the accounting records. Therefore the convention of
consistency is used, which states that once a firm has fixed a method for the accounting
treatment of an item, it will enter all similar items that follow in exactly the same way.
Prudence concept. If an item can be dealt with in more than one way, the most
conservative option should be followed, meaning that if there were a choice of accounting
methods, it would be prudent to select that which has the least favourable effect on net
income and financial position. Where there is doubt or uncertainty, the prudence concept
requires that estimates be conservative. It is also known as the doctrine of conservatism.

There are 11 basic stages in the accounting cycle (see Figure 4.1). Some of these stages are
performed on a daily basis, some on a monthly basis, while others are only performed at the
end of the accounting period. There are more steps in the full accounting cycle than in the
basic accounting cycle.
Figure 4.1 The accounting cycle
4.2.1 Transactions
Transactions occur daily in any business concern. A transaction is an agreement between two
parties to make something happen. Cash is not necessarily involved in this occurrence. It
could be that we
buy (credit or cash)

sell (credit or cash)
pay
receive money
return goods
receive goods back, etc.
We will always be one of the two parties involved, for example
we and the owner

we and the bank
we and the debtor
we and the creditor
we and any other party.

Under no circumstances may any entry be made in the records without a source document to
substantiate the entry. A specific source document is used for every type of transaction. It is
also important to distinguish between an original and a duplicate source document.
Examples of source documents used:
Receipt – for cash received

Cash slip or cash register slip – for cash sales of goods
Cheque – for cash payment
Credit purchase invoice – for credit purchases
Credit sales invoice – for credit sales
Credit note – for returns by debtors
Debit note – for returns to creditors
4.2.3 Journals
The purpose of a journal is to summarise transactions of the same type. A distinction is made,
for example, between a cash transaction and a credit transaction. A further distinction is made
with regard to cash transactions, namely cash payments and cash receipts.
The following journals are applicable:
General journal (GJ)

Cash receipts journal (CRJ)
Cash payments journal (CPJ)
Debtors’ journal (DJ) or sales journal (SJ)
Creditors’ journal (CJ) or purchases journal (PJ)
Debtors’ allowances journal (DAJ) or sales returns journal (SRJ)
Creditors’ allowances journal (CAJ) or purchase returns journal (PRJ)
Petty cash journal (book) (PCJ)
GENERAL LEDGER
When information is transferred from the journals to the general ledger, we use the term post.
The purpose of a general ledger account is to determine a balance for each account in the
records. An account is opened for every item, whether it is an asset, liability, income or
expense, and the balance or total is determined for every account. A balance is determined by
calculating the difference between the debit and the credit side of each account. The left-hand
side of an account represents the debit side, and the right-hand side the credit side.
EXAMPLE OF A GENERAL LEDGER ACCOUNT
A general ledger account is in the shape of a “T”, with the name of the account at the top:
“Vehicles” in this instance. All transactions relating to vehicles (buying, selling, etc.), will be
accounted for in this account to enable us to determine the balance at the end of a specific
period.
DEBTORS AND CREDITORS LEDGERS
These are subsidiary ledgers, since they provide more details about specific accounts in the
general ledger. The debtors ledger provides more details about the debtors control account in
the general ledger, i.e. it contains all the details of the individual debtors. The creditors ledger
provides more details of the creditors control account in the general ledger, i.e. it contains all
the details of the individual creditors.

This represents a summary of the debit and credit balances in the general ledger before any
adjustments are made to these balances. The main purpose for drafting the trial balance at this
point in the accounting cycle is to ensure that the transactions have been captured correctly.
The debit side of the trial balance must equal the credit side.
4.2.6 Adjustments
An adjustment is not a transaction; in other words, it does not involve two parties.
Adjustments are changes that are made at the end of the financial period. Examples of
adjustments:
Depreciation
Expenses prepaid
Accrued expenses
Accrued income
Income received in advance
Allowance for credit losses
Adjustments are made in the general journal and the journal description acts as the source
document. The entries in the general journal are posted to the general ledger accounts.
Adjustments will be covered in more detail in Chapter 5.

A post-adjustment trial balance is prepared after making all the necessary adjustments. It
represents the final balances of all general ledger accounts and includes income, expense,
asset, owner’s equity and liability accounts.

Closing entries are made using the general journal. All income and expense accounts are
closed so that no balances remain on these accounts and a clean start can be made during the
next financial year. Income and expense accounts that influence gross profit are closed off
against the trading account; all other income and expense accounts are closed off against the
profit and loss account. Closing entries will be covered in more detail in Chapter 5.
After all the closing entries have been made, the only balances that remain in the general
ledger are assets, liabilities and profit or loss as calculated in the profit and loss account. The
final trial balance therefore consists of a summary of those closing balances that remain in
the general ledger after all the closing entries have been made.

The financial statements of a business entity comprise five sections. These are as follows:
Statement of profit or loss and other comprehensive income

Statement of financial position
Statement of changes in equity
Statement of cash flow
Notes
Note: The statement of cash flow is beyond the scope of this book and will not be covered.
4.2.10.1 Statement of profit or loss and other comprehensive income

The purpose of the statement of profit or loss and other comprehensive income is to
determine the gross and net profit of the business concern for a relevant period. Only income
and expenses appear in the statement of profit or loss and other comprehensive income. The
statement of profit or loss and other comprehensive income shows the performance of the
business for the whole financial period under review.
The heading of the statement of profit or loss and other comprehensive income always reads
as follows:
Statement of profit or loss and other comprehensive income of __________ for the year
ended __________ 20xx.
4.2.10.2 Statement of financial position

The statement of financial position shows the financial position of the business at that
particular point in time.
The heading of the statement of financial position always reads as follows:
Statement of financial position of __________ at __________ 20xx.
4.2.10.3 Statement of changes in equity

The purpose of the statement of changes in equity is to show the value of the owners’
investment in the business.
The heading of the statement of changes in equity always reads as follows:
Statement of changes in equity of __________ for the year ended__________ 20xx.
4.2.10.4 Statement of cash flow

The purpose of the cash flow statement is to show the movement of cash within a specific
financial period.
The heading of the statement of cash flow always reads as follows:
Statement of cash flow of __________ for the year ended__________ 20xx.
4.2.10.5 Notes to the financial statements

The main purpose of the notes is to provide additional information regarding certain items in
the statement of profit or loss and other comprehensive income, as well as the statement of
financial position. The main notes drafted include accounting policies, non-current assets,
inventories (stock), investments, etc. For the purpose of this book, we will only focus on the
notes for accounting policy and non-current assets.
The notes are always numbered, so that they can be cross-referenced, that is, found easily on
the face of the financial statements.

The final step in the accounting cycle is the analysis and interpretation of the information
contained in the financial statements. This is done by calculating ratios and comparing the
figures in the financial statements with those of other concerns or with budgets that have
been drawn up previously.
4.3 Retailers
Up to this point, we have dealt with the financial statements (i.e. the statement of profit or
loss and other comprehensive income, as well as the statement of financial position) of a
service business, that is, a business that provides a service for which it charges a fee. The fee
received for services rendered is called fee income. Rather than offering a service
(hairdressing, plumbing, etc.), for which the customer is charged a fee, many businesses
(supermarket, shoe store, etc.) choose to sell a physical, tangible product in order to make a
profit. These businesses are known as retailers.
The retailer buys products from a wholesaler and sells them to consumers. The retailer makes
a profit by adding a mark-up to the cost of the product. The selling price includes this mark-
up.
In other words: Cost price R1 000
+ Mark-up R250
= Selling price R1 250
The selling price must be high enough to
cover the amount paid for the product

pay the business operating expenses
make a profit.
The products bought for the purpose of resale are called trading stock. Trading stock is also
called “purchases”, “goods” or “merchandise”. These descriptions imply that the items are
bought for resale and they should not be confused with products the business buys for its own
use. Trading stock is usually a retailer’s largest asset and the way this stock is controlled and
accounted for is very important to the profitability of the business.
Retailing businesses may account for their stock using one of two methods:
The perpetual method or

The periodic method

Perpetual means continuous. According to this method the selling price and the cost price are
known for each item sold. It is therefore very easy to work out how profitable an item is by
simply matching the selling price of the goods sold to the cost price of those same goods.
The amount by which the selling price exceeds the cost price is known as the gross profit.
Gross profit = Selling price – Cost price
Establishing the gross profit on each item sold is very useful. However, the implementation
of this method in an organisation with a large turnover of items, like a supermarket, can be
difficult and expensive. A sophisticated computerised system would be required to keep track
of the cost price and selling price of each item sold.
The recording of transactions under the perpetual system requires two important accounts,
namely trading stock and cost of sales. The trading stock account is continuously updated to
reflect the cost of the stock available for sale, while the cost of sales account is continuously
updated to reflect the cost of the stock sold.
Stocktaking occurs at the end of the accounting period to verify if the balance of stock
available for sale and the balance of the trading stock account agrees.

Organisations that trade in a large volume of goods and for which the perpetual method is not
practical still have the same basic information needs. At some point, they must be able to
determine the gross profit of the organisation. In order to do this, they will use the periodic
method of accounting for stock whereby the cost of stock available for sale and the cost of
goods sold is only updated periodically.
THE RECORDING OF TRANSACTIONS UNDER THE PERIODIC METHOD

When a retailer using the periodic method buys items for resale at a profit, the cost price of
the item affects the purchases account.
STOCK ON HAND
As long as the retailer sells all his stock, then the calculation of the gross profit is the same as
in the perpetual method because cost of sales = purchases. This situation seldom arises and is
not desirable, since a retailer always needs stock on the shelves to sell.
The retailer can still work out the cost price of the goods sold by using the following formula:
Cost of sales = Opening stock + Purchases – Closing stock
In order to determine the amount of closing stock, the retailer will have to do a physical stock
count of the stock that he has not sold. In other words, he will periodically (from time to
time) have to do stocktaking in order to calculate the cost of sales so that he can then work
out the gross profit. The stocktaking is usually done on the last day of the financial period. It
is important to remember that the closing stock at the end of one financial period becomes
the opening stock at the beginning of the following period.
Example 1 Cash journals (perpetual method)

Roshan Nunden has just opened his own business called Rosh Traders. The cash
transactions for the first month of trading were as follows:
August 20x6
1 Roshan deposited R70 000 into the business bank account as his capital
contribution.
2 Roshan obtained a loan of R30 000 from Gold Bank at 15% interest per annum.
5 Purchased equipment and tools for cash R35 000 from Equip Ltd.
7 Purchased stock for resale from Nadesan Suppliers R25 000.
10 Issued a cheque to pay weekly wages R1 500.
12 Sold goods to customers for cash R20 000, cost price R16 000.
15 Purchased goods for resale from Naidoo Suppliers R30 000.
18 Sold goods for cash R15 000; cost price R12 000.
20 Roshan withdrew cash to buy a birthday gift for his wife R1 500.
25 Paid interest on loan for the month.
Paid monthly rental of R2 000 to Properties Ltd.
Paid the municipality R1 000 for water and electricity.
Required
Assume that the business uses the perpetual method of stock valuation. Prepare the
following for the month of August 20x6:
Cash receipts and cash payments journals; general ledger and trial balance
Note:
Under the perpetual method both the sales and cost of sales are recorded in the CRJ,
while all goods bought are recorded under trading stock in the CPJ.
Solution
Cash receipts journal of Rosh Traders for August 20x6 FOL.CRJ1

Doc Day Details Fol Analysis of Bank Sales Cost of Sundry
no. receipts sales accounts
Amount Fol Details
rec 1 1 Roshan 70 000,00 70 70 B1 Capital
Nunden 000,00 000,00
rec 2 2 Gold Bank 30 000,00 30 30 B2 Loan: Gold
000,00 000,00 Bank
CRR1 12 Sales 20 000,00 20 20 16000,00
000,00 000,00
CRR2 18 Sales 15 000,00 15 15 12000,00
000,00 000,00
135 35 28 000,00 100
000,00 000,00 000,00
B3 N1 N2
Cash payments journal of Rosh Traders for August 20x6 FOL. CPJ1
Cheque Day Details Fol Bank Trading Wages Sundry Details
number stock accounts
Amount Fol
01 5 Equip Ltd 35 35 B4 Equipment and
000,00 000,00 tools
02 7 Nadesan 25 25 000,00
Suppliers 000,00
03 10 Cash 1 500,00 1
500,00
04 15 Naidoo 30 30 000,00
Suppliers 000,00
05 17 Cash 1 500,00 1
500,00
06 20 Cash 1 500,00 1 500,00 B5 Drawings
07 24 Cash 1 500,00 1
500,00
08 25 Gold Bank 375,00 375,00 N3 Interest on loan
09 25 Properties Ltd 2 000,00 2 000,00 N4 Rent
010 31 Cash 1 500,00 1
500,00
Municipality 1 000,00 1 000,00 N5 Water and
electricity
100 55 000,00 6 39
875,00 000,00 875,00
B3 B6 N6
* R30 000 × 15 % ÷ 12 = R375

Notes: Cash receipts journal and cash payments journal:
The headings and columns used in the journals depend on how often the transactions
occur. This will vary from business to business.
Transactions that occur regularly are recorded in a separate column, while transactions
that occur infrequently are recorded in the sundries column.
Cash receipts and payments for the month are recorded in date order.
Cash received is not banked after each transaction, but rather at the end of the day.
Consequently, the CRJ has an analysis of receipts column and a bank column. All
transactions are entered into both the analysis of receipts column and the bank column.
The analysis of receipts column is particularly useful when more than one receipt has
occured on the same day. The bank column reflects the total receipts that are banked
for the day.
Transactions recorded in the sundry accounts are posted to the individual accounts in
the general ledger. The folio column indicates the folio reference of the affected
accounts in the general ledger.
The totals of the other columns also have folio references and are posted to the general
ledger as well.
Folio references are important, as they assist with the cross-checking of transactions.
General ledger of Rosh Traders for the month of August 20x6

Capital B1
Date Details Fol Amount Date Details Fol Amount

1 Aug Bank CRJ1 70
20x6 000,00
Loan: Gold Bank B2
2 Aug Bank CRJ1 30
20x6 000,00
Bank B3
31 Aug Total CRJ1 135 31 Aug Total CPJ1 100
20x6 receipts 000,00 20x6 payments 875,00
Balance c/d 3
4125,00
135 135
000,00 000,00
1 Sept Balance b/d 34
20x6 125,00
Tools and equipment B4
5 Aug Bank CPJ1 35
20x6 000,00
Drawings B5
20 Aug Bank CPJ1 1 500,00
20x6
Trading stock B6
31 Aug Bank CPJ1 55 31 Aug Cost of CRJ1 28
20x6 000,00 20x6 sales 000,00
Balance c/d 27
000,00
55 55
000,00 000,00
20x6 000,00
Sales N1
31 Aug Bank CRJ1 35
20x6 000,00
Cost of sales N2
31 Aug Trading CRJ1 28
20x6 stock 000,00
Interest on loan N3
25 Aug Bank CRJ1 375,00
20x6
Rent N4
20x6
Water and electricity N5
20x6
Wages N6
20x6
Notes: General ledger
The general ledger is divided into two sections, i.e. the balance sheet section and the
nominal accounts section.
The balance sheet section comprises all the assets, liabilities and equity accounts. The
folio reference for the balance sheet section accounts starts with a “B”.
The nominal accounts section comprises all income and expense accounts. The folio
reference for the nominal accounts section starts with an “N”.
In the general ledger the balance sheet accounts are balanced off, while the nominal
accounts are totalled.
Trial balance of Rosh Traders on 31 August 20x6
Folio Debit Credit

Balance sheet section R R
Capital B1 70 000,00
Loan: Gold Bank B2 30 000,00
Bank B3 34 125,00
Tools and equipment B4 35 000,00
Drawings B5 27 000,00
Trading stock B6 1 500,00
Nominal accounts section
Sales N1 35 000,00
Cost of sales N2 28 000,00
Interest on loan N3 375,00
Rent N4 2 000,00
Water and electricity N5 6 000,00
Wages N6 1 000,00
135 000,00 135 000,00
Notes: Trial balance

The trial balance is a summary of all the accounts in the general ledger and their
respective balances or totals.
It is used to check the accuracy of the general ledger, as the total debits must equal the
total credits.
Example 2 Cash journals (periodic method)

Assuming that Rosh Traders uses the periodic method of stock valuation, prepare the
following for the month of August 20x6:
Cash receipts and cash payments journals; general ledger and trial balance
Note: Under the periodic method, only sales is recorded in the CRJ, while all goods
bought are recorded under purchases in the CPJ.
Solution
Cash receipts journal of Rosh Traders for August 20x6 FOL.CRJ1

Doc Day Details Fol Analysis of Bank Sales Sundry
no. receipts accounts
Amount Fol Details
rec 1 1 Roshan 70 000,00 70 000,00 70 000,00 B1 Capital
Nunden
rec 2 2 Gold Bank 30 000,00 30 000,00 30 000,00 B2 Loan: Gold
Bank
CRR1 12 Sales 20 000,00 20 000,00 20
000,00
CRR2 18 Sales 15 000,00 15 000,00 15
000,00
135 35 100
000,00 000,00 000,00
B3 N1
Cash payments journal of Rosh Traders for August 20x6 FOL. CPJ1
Cheque Day Details Fol Bank Purchases Wages Sundry
number account
Amount Fol Details
01 5 Equip Ltd 35 35 B4 Equipment and
000,00 000,00 tools
02 7 Nadesan 25 25 000,00
Suppliers 000,00
03 10 Cash 1 500,00 1
500,00
04 15 Naidoo 30 30 000,00
Suppliers 000,00
05 17 Cash 1 500,00 1
500,00
06 20 Cash 1 500,00 1 B5 Drawings
500,00
07 24 Cash 1 500,00 1
500,00
08 25 Gold Bank 375,00 375,00 N3 Interest on loan
09 25 Properties Ltd 2 000,00 2 N4 Rent
000,00
010 31 Cash 1 500,00 1
500,00
Municipality 1 000,00 1 N5 Water and
000,00 electricity
100 55 000,00 6 39
875,00 000,00 875,00
B3 N2 N6
General ledger of Rosh Traders for the month of August 20x6

Capital B1

1 Aug Bank CRJ1 70
20x6 000,00
Loan: Gold Bank B2
2 Aug Bank CRJ1 30
20x6 000,00
Bank B3
31 Aug Total CRJ1 135 31 Aug Total CPJ1 100
Balance c/d 34
125,00
135 135
000,00 000,00
20x6 125,00
Tools and equipment B4
5 Aug Bank CPJ1 35
20x6 000,00
Drawings B5
20x6
Sales N1
31 Aug Bank CRJ1 35
20x6 000,00
Purchases N2
31 Aug Bank CPJ1 55
20x6 000,00
Interest on loan N3

25 Aug Bank CRJ1 375
20x6
Rent N4
20x6
20x6
Wages N6
20x6
Trial balance of Rosh Traders on 31 August 20x6
Folio Debit Credit

Balance sheet section R R
Loan: Gold Bank B2 30 000,00
Bank B3 34 125,00
Tools and equipment B4 35 000,00
Nominal accounts section
Sales N1 35 000,00
Purchases N2 55 000,00
Interest on loan N3 375,00
Rent N4 2 000,00
Wages N6 6 000,00
135 000,00 135 000,00
Example 3 Cash and credit journals (perpetual method)

Mr Entrepreneur recently retired from his job. He lives in an area where there are only
informal traders and spaza shops, which sell a limited range of goods. The residents have
to travel at least 20 kilometres to the nearest supermarket. He therefore decided to use his
retirement savings to start a local supermarket, which he named the Convenient Store.
He found an ideal building suitable for his requirement, i.e. a medium-sized supermarket,
and entered into a lease agreement with Properties Ltd.
Initially he decided on operating his business from Monday through to Saturday. However,
should the demand increase, he might consider extending his operating hours to a
Sunday. He appointed a manager to oversee the business operations as well as, three
other workers. He also decided to offer certain customers the opportunity to buy on credit
but he would first do a thorough background check on each applicant. To ensure a
sufficient cash flow he has opted to buy goods for cash as well as on credit. He would also
negotiate with his prospective creditors for credit terms that are longer than the terms of
his debtors.
The following transactions took place during April 20x6, his first month of trading:
1 Mr Entrepreneur deposited R65 000 into a bank account in the name of the business,
as his capital contribution.
Paid the rental of R3 000 to Properties Ltd.
Paid the water and electricity of R3 000 to the municipality.
Purchased shop fittings on credit from City Equipment totalling R15 000 and paid a
10% deposit.
Purchased stock from XYZ Traders for R90 000 cash.
2 Purchased stock for resale on credit from Stock Suppliers, R35 311,50. Returned
stock to the value of R311,50 to Stock Suppliers which had been damaged in transit.
Bought packing material to the value of R702 from HS Packaging and paid by
cheque.
Drew a cheque for the cash float to the value of R500.
3 Cash sales from the opening day R28 011; cost of sales R22 408,80.
5 Sublet part of the building to Mr P. Gordon and received rental for R750.
Cash sales for the day totalled R18 682,50; cost of sales R14 946.
6 Drew cash to pay weekly wages of R2 250.
8 Bought stock to the value of R8 067 from A.Z. Mthembu and paid by cheque.
9 Sold goods on credit to B Ross R1 039,50; cost of sales R831,60.
12 Purchased computer equipment and office supplies from Bee Wholesalers. The
computer equipment totalled R7 890 and was purchased on credit, while the office
supplies, which totalled R717, were purchased for cash.
13 Sold goods on credit to V. Persad totalling R448,50; cost of sales R358,80.
Drew cash to pay weekly wages of R2 250.
18 Sold goods for cash, R13 185; cost of sales R10 548.
20 Drew a cheque to pay for the following:
Wages R2 250
For the owner’s personal use R1 500
21 Bought stock from B.T. Zenda and paid by cheque R4 012,50.
Sold stock for cash R18 855; cost of sales R15 084.
Sold goods on credit to V. Persad R267; cost of sales R213,60.
On the same day, V. Persad returned goods to the value of R100, which were
damaged. Cost price of these goods was R80.
22 B. Ross paid R142,50 on her account and was allowed a discount of R7,50.
Sold goods for cash R15 357; cost of sales R12 285,60.
23 Paid R825 to the local newspaper for advertising.
26 Drew a cheque to pay weekly wages R2 250.
Purchased office supplies for R500 on credit from Bee Wholesalers.
Received R448,50 from V. Persad in part payment of her account.
28 Issued cheques to the following creditors:
Stock Suppliers R30 000
Bee Wholesalers R1 500
City Equipment R1 500
and received a discount of R600, R30 and R30 respectively.
Also issued a cheque to Properties Ltd for the monthly rental of R3 000.
29 Sold goods for cash R25 113; cost of sales R20 090,40.
Sold goods on credit to B. Ross R393; cost of sales R314,40. Mrs Ross paid R300 on
her account.
30 Paid the telephone account of R892,50 to Moklet and R3 750 to Mr I.N. Charge, the
manager, for his salary.
31 Sold goods for cash R22 926; cost of sales R18 340,80.
Required
Assuming that the Convenient Store uses the perpetual method to account for its stock,
prepare the following for the month of April 20x6:
a) All the relevant subsidiary journals
b) Debtors ledger; creditors ledger and general ledger, and extract a trial balance
Solution
a)
Cash receipts journal of the Convenient Store for April 20x6 FOL.CRJ1
Doc Day Details Fol Analysis Bank Sales Cost Debtors Discount Sundry
no. of of control allowed accounts
receipts sales Amount Fol Details
rec 1 1 Mr 65 65 65 B1 Capital
Entrepreneur 000,00 000,00 000,00
CRR1 3 Sales 28 28 28 22
011,00 011,00 011,00 408,80
rec 2 5 P. Gordon 750,00 750,00 750,00 N4 Rent
received
CRR2 Sales 18 18 18 14
682,50 682,50 682,50 946,00
CRR3 18 Sales 13 13 13 10
185,00 185,00 185,00 548,00
CRR4 21 Sales 18 18 18 15
855,00 855,00 855,00 084,00
rec3 22 B. Ross DL1 142,50 142,50 150,00 –7,50
CRR5 Sales 15 15 15 12
357,00 357,00 357,00 285,60
rec4 26 V. Persad DL2 448,50 448,50 448,50
CRR6 29 Sales 25 25 25 20
113,00 113,00 113,00 090,40
rec5 B. Ross DL1 300,00 300,00 300,00
CRR7 31 Sales 22 22 22 18
926,00 926,00 926,00 340,80
208 142 113 898,50 –7,50 65
770,50 129,50 703,60 750,00
B6 N9 N11 B7 N10
Cash payments journal of the Convenient Store for April 20x6 FOL. CPJ1
Cheque Day Details Fol Bank Trading Creditors Discount Wages Sundry
number stock control received account
Amount Fol Details
01 1 Properties 3 3 N1 Rent
Ltd 000,00 000,00
02 Municipality 3 3 N2 Water and
000,00 000,00 electricity
03 City CL1 1 1 500,00
Equipment 500,00
04 XYZ 90 90
Traders 000,00 000,00
05 2 HS 702,00 702,00 N3 Packing
Packaging material
06 Cash 500,00 500,00 B3 Cash float
07 6 Cash 2 2
250,00 250,00
08 8 A.Z. 8 8
Mthembu 067,00 067,00
09 12 Bee 717,00 717,00 N5 Office
Wholesalers supplies
10 13 Cash 2 2
250,00 250,00
11 20 Cash 3 2 1 B5 Drawings
750,00 250,00 500,00
12 21 B.T. Zenda 4 4
012,50 012,50
13 23 Local 825,00 825,00 N6 Advertising
newspaper
14 26 Cash 2 2
250,00 250,00
15 28 Stock CL2 29 30 000,00 –600,00
Suppliers 400,00
16 Bee CL3 1 1 500,00 –30,00
Wholesalers 470,00
17 City CL1 1 1 500,00 –30,00
Equipment 470,00
18 Properties 3 3 N1 Rent
Ltd 000,00 000,00
19 30 Moklet 892,50 892,50 N7 Telephone
20 Manager: 3 3 N8 Salaries
I.N. Charge 750,00 750,00
162 102 34 500,00 –660,00 9 17
806,00 079,50 000,00 886,50
B6 B9 B8 N12 N13
Notes: Cash receipts journal and cash payments journal:
When goods are bought or sold on credit an additional folio column is used in the cash
journals.
The additional folio references in the cash journal are for the individual debtor and
creditor accounts in the debtors ledger and creditors ledger.
The individual debtor accounts in the debtors ledger are credited when cash is received
from the debtors.
The individual creditor accounts in the creditors ledger are debited when cash is paid to
the creditors.
Debtors journal of the Convenient Store for April 20x6 FOL.DJ1

Doc Day Details Fol Debtors control Sales Cost of sales
Inv002 9 B. Ross DL1 1 039,50 1 039,50 831,60
Inv003 13 V. Persad DL2 448,50 448,50 358,80
Inv004 21 V. Persad DL2 267,00 267,00 213,60
Inv005 29 B. Ross DL1 393,00 393,00 314,40
2 148,00 2 148,00 1 718,40
B7 N9 N11
Debtors allowances journal of the Convenient Store for April 20x6 FOL.DAJ1
Doc Day Details Fol Debtors allowances Cost of sales
Credit note 1 21 V. Persad DL2 100,00 80,00
100,00 80,00
N14 N11
Notes: Debtors journal and debtors allowances journal:
Credit sales and returns for the month are recorded in date order.
Only the totals of the columns are posted to the general ledger.
The folio references in the debtors journal and debtors allowances journal are for the
individual debtor accounts in the debtors ledger.
The individual debtor accounts in the debtors ledger are debited with the credit sales
and are credited with the returns.
The total of all the debtor balances in the debtors ledger (debtors schedule) must equal
the balance reflected in the general ledger debtors control account.
Creditors journal of the Convenient Store for April 20x6 FOL. CJ1
Doc Day Details Fol Creditors Trading Sundry
control stock account
Amount Fol Details
InvF01 1 City Equipment CL1 15 000,00 15 000,00 B2 Shop fittings
InvF02 2 Stock Suppliers CL2 35 311,50 35 311,50
InvF03 12 Bee CL3 7 890,00 7 890,00 B4 Computer
Wholesalers equipment
InvF04 26 Bee CL3 500,00 500,00 N5 Office supplies
Wholesalers
58 701,50 35 311,50 23 390,00
B8 B9
Creditors allowances journal of the Convenient Store for April 20x6 FOL. CAJ1
Doc Day Details Fol Creditors control Trading stock
Debit note 1 2 Stock Suppliers CL2 311,50 311,50
311,50 311,50
B8 B9
Notes: Creditors journal and creditors allowances journal:
Credit purchases and returns for the month are recorded in date order.
Only the totals of the columns are posted to the general ledger.
The folio references in the creditors journal and creditors allowances journal are for the
individual creditor accounts in the creditors ledger.
The individual creditor accounts in the creditors ledger are credited with the credit
purchases and are debited with the returns.
The total of all the creditor balances in the creditors ledger (creditors schedule) must
equal the balance reflected in the general ledger creditors control account.
b)
General ledger of the Convenient Store for the month of April 20x6
Capital B1

1 Bank CRJ1 65
April 000,00
20x6
Shop fittings B2
1 Creditors control CJ1 15
April 000,00
20x6
Cash float B3
2 Bank CPJ1 500,00
April
20x6
Computer equipment B4
12 Creditors control CJ1 7
April 890,00
20x6
Drawings B5
20 Bank CPJ1 1
April 500,00
20x6
Bank B6
30 Total receipts CRJ1 208 30 Total CPJ1 162
April 770,50 April payments 806,00
20x6 20x6
Balance c/d 45
964,50
208 208
770,50 770,50
1 Balance b/d 45
May 964,50
20x6
Debtors control B7
30 Sales DJ1 2 21 Debtors DAJ1 100,00
April 148,00 April allowances
20x6 20x6
30 Bank and CRJ1 898,50
April discount
20x6
Balance (must c/d 1
equal the 149,50
balance in the
debtors
schedule)
2 2
148,00 148,00
1 Balance b/d 1
May 149,50
20x6
Creditors control B8
2 Trading stock CAJ1 311,50 30 Total CJ1 58
April April purchases 701,50
20x6 20x6
30 Bank and CPJ1 34
April discount 500,00
20x6
Balance (must c/d 23
equal the 890,00
balance in the
creditors
schedule)
58 58
701,50 701,50
1 Balance b/d 23
May 890,00
20x6
Trading stock B9

21 Cost of sales DAJ1 80,00 2 Creditors CAJ1 311,50
April April control
20x6 20x6
30 Bank CPJ1 102 30 Cost of sales CRJ1 113
April 079,50 April 703,60
20x6 20x6
Creditors control CJ1 35 Cost of sales DJ1 1
311,50 718,40
Balance c/d 21
737,50
137 137
471,00 471,00
1 Balance b/d 21
May 737,50
20x6
Rent N1
1 Bank CPJ1 3
April 000,00
20x6
28 Bank CPJ1 3
April 000,00
20x6
6
000,00
1 Bank CPJ1 3
April 000,00
20x6
Packing material N3
2 Bank CPJ1 702,00
April
20x6
Rent received N4
5 Bank CRJ1 750,00
April
20x6
Office supplies N5
12 Bank CPJ1 717,00
April
20x6
26 Creditors control CJ1 500,00
April
20x6
1
217,00
Advertising N6
23 Bank CPJ1 825,00
April
20x6
Telephone N7

30 Bank CPJ1 892,50
April
20x6
Salaries N8
30 Bank CPJ1 3
April 750,00
20x6
Sales N9
30 Bank CRJ1 142
April 129,50
20x6
30 Debtors DJ1 2
control 148,00
144
277,50
Discount allowed N10
30 Debtors control CRJ1 7,50
April
20x6
Cost of sales N11
30 Trading stock CRJ1 113 21 Trading stock DAJ1 80,00
April 703,60 April
20x6 20x6
Trading stock DJ1 1 Total 115
718,40 342,00
115 115
422,00 422,00
Discount received N12
30 Creditors CPJ1 660,00
April control
20x6
Wages N13
30 Bank CPJ1 9
April 000,00
20x6
Debtors allowances (sales returns) N14
21 Debtors control DAJ1 100,00
April
20x6
Debtors ledger of the Convenient Store
B. Ross DL1
Date Details Fol Debit Credit Balance
9 April 20x6 Invoice 002 DJ1 1 039,50 1 039,50
22 April 20x6 Receipt 4 CRJ1 142,50 897,00
Discount allowed CRJ1 7,50 889,50
29 April 20x6 Invoice 005 DJ1 393,00 1 282,50
Receipt 5 CRJ1 300,00 982,50
V. Persad DL2
13 April 20x6 Invoice 003 DJ1 448,50 448,50
21 April 20x6 Credit note 1 DAJ1 100,00 615,50
Debtors schedule
B. Ross DL1 982,50

V. Persad DL2 167,00
1 149,50
Creditors ledger of the Convenient Store
City Equipment CL1

1 April 20x6 Invoice F01 CJ1 1 5000,00 15 000,00
1 April 20x6 Cheque 03 CPJ1 1 500,00 13 500,00
Discount received CPJ1 30,00 12 000,00
Stock Suppliers CL2

2 April 20x6 Debit note 1 CAJ1 311,50 35 000,00
Bee Wholesalers CL3

26 April 20x6 Invoice F04 CJ1 500,00 8 390,00
Creditors schedule
City Equipment CL1 12 000,00

Stock Supplies CL2 5 000,00
Bee Wholesalers CL3 6 890,00
23 890,00
Note: The debtors and creditors schedules are a summary of the individual accounts in
the debtors and creditors ledgers.
Trial balance of the Convenient Store on 30 April 20x6
Folio Debit Credit

Shop fittings B2 15 000,00
Cash float B3 500,00
Computer equipment B4 7 890,00
Bank B6 45 964,50
Debtors control B7 1 149,50
Creditors control B8 23 890,00
Trading stock B9 21 737,50
Rent N1 6 000,00
Packing material N3 702,00
Rent received N4 750,00
Office supplies N5 1 217,00
Advertising N6 825,00
Telephone N7 892,50
Salaries N8 3 750,00
Sales N9 144 277,50
Discount allowed N10 7,50
Cost of sales N11 11 5342,00
Discount received N12 660,00
Wages N13 9 000,00
Debtors allowances N14 100,00
234 577,50 234 577,50
Example 4 Cash and credit journals (periodic method)

Assuming that the Convenient Store uses the periodic method to account for their stock,
prepare the following for the month of April 20x6:
b) Debtors ledger, creditors ledger and general ledger, and extract a trial balance
Solution
a)
Cash receipts journal of the Convenient Store for April 20x6 FOL.CRJ1
Doc Day Details Fol Analysis Bank Sales Debtors Discount Sundry
no. of control allowed accounts
receipts Amount Fol Details
rec 1 1 Mr 65 000,00 65 65 B1 Capital
Entrepreneur 000,00 000,00
CRR1 3 Sales 28 011,00 28 28
011,00 011,00
rec 2 5 P. Gordon 750,00 750,00 750,00 N4 Rent
received
CRR2 Sales 18 682,50 18 18
682,50 682,50
CRR3 18 Sales 13 185,00 13 13
185,00 185,00
CRR4 21 Sales 18 855,00 18 18
855,00 855,00
rec3 22 B. Ross DL1 142,50 142,50 150,00 –7,50
CRR5 Sales 15 357,00 15 15
357,00 357,00
rec4 26 V. Persad DL2 448,50 448,50 448,50
CRR6 29 Sales 25 113,00 25 25
113,00 113,00
rec5 B. Ross DL1 300,00 300,00 300,00
CRR7 31 Sales 22 926,00 22 22
926,00 926,00
208 142 898,50 –7,50 65
770,50 129,50 750,00
B6 N9 B7 N10
Cash payments journal of the Convenient Store for April 20x6 FOL. CPJ1
Cheque Day Details Fol Bank Purchases Creditors Discount Wages Sundry
number control received account
Amount Fol Details
01 1 Properties 3 3 N1 Rent
Ltd 000,00 000,00
02 Municipality 3 3 N2 Water and
000,00 000,00 electricity
03 City CL1 1 1 500,00
Equipment 500,00
04 XYZ traders 90 90 000,00
000,00
05 2 HS 702,00 702,00 N3 Packing
Packaging material
06 Cash 500,00 500,00 B3 Cash float
07 6 Cash 2 2
250,00 250,00
08 8 A.Z. 8 8 067,00
Mthembu 067,00
09 12 Bee 717,00 717,00 N5 Office
Wholesalers supplies
10 13 Cash 2 2
250,00 250,00
11 20 Cash 3 2 1 B5 Drawings
750,00 250,00 500,00
12 21 B.T. Zenda 4 4 012,50
012,50
13 23 Local 825,00 825,00 N6 Advertising
newspaper
14 26 Cash 2 2
250,00 250,00
15 28 Stock CL2 29 30 000,00 –600,00
Suppliers 400,00
16 Bee CL3 1 1 500,00 –30,00
Wholesalers 470,00
17 City CL1 1 1 500,00 –30,00
Equipment 470,00
18 Properties 3 3 N1 Rent
Ltd 000,00 000,00
19 Moklet 892,50 892,50 N7 Telephone
20 Manager: 3 3 N8 Salaries
I.N. Charge 750,00 750,00
162 102 079,50 34 500,00 –660,00 9 17
806,00 000,00 886,50
B6 N11 B8 N12 N13
Debtors journal of the Convenient Store for April 20x6 FOL.DJ1

Doc Day Details Fol Debtors control Sales
Inv002 9 B. Ross DL1 1 039,50 1 039,50
Inv003 13 V. Persad DL2 448,50 448,50
Inv004 21 V. Persad DL2 267,00 267,00
Inv005 29 B. Ross DL1 393,00 393,00
2 148,00 2 148,00
B7 N9
Debtors allowances journal of the Convenient Store for April 20x6 FOL.DAJ1
Doc Day Details Fol Debtors control Sales returns
Credit note 1 21 V. Persad DL2 100,00 100,00
100,00 100,00
B7 N15
Creditors journal of the Convenient Store for April 20x6 FOL. CJ1
Doc Day Details Fol Creditors control Purchases Sundry account
Amount Fol Details
InvF01 1 City Equipment CL1 15 000,00 15 000,00 B2 Shop fittings
InvF02 2 Stock Suppliers CL2 35 311,50 35 311,50
InvF03 12 Bee Wholesalers CL3 7 890,00 7 890,00 B4 Computer equipment
InvF04 26 Bee Wholesalers CL3 500,00 500,00 N5 Office supplies
58 701,50 35 311,50 23 390,00
B8 N11
Creditors allowances journal of the Convenient Store for April 20x6 FOL. CAJ1
Doc Day Details Fol Creditors control Purchases returns
Debit note 1 2 Stock Suppliers CL2 311,50 311,50
311,50 311,50
B8 N14
b)
General Ledger of the Convenient Store for the month of April 20x6
Capital B1

1 April Bank CRJ1 65
20x6 000,00
Shop fittings B2
1 April Creditors CJ1 15
20x6 control 000,00
Cash float B3
2 April Bank CPJ1 500,00
20x6
Computer equipment B4
12 April Creditors CJ1 7
20x6 control 890,00
Drawings B5
20 April Bank CPJ1 1
20x6 500,00
Bank B6
30 April Total CRJ1 208 30 April Total CPJ1 162
Balance c/d 45
964,50
208 208
770,50 770,50
1 May Balance b/d 45
20x6 964,50
Debtors control B7

30 April Sales DJ1 2 21 April Bank and CRJ1 898,50
20x6 148,00 20x6 discount
30 April Sales DAJ1 100,00
20x6 returns
Balance c/d 1
149,50
2 2
148,00 148,00
1 May Balance b/d 1
20x6 149,50
Creditors control B8
2 April Bank and CPJ1 34 30 April Total CJ1 58
20x6 discount 500,00 20x6 purchases 701,50
30 April Purchases CAJ1 311,50
20x6 returns
Balance c/d 23
890,00
58 58
701,50 701,50
1 May Balance b/d 23
20x6 890,00
Rent N1
1 April Bank CPJ1 3
20x6 000,00
20x6 000,00
6
000,00
1 April Bank CPJ1 3
20x6 000,00
Packing material N3
20x6
Rent received N4
5 April Bank CRJ1 750,00
20x6
Office supplies N5

20x6
26 April Creditors CJ1 500,00
20x6 control
1
217,00
Advertising N6
20x6
Telephone N7
20x6
Salaries N8
20x6 750,00
Sales N9
30 April Bank CRJ1 142
20x6 129,50
30 Debtors DJ1 2
control 148,00
144
277,50
Discount allowed N10
30 April Debtors CRJ1 7,50
20x6 control
Purchases N11
20x6 079,50
Creditors CJ1 35
control 311,50
137
391,00
Discount received N12

30 April Creditors CPJ1 660,00
20x6 control
Wages N13
20x6 000,00
Purchases returns N14
2 April Creditors CAJ1 311,50
20x6 control
Sales returns N15
21 April Debtors DAJ1 100,00
20x6 control
Debtors ledger of the Convenient Store
B. Ross DL1
9 April 20x6 Invoice 002 DJ1 1 039,50 1 039,5
Discount allowed CRJ1 7,50 889,50
29 April 20x6 Invoice 005 DJ1 393,00 1 282,50
Receipt 5 CRJ1 300,00 982,50
V. Persad DL2
21 April 20x6 Credit note 1 DAJ1 100,00 615,50
Debtors schedule
B. Ross DL1 982,50

V. Persad DL2 167,00
1 149,50
Creditors ledger of the Convenient Store
City Equipment CL1

Stock Suppliers CL2

2 April 20x6 Debit note 1 CAJ1 311,50 35 000,00
Bee Wholesalers CL3

26 April 20x6 Invoice F04 CJ1 500 8 390,00
Creditors Schedule
City Equipment CL1 12 000,00

Stock Suppliers CL2 5 000,00
Bee Wholesalers CL3 6 890,00
Trial balance of the Convenient Store on 30 April 20x6
Folio Debit Credit

Shop fittings B2 15 000,00
Cash float B3 500,00
Computer equipment B4 7 890,00
Bank B6 45 964,50
Debtors control B7 1 149,50
Creditors control B8 23 890,00
Rent N1 6 000,00
Packing material N3 702,00
Rent received N4 750,00
Office supplies N5 1 217,00
Advertising N6 825,00
Telephone N7 892,50
Salaries N8 3 750,00
Sales N9 144 277,50
Discount allowed N10 7,50
Purchases N11 137 391,00
Discount received N12 660,00
Wages N13 9 000,00
Purchases returns N14 311,50
Sales returns N15 100,00
234 889,00 234 889,00
Example 5 Perpetual method (basic financial statements)

Trial balance of Weesel Stores on 31 December 20x1
R
Capital 57 300
Drawings 7 500
Equipment 68 000
Accumulated depreciation on equipment 10 200
Loan (7,5% p.a.) 30 000
Trading stock 17 200
Fixed deposit (12% p.a.) 10 000
Debtors control (trade receivables) 15 400
Creditors control (trade payables) 16 300
Bank 6 200
Sales 135 000
Cost of sales 90 000
General expenses 8 000
Wages and salaries 24 500
Interest income 250
Interest on loan 2 250
Required
Prepare the financial statements of Weesel Stores; their financial year-end is 31
December 20x1.
Solution
Statement of profit or loss and other comprehensive income of Weesel Stores for
the year ended 31 December 20x1
R R
Sales (revenue) 135 000
Less: Cost of sales 90 000
Gross profit for the year 45 000
Add: Other income 250
Interest income 250
Gross income for the year 45 250
Less: Operating expenses 34 750
General expenses 8 000
Less: Interest on loan (finance cost) 2 250
Net profit for the period 10 500
The profit for the period belongs to the owner and is reflected in the statement of changes
in equity.
Note:
The interest income and interest expense items are shown separately. The purpose is to
indicate the income generated and expenses incurred from normal operations.
Other comprehensive income includes revaluation surplus on land, which is beyond the
scope of this book.
Statement of financial position of Weesel Stores at 31 December 20x1
Assets Notes R R
Non-current assets 2 67 800
Equipment 57 800
Fixed deposit (12% p.a.) 10 000
Stock 17 200
Debtors 15 400
Bank 6 200
Total assets 106 600
Equity
Owner’s equity 60 300
Non-current liabilities 30 000
Loan (7,5% p.a.) 30 000
Creditors 16 300
Total equity and liabilities 106 600
Statement of changes in equity for the year ended 31 December 20x1
Capital R57 300

+ Net profit for the period R10 500
– Drawings (R7 500)
R60 300
The R60 300 is reflected on the face of the statement of financial position as owner’s
equity.
Notes of Weesel Stores for the year ended 31 December 20x1
Note 1: Accounting policies

The financial statements have been prepared in accordance with generally accepted
guidelines laid down in the International Financial Reporting Standards (IFRS). The
financial statements have used accounting policies that are consistent with previous
financial periods.
Note 2: Non-current liabilities
Cost Accumulated depreciation Book value/carrying value
R R R
Equipment 68 000 10 200 57 800
Example 6 Periodic method (basic financial statements)

Trial balance of Hobbit Traders on 31 March 20x2
R
Capital 106 100
Drawings 12 500
Vehicles 55 000
Accumulated depreciation on vehicles 5 500
Equipment 30 000
Accumulated depreciation on equipment 3 000
Shares: JSE 8 500
Stock (1 April 20x1) 20 000
Debtors control 6 365
Creditors control 5 900
Bank 12 065
Cash float 380
Sales 126 766
Purchases 90 545
Consumable stores 725
Stationery expenses 1 934
Rent income 3 170
Wages 11 475
General expenses 947
Additional information
Stock on hand at 31 March 20x2 was R10 000.
Required
Prepare the financial statements for Hobbit Traders.
Solution
Statement of profit and loss and other comprehensive income of Hobbit Traders for
the year ended 31 March 20x2
R R
Sales 126 766
Opening stock 20 000
Add: Purchases 90 545
Goods available for sale 110 545
Less: Closing stock 10 000
Gross profit for the year 26 221
Add: Other income 3 170
Rent income 3 170
Gross income for the year 29 391
Consumable stores 725
Stationery 1 934
Wages 11 475
General expenses 947
Note: Since the business has no external financing, finance costs were not included in the
statement of profit or loss and other comprehensive income.
Statement of financial position of Hobbit Traders at 31 March 20x2
Assets Notes R R
Non-current assets 2 85 000
Vehicles 49 500
Equipment 27 000
Shares: JSE 8 500

Stock 10 000
Debtors 6 365
Bank 12 065
Cash float 380
Total assets 113 810
Equity and liabilities 107 910

Owner’s equity 107 910
Non-current liabilities –
Creditors 5 900
Statement of changes in equity of Hobbit Traders for the year ended 31 March 20x2
Capital R106 100

+ Net profit for the period R 14 310
– Drawings (R12 500)
R107 910
Notes of Hobbit Traders Stores for the year ended 31 March 20x2
Note 1: Accounting policies

The financial statements have been prepared in accordance with generally accepted
guidelines laid down in the International Financial Reporting Standards (IFRS). The
financial statements have used accounting policies that are consistent with previous
financial periods.
Note 2: Non-current assets
Cost Accumulated depreciation Book value/carrying value
R R R
Vehicles 55 000 5 500 49 500

Equipment 30 000 3 000 27 000
85 000 8 500 76 500
When the periodic method is used, there are various items that affect the purchases and
sales accounts.
Items affecting the purchases account are as follows:
Carriage on purchases
The cost of transporting goods purchased to the business premises is called “carriage on
purchases”, which increases the value of the purchases.
Alternative terms used for carriage on purchases are
railage on purchases
railage in
freight in.
Purchases returns
This item arises when a business returns goods previously purchased to the supplier.
Purchases returns decrease the value of the purchases.
The alternative term used for purchases returns is “returns outwards”.
Customs/import duties
This is the cost of bringing goods into the country.
Items affecting the sales account are as follows:
Sales returns
This item arises when clients return goods previously sold to them. Sales returns decrease
the value of the sales. The alternative term used for sales returns is “returns inwards”.
Carriage on sales
This is the cost incurred in transporting the goods sold to the client. Carriage on sales is
treated as a normal operating expense, that is, it is used in the calculation of the net
profit and not the gross profit. It does not increase the value of sales.
Note: Carriage on sales does not affect the sales account.
Alternative terms used for carriage on sales are
railage on sales
railage out
freight out.
Example 7 Periodic method items affecting purchases and sales

Below is an extract from the books of Black Traders as at 31 December 20x1, the end of
their financial period.
Sales R155 000

Purchases 82 000
Sales returns 5 000
Purchases returns 2 000
Carriage on purchases 3 000
Carriage on sales 1 500
Stock (1/1/20x1) 50 000
A physical stocktaking on 31 December 20x1 revealed that stock to the value of R45 000
was on hand.
Required
Calculate the gross profit for the period. Indicate how carriage on sales will be disclosed.
Solution
Calculation of gross profit for the period
R R
Net sales (R155 000 – R5 000) 150 000

Opening stock 50 000
Add: Net purchases (R82 000 – R2 000) 80 000
Add: Carriage on purchases 3 000
Goods available for sale 133 000
Less: Closing stock 45 000
Gross profit for the period 62 000
Note: Carriage on sales was not added to the sales figure and therefore had no effect on
the calculation of gross profit.
TUTORIAL EXERCISES
Exercise 1
Trade It Ltd has been in operation since 20x1. The business has been very profitable over
the last few years. It has retained a large portion of the market because of the high-quality
products that it sells. Its meticulous record-keeping has also assisted in timely decision
making.
The following transactions took place in the month of July 20x9:
1 The owner, Mr Retail, increased his capital contribution by R50 000.

2 The business premises require upgrades for which Mr Retail secured a loan from
Lend It Bank. The loan totalled R20 000 at an interest rate of 15% per annum.
4 Bought replenishment stock on credit from ABC Ltd totalling R11 748 and from XYZ
traders R10 447,50.
5 Sold goods for cash R1 340; cost of sales R1 072.
9 Sold goods on credit to C James R717; cost of sales R573,60.
10 Paid weekly wages R500.
13 Sold goods on credit to S. Blair totalling R486, cost of sales R388,80.
17 Paid weekly wages.
19 Bought stock for cash R2 000.
21 Received a cheque of R285 from C. James and allowed him a discount of R15.
Sold goods on credit to C. James R543; cost of sales R434,14.
24 Paid weekly wages.
28 Issued cheques to the following creditors:
ABC Ltd R8 820
XYZ Traders R7 350
and received a discount of R180 and R150 respectively.
29 Received payment from the following debtors:
S. Blair R462 discount allowed R24
C. James R608 discount allowed R32
Paid monthly interest on loan.
30 Paid the monthly rental of R2 000 to Maxre.
Paid the municipality R1 500 for water and electricity for the month.
Required
Assuming that Trade It Ltd uses the perpetual method to account for its stock, prepare the
following for the month of July 20x9:

Exercise 2
Using the same transactions provided in Exercise 1, prepare the following for the month of
July 20x9:

Assume that Trade It Ltd uses the periodic method to account for their stock.
Exercise 3
The accountant of Balance It Ltd has drafted the journals for the month of April 20x5.
Using the information from the journals, draft the debtors control and creditors control
accounts. Balance these accounts on 30 April 20x5.
Column totals of the journals on 30 April 20x5:
Cash receipts journal CRJ4

Sundry accounts Cost of sales Sales Debtors Discount allowed Bank
27 290 32 400 48 600 42 790 3 210 120 330
Cash payments journal CPJ4

Sundry Trading Wages Creditors Discount Bank
accounts stock received
8 440 16 800 4 000 76 590 4 040 104
490
Debtors journal DJ4

Sales Cost of sales
31 200 20 800
Creditors journal CJ4

Creditors Trading Equipment Stationery Packing Sundry
control stock material accounts
86 970 52 870 17 120 1 840 5 770 9 370
Creditors allowances journal CAJ4

Creditors Trading Equipment Stationery Packing Sundry
control stock material accounts
9 530 4 490 3 020 470 810 740
Exercise 4
Trial balance of Shiloh Clothing on 28 February 20x2
R
Capital 98 000
Drawings 14 500
Premises 70 000
Vehicles 12 500
Equipment 12 100
Loan PBS (17% p.a.) 8 000
Mortgage bond (15% p.a.) 10 000
Shares JSE 850
Accounts receivable 1 500
Accounts payable 14 500
Trading stock 13 250
Cash float 250
Bank 21 750
Sales 63 750
Cost of sales 42 500
Advertising 540
Bank charges 165
Dividends received 30
Interest paid 2 860
Electricity and water 160
Licence 225
Rent income 7 200
Wages 7 920
Stationery and postage 140
Telephone 270
Required
Prepare the annual financial statements of Shiloh Clothing.
Exercise 5
The trial balance of Simba’s Hardware Store on 30 June 20x2 is given below.
Debit R Credit R
Capital 121 000
Drawings 34 000
Loan: Helpful Bank 30 000
Vehicles 72 000
Equipment 67 300
Stock (1/7/20x1) 17 500
Debtors 8 400
Creditors 10 900
Bank 1 780
Cash float 250
Sales 197 320
Purchases 111 000
Carriage in 2 700
Advertising 4 600
Consumable stores 7 300
Hire income 2 200
Interest on loan 5 400
Salaries and wages 26 790
Stationery 500
Sundry expenses 1 900
361 420 361 420
The stock at 30 June 20x2 was R21 000.
Required
Draft the following financial statements:
a) The statement of profit or loss and other comprehensive income for the year ended 30
June 20x2
b) The statement of financial position at 30 June 20x2
5 Basic financial statements
with year-end adjustments
Outcomes
journalise the following adjustments:

– depreciation
– allowances for credit losses
– prepaid expenses
– accrued expenses
– accrued income
– income received in advance
draft the financial statements after the yea-end

adjustments have been taken
into account
make the closing transfers at the end of the accounting
period.
Chapter outline

5.1.1 Depreciation
5.2 Closing process
The following adjustments are made at year-end:
Depreciation
Prepaid expenses
Accrued expenses
Accrued income
Income received in advance/prepaid income
5.1.1 Depreciation
When a business buys an item such as a vehicle or equipment,
the cost is treated as an asset and not as an expense, which
decreases the owner’s equity.
These assets are acquired to be utilised over a period of years.
With use, the asset is likely to lose value through wear and
tear. This loss should be allocated to the financial year in
which the asset was used to generate income. For fair
presentation, this should be recorded as an expense for that
year and the value of the asset should be decreased
accordingly. This is done to match the income earned with the
expense incurred in earning that income.
This allocated expense is called depreciation. The basics that

underlie depreciation are the following:
The asset should be used to generate income in the course

of conducting business.
The expense should be fairly allocated over the lifetime of
the asset.
The asset should be fairly presented in the statement of
financial position, that is, at book value/carrying value.
Depreciation is an expense which affects the statement of

profit or loss and other comprehensive income; it is a non-
cash item, as no cheque is issued.
Example 1 Depreciation
A business has equipment which costs R10 000. Provide
for depreciation of R1 000 on equipment.
Solution
Two accounts are affected (double-entry principle):
1. Depreciation (an expense which appears in the
statement of profit or loss and other comprehensive
income)
2. Accumulated depreciation on equipment (a negative
asset which appears in the statement of financial
position)
Debit Credit
Depreciation (+) R1
000
Accumulated depreciation on R1
equipment (+) 000
Methods of calculating depreciation

There are many ways of calculating depreciation, but for
the purpose of this book we will only be covering two
methods, namely the straight-line method and the reducing
balance method.
The straight-line method. This method is also known as

the cost method or fixed instalment method. In terms of
this method an equal or fixed amount of depreciation is
written off each year. The depreciation to be written off
each year is calculated as a fixed percentage of the cost
of the asset.
The reducing balance method. This method is also
known as the diminishing balance method. This is an
accelerated method because more depreciation is
written off in the earlier years. The reason for this is that
the asset is likely to require more repair expenses in
later years. In this way the costs are smoothed out over
the lifetime of the asset. The depreciation to be written
off each year is calculated as a fixed percentage of the
book value/carrying value (cost less accumulated
depreciation) of the asset.
Example 2 Depreciation
The following balances were extracted from the books of
SS Stores as at 28 February 20x2:
Vehicles at cost R120 000

Accumulated depreciation on vehicles R33 300
Equipment at cost R70 000
Accumulated depreciation on equipment R42 000
Adjustments
1. Depreciation on vehicles must be provided for at 15%

per annum using the reducing balance method.
2. Depreciation on equipment must be provided for at
10% per annum using the fixed instalment method.
Required
Prepare the journal entry for depreciation and indicate how
the following will be shown in the statement of profit or loss
and other comprehensive income, as well as the statement
of financial position:
Accumulated depreciation on vehicles

Accumulated depreciation on equipment
Depreciation
Solution
Workings:
Calculation of depreciation on vehicles
Book value = Cost – Accumulated depreciation on

vehicles
= R120 000 – R33 300
= R86 700
Depreciation= Book value × 15%
= R86 700 × 15% = R13 005
Calculation of depreciation on equipment
Cost = R70 000
Depreciation= R70 000 × 10% = R7 000
Total depreciation for the period is therefore R13 005 +

R7000 = R20 005
Debit Credit
Depreciation (+) (R13 005 + R7 000) R20
005
Accumulated depreciation on vehicles R13
(+) 005
Accumulated depreciation on R7
equipment (+) 000
Statement of profit or loss and other comprehensive

income
Less: Operating expenses

Depreciation (R13 005 + R7 000) R20 005
Non-current assets
Accumulated depreciation on vehicles (R33 300 + R13
005) = R46 305
Accumulated depreciation on equipment (R42 000 + R7
000) = R49 000
TUTORIAL EXERCISE Year-end adjustments:

depreciation
Exercise 1
The following balances were extracted from the books of
TKZ Stores as at 30 June 20x2.
Furniture and fittings at cost R42

000
Accumulated depreciation on furniture and R6 300
fittings
Vehicles at cost R35
000
Accumulated depreciation on vehicles R18
000
Adjustments
1. Depreciation on vehicles must be provided for at 20%

per annum using the straight-line method.
2. Depreciation on furniture and fittings must be provided
for at 15% per annum using the reducing balance
method.
Required
Prepare the journal entry for depreciation and indicate how
the following will be shown in the statement of profit or loss
Accumulated depreciation on furniture and fittings

Accumulated depreciation on vehicles
Depreciation

When preparing financial statements, the accountant will be
conscious of the fact that some of the debtors included in the
debtors control balance are unlikely to settle their accounts;
they are doubtful debts.
It would be prudent for the accountant to provide for this

eventuality and reflect a reduced amount for debtors in the
statement of financial position. By providing for the
anticipated credit losses, the accountant will avoid giving the
reader of the financial statements a misleading impression of
the value of the business assets. This is in line with the
accounting concept called prudence (the doctrine of
conservatism).
In providing for these anticipated credit losses or doubtful

debts, the accountant will also be attempting to ensure the
satisfactory matching of the year’s income from credit sales
with the expenses incurred in earning that income (debts not
settled).
The accountant must anticipate the percentage of debtors who
are in doubt. How much to provide for doubtful debts is
usually based on past experience and the economic climate.
The following are typical transactions encountered with regard

to doubtful debts:
Writing off credit losses when an allowance for credit losses

account does not exist
The creation of an allowance for credit losses
Increasing the allowance for credit losses
Decreasing the allowance for credit losses
Writing off credit losses when an allowance for credit losses
account does exist
Note: Since the allowance for credit losses is merely an

estimate, it is likely that this estimate will not be 100%
correct; consequently from year to year this estimate will have
to be adjusted; that is, either increased or decreased.
5.1.2.1 Writing off credit losses when an allowance

for credit losses account does not exist
Debit: credit losses (expense item) will increase.
Credit: debtors control (current asset) will decrease.
5.1.2.2 The creation of an allowance for credit losses

Credit: allowance for credit losses (negative asset) will
increase.
5.1.2.3 Increasing the allowance for credit losses

Credit: allowance for credit losses (negative asset) will

increase.
5.1.2.4 Decreasing the allowance for credit losses

Debit: allowance for credit losses (negative asset) will
decrease.
Credit: credit losses (expense item) will decrease.
5.1.2.5 Writing off credit losses when an allowance

for credit losses account does exist
Debit: allowance for credit losses (negative asset) will
decrease.
Credit: debtors control (current asset) will decrease.
ILLUSTRATIVE EXAMPLE Allowance for credit

losses
The following balances appeared among others in the

books of EE Traders at 30 June 20x3, the last day of the
financial year:
Debtors R50 700

Allowance for credit losses R2 500
Adjustments
1. J. James, who owes the business R700, has been

declared insolvent and his debt must be written off.
2. Adjust the allowance for credit losses to 8% of
outstanding debtors.
Required
Prepare the journal entry and indicate how the following
accounts will be shown in the statement of profit or loss
Debtors control
Credit losses
Solution
Step 1
Before the allowance for credit losses account can be
adjusted, any outstanding credit losses must be written off.
Since the allowance of credit losses account exists, the
journal entry is as follows:
Debit Credit
Allowance for credit losses R700
Debtors control R700
Step 2
After writing off credit losses, adjust the allowance for
credit losses to 8% of outstanding debtors. The calculation
is as follows:
Outstanding debtors are = R50 000 (R50

700 – R700)
Allowance for credit losses should be = R4 000 (R50
8% of outstanding debtors 000 × 8%)
Currently the allowance for credit losses = R1 800 (R2 500
is – 700)
Therefore the allowance for credit losses must be

increased by R2 200 in order to equal R4 000 (i.e. R4 000
– R1 800 = R2 200).
Increasing the allowance for credit losses
Journal entry
Debit Credit
Credit losses R2 200
Allowance for credit losses R2 200
Change (increase) in the allowance for credit losses by R2

200.
In conclusion, the balances/totals on the above accounts
are as follows:
Debtors control R50 000 (current asset)

Allowance for credit losses R4 000 (negative asset)
Credit losses R2 200 (expense item)

income
Credit losses R2 200
Statement of financial positio

Current assets R46 000
Debtors R50 000
Less: Allowance for credit losses R4 000
TUTORIAL EXERCISE Year-end adjustment:

allowance for credit
losses
Exercise 2
The following balances appeared among others in the
books of ZZ Traders at 28 February 20x1, the last day of
the financial year:
Debtors control R58

account 200
Allowance for credit R2
losses 150
Credit losses R9
360
Adjustments
1. I. Isaac, who owes the business R640, has been

declared insolvent and his debt must be written off.
2. Adjust the allowance for credit losses to 5% of
Required
Prepare the journal entry and indicate how the following
accounts will be shown in the statement of profit or loss
and other comprehensive income and the statement of
financial position:
1. Debtors control
2. Allowance for credit losses
3. Credit losses

Prepaid expenses refer to payments that you have made in one
accounting period even though some of them are only due in
the next accounting period. Even though the expense was
made in full, only the part due for payment in the current
accounting period should be matched to the income of the
current accounting period.
The following information was extracted from the records

of ABC Traders for the financial year ended 28 February
20x1:
Insurance R13 000

Additional The insurance was paid until 31 March
information 20x1
Required
Prepare the journal entry and show the effect of the
transaction on the statement of profit and loss and other
comprehensive income, as well as the statement of
financial position.
Journal entry
Debit Credit
Prepaid expenses 1 000
Insurance 1 000
Notes: The insurance was paid from 1 March 20x0 to 31

March 20x1 (13 months). Therefore the insurance per
month equals R1 000 (R13 000/13 months). The amount of
R1 000 which relates to the next accounting period, but
has been paid in the current accounting period, is the
prepaid expense. The insurance is an expense account
that is credited because it must decrease, and the prepaid
expense is debited because it is an asset account which
increased.

income
Insurance (R13 000 – R1 000) R12 000

Current assets
Prepaid expenses R1 000
These refer to expenses that have been incurred in the current
accounting period, but have not been paid for. These expenses
have to be written off against the income of the current
accounting period, even though they have not yet been paid.

20x1.
Water and R5 500

electricity
Additional The water and electricity for February
information 20x1 is still due
Required
financial position.
Journal entry
Debit Credit
Water and electricity 500
Accrued expenses 500
Notes: The water and electricity was paid from 1 March

20x0 to 31 January 20x1 (11 months). Therefore the water
and electricity per month equals R500 (R5 500/11 months).
The amount of R500 which relates to the current
accounting period, but has not been paid, is the accrued
expense. Water and electricity is an expense account that
is debited because it must increase, and accrued
expenses is credited because it is a liability account which
increased.

income
Less:Operating expenses
Water and electricity (R5 500 + R6
500) 000

Current liabilities
Accrued expenses R500

This refers to income that you have earned during the current
accounting period, but have not yet received. This income
must be recorded in full in the current accounting period, even
though it has not yet been received.

20x1.
Rent received R22 000
Additional The rent has only been received for 11
information months
Required
financial position.
Journal entry
Debit Credit
Accrued income R2 000
Rent R2 000
Notes: The rent was received from 1 March 20x0 to 31

January 20x1 (11 months). Therefore the rent per month
equals R2 000 (22 000 / 11 months). The amount of R2
000, which has not been received, relates to the current
accounting period, and is accrued income. Rent is an
income account that is credited because it must increase,
and accrued income is debited because it is an asset
account which increased.

income
Add: Other income
Rent (R22 000 + R2 000) R24 000

Current assets
Accrued income R2 000

This refers to income that you have received in advance (that
is, before it is due). In terms of the matching principle only the
income generated for the current accounting period should be
recorded in the statement of profit or loss and other
comprehensive income and the prepaid amount should be
deferred or transferred to the next accounting period as a
current liability in the statement of financial position.

20x1.

Additional The rent received includes March
information 20x1
Required
financial position.
Journal entry
Debit Credit
Income received in advance R2 000
Notes: The rent was received for 1 March 20x0 to 31

March 20x1 (13 months). Therefore the rent per month
equals R2 000 (26 000/13 months). The amount of R2 000
which has been received in advance relates to the next
accounting period and is income received in advance. Rent
is an income account that is debited because it must
decrease, and income received in advance is credited
because it is a liability account which increased.

income
Add: Other income
Rent (R26 000 – R2 000) R24 000

Current liability
Income received in advance R2 000
5.2 Closing process
Once all the year-end adjustments have been dealt with, the
closing-off process takes place. The purpose of this process is
to close off all the income and expense accounts for the
period, in order to determine the profit or loss for the period.
No totals remain in these accounts and a clean start can be
made in the next financial period. The main accounts involved
in this process are the trading account, and the profit and loss
account. The closing-off process is summarised in steps 1 to 4.
Step 1: Close off the sales and cost of sales accounts to the
trading account, in order to determine the gross profit for the
period.
Trading account
Cost of sales xxx Sales xxx
Profit and loss xxx
account (gross profit)
xxx xxx
Step 2: Transfer the gross profit calculated in the trading

account to the profit and loss account.
Step 3: Close off all the income and expense accounts to the
profit and loss account, and determine the net profit or loss for
the period.
Step 4: The net profit is transferred to the capital account,

since it belongs to the owner.
Profit and loss account

All expense xxx Trading (gross profit)
xxx
accounts
Capital (net profit) xxx All income accounts xxx
xxx xxx
TUTORIAL EXERCISES
Exercise 3
Indicate in the spaces below whether the following
accounts must appear in the statement of profit or loss and
other comprehensive income, or the statement of financial
position:
Purchases Loan: ABC Bank

Prepaid income Depreciation (year)
Debtors Refreshments
Wages Equipment
Rent paid Accumulated depreciation
Interest received Drawings
Unused Prepaid expenses
stationery
Accrued income Accrued expenses
Exercise 4
The following balances are extracted from the ledger of
Pretty Princess Delivery Services on 31 December 20x1:
R
Office equipment at cost 5 000
Delivery vehicle at cost 17 000
Cash in bank 36 000
Debtors 20 000
Stock of spares 15 000
Insurance paid in advance 3 000
Capital 30 000
Drawings 3 000
Creditors 30 500
Salaries 6 000
Municipal costs 1 500
Rental paid 3 000
Fees received for services rendered 49 000
ADDITIONAL INFORMATION
1. Spares costing R10 000 were used during the year.

2. Depreciation must be provided as follows:
Office equipment R1 500

Delivery vehicle R7 000
3. Interest owing to creditors amounted to R750.

4. Only R2 000 of the insurance paid in advance has
expired.
Required
Draft a statement of profit or loss and other comprehensive
income, as well as a statement of financial position for
Pretty Princess Delivery Services.
Exercise 5
The following balances were, inter alia, taken from the
ledger of Hot Chicks on 28 February 20x3.
R
Purchases 364 965
Discount received 3 690
Rates and taxes 4 320
Rent received 13 200
Sales 564 369
Telephone 3 622
Stationery 2 913
Returns inwards 5 729
Furniture at cost 24 364
Allowance for credit losses 3 600
Returns outwards 2 984
Accumulated depreciation on furniture 1 464
Accumulated depreciation on plant 13 000
Repairs 995
Insurance 1 985
Credit losses 1 365
Debtors 74 965
Drawings 14 360
Plant at cost 73 000
Stock (1/3/02) 36 982
1. Stock on 28 February 20x3 amounted to R42 029.

2. Provide depreciation as follows:
Furniture – 10% per annum on reducing balance
method
Plant – 20% per annum on straight-line method
3. Write off a debtor to the value of R965 as irrecoverable.
4. Adjust the allowance of credit losses to 5% of
Required
Prepare a statement of profit or loss and other
comprehensive income for the year ended 28 February
20x3.
Exercise 6
The following information relates to the trial balance of
Speedy Dealers on 31 December 20x1.
Debit Credit
R R
Capital 500 000
Cash at bank 11 900
Buildings 360 000
Vehicles 240 000
Furniture 30 000
Salaries 77 000
Electricity and water 6 600
Sales 507 230
Purchases 341 000
Carriage on purchases 800
Sales returns and allowances 1 230
Purchases returns and 1 100
allowances
Commission received 960
Rent received 5 720
Insurance 5 500
Packing material 1 600
Drawings 8 800
Credit losses 460
Opening inventory 8 000
Debtors 80 280
Creditors 101 500
Accumulated depreciation: 52 000
Vehicles
Accumulated depreciation: 6 000
Furniture
1 174 1 174
510 510
1. Inventory on 31 December 20x1:
Trading stock R13 000

Packing material R350
2. Debtor P. Jabu is insolvent; his debt of R240 has to be

written off as irrecoverable.
3. An employee is on leave and his January salary of R3
000 has been paid to him in advance.
4. Delivery fees of R100 on purchases have not yet been
paid.
5. An insurance premium of R500 per month has been
paid until the end of November 20x1.
6. Rent has been received until the end of January 20x2.
7. Commission to the value of R1 760 was earned on 28
December 20x1. This amount is still outstanding.
8. Provision must be allowed for depreciation as follows:
Vehicles R31 500

Furniture R2 500
Required
Draft a statement of profit or loss and other comprehensive
income, and a statement of financial position for Speedy
Dealers.
Exercise 7
The following are taken from the pre-adjustment trial
balance of Valerie Irons, a general dealer, on 31 December
20x4.
R
Capital 39 000
Drawings 7 000
Carriage on sales 582
Insurance 150
Rates 270
Railage on purchases 540
Telephone 250
Repairs 400
Stationery and printing 208
Discount allowed 180
Discount received 120
Rent received 440
Inventory 1/1/20x4 8 370
Purchases 26 850
Sales 50 682
Returns inwards 190
Returns outwards 220
Trade debtors 6 130
Bond on land and buildings 10 000
Bank overdraft 1 200
Cash on hand 467
Trade creditors 2 375
Bills payable 3 800
Bills receivable 700
Furniture and fittings 6 400
Land and buildings 43 000
Accumulated depreciation on furniture 1 000
Allowance for credit losses 150
1. Inventory at 31 December 20x4 was R9 560.

2. On checking debtors accounts it was found that debts
of R130 must be written off.
3. Adjust the allowance for credit losses to 5% of debtors.
4. Calculate the depreciation on furniture and fittings at
10% per annum on the diminishing balance method.
Required
7.1 Prepare the statement of profit or loss and other
comprehensive income for the year ended 31
December 20x4.
7.2 Prepare the statement of financial position at 31
December 20x4.
Exercise 8
The following information was obtained from the
accounting records of Nitro Traders on 28 February 20x6,
the end of the accounting period of the entity.
Pre-adjustment trial balance of Nitro Traders on 28
February 20x6
Debit Credit
R R
Capital 66 100
Drawings 16 000
Vehicles (at cost price) 100
000
Equipment (at cost price) 40 000
Accumulated depreciation on 36 000
vehicles
Accumulated depreciation on 8 000
equipment
Loan: Zuza Bank 20 000
Bank 4 300
Fixed deposit: Zuza Bank 15 000
Debtors control 5 200
Trading inventory (1 March 20x5) 10 000
Creditors control 4 100
Sales 250
000
Purchases 153
600
Carriage on sales 550
Rent expense 15 600
Stationery 3 800
Insurance 4 800
Rates and taxes 350
Credit losses 400
Telephone 1 980
Water and electricity 10 800
Commission received 180
Rental income 2 200
ADJUSTMENTS
1. A physical stocktaking on 28 February 20x6 showed

the following:
Stationery on hand R200
Inventory on hand R17 800
2. Depreciation must be provided for as follows:
Vehicles – 20% per annum on the cost price
Equipment – 10% per annum on reducing balance
method
3. The loan from Zuza Bank was obtained on 31
December 20x5. Interest was payable at the end of
each six months at 15% per annum. As yet, no interest
has been paid.
4. A fixed deposit was made on 1 September 20x5. The
interest rate amounted to 10% per annum. As yet, no
interest has been received.
5. An additional amount of R200 must be written off as
irrecoverable.
6. Insurance included an amount of R1 800 in respect of
additional insurance taken out and paid for, for the
period 1 January 20x6 to 31 December 20x6.
7. Rental income of R200 was received in advance.
Required
8.1 Prepare the statement of profit or loss and other
comprehensive income for the year ended 28
February 20x6.
8.2 Prepare the statement of financial position at 28
February 20x6.
6 Company financial statements and
their analysis and interpretation
Outcomes
At the end of this chapter students should
have an understanding of company terminology

be able to draft a statement of comprehensive income and a statement
of financial position for a company
be able to calculate selected liquidity, efficiency and profitability ratios
and interpret the results of these ratios.
Chapter outline
6.1 Introduction
6.2.1 Share capital
6.2.2 Share premium
6.2.4 Reserves
6.3 Company financial statements (statement of comprehensive income
and statement of financial position)
6.8 Solvency ratios
6.1 Introduction
Companies were introduced in Chapter 1. In this chapter we will cover

vari-ous company terminology and financial statements. We will also
cover the analysis and interpretation of company financial statements
using ratio analysis.
In 2011, the government adopted new Companies Act Regulations under

the Companies Act of 2008 that prescribe the reporting frameworks based
on each individual company’s public interest score. Entities that are
currently reporting under Statements of Generally Accepted Accounting
Practice (SA GAAP) are required to move to either IFRS (International
Financial Reporting Standards) or IFRS for SMEs, as SA GAAP is no
longer available for use in respect of financial years commencing on or
after 1 December 2012. The International Accounting Standards Board
(IASB) has provided several exceptions to entities to ease the transition to
either IFRS or IFRS for SMEs.
The main difference that distinguishes a company from other forms of

ownership is its limited liability; that is, the owner’s personal assets are
protected. This makes it possible to raise large amounts of capital. Other
benefits to shareholders include the transferability of shares and the
continued existence of the company, even with changes in ownership.
The Companies Act of 2008 specifies the rules and regulations for
companies from registration to deregistration and provides for the
formation of two types of companies, namely a profit company and a non-
profit company.
PROFIT COMPANIES
These are companies that are incorporated for the purpose of financial gain
for their shareholders. Profit companies are further subdivided into five
types:
State-owned company (SOC)

Private company (Pty) Ltd
Public company (Ltd)
Personal liability company (Inc.)
External company (foreign companies, incorporated outside the
Republic of South Africa)
We will focus only on public companies (Ltd) and private companies (Pty)
Ltd. The main difference is that only the public company may apply for a
listing of its shares on the JSE and can sell shares to the general public. In
public companies, management does not rest with the shareholders;
instead, shareholders appoint directors to manage the company. In private
companies, the owners retain control of the management of the company
and are also normally the directors of the company. The Companies and
Intellectual Properties Commission (CIPC) is the place where company
documents are available for public inspection.
A company is incorporated by lodging the Notice of Incorporation and

Memorandum of Incorporation (MOI). The MOI is a document that sets
out the rights, duties and responsibilities of the directors, shareholders and
others that have a relationship with the company.
6.2.1 Share capital

Once a company has been formed, capital can be raised by issuing shares.
This is known as share capital. We have what is known as authorised share
capital and issued share capital.
6.2.1.1 Authorised share capital

This is the amount of share capital that the company is authorised to issue
according to the CIPC. The authorised share capital must state specifically
the types of share, for example preference or ordinary, and the number of
shares, as well as the par value / nominal value of the shares. The company
can issue all or only part of this capital as it wishes.
6.2.1.2 Issued share capital

This is the amount of the authorised share capital that the company has
actually issued.
6.2.2 Share premium

If the company has been making good profits, it may choose to issue
shares for more than the nominal value (the original price of the shares).
This extra money generated is known as the share premium. For example,
the nominal value of a share is R1,00 but the company issues the shares for
R1,50 each. The extra 50 cents generated per share is the share premium.
This is seen as a capital profit on the sale of the shares.

The shareholders of the company receive a share of the profits in the form
of dividends. The dividends they receive are dependent on the type of
share they have purchased, as well as the company’s dividend policy.
6.2.3.1 Preference shares

Holders of these shares receive a fixed rate dividend every year and have
preferential rights over and above those of ordinary shareholders, that is,
they must be paid their dividends first. These shareholders do not have
voting rights. There are various types of preference shares, which will not
be covered in this book.
6.2.3.2 Ordinary shares

Holders of these shares do not receive a fixed dividend each year. The
dividend received fluctuates according to the company’s prosperity and
dividend policy. The owners of these shares have voting rights and rank
after preference shareholders for certain rights, for example a payout on
liquidation of the company.
6.2.4 Reserves
The equity of a company consists of share capital and reserves. Reserves
are essential profits that are retained within the business and can be used
for expansion of the business, for example to purchase new machinery,
inventory, etc. There are two types of reserves, non-distributable and
distributable.
6.2.4.1 Non-distributable reserves

These reserves are non-trading profits which are not available for
distribution to shareholders as a dividend. They are recorded in the
financial statements as share capital and share premium.
6.2.4.2 Distributable reserves

This refers predominantly to retained earnings. This figure is adjusted
every year with that amount in the statement of comprehensive income
that is not spent on expenses and dividends.

Companies are treated as separate legal entities and are therefore liable for
taxation (as opposed to sole traders and partnerships, which are not
separate from their owners).
Once the profits have been calculated, the first slice must go to the
Receiver of Revenue in the form of taxation.
Thereafter, profits are divided between reserves and dividends, with the
remainder being retained in the company (as retained earnings).
Ordinary shareholders have no rights to profits. They only receive a share
of the profits if the directors declare a dividend. In other words, the
payment of a dividend is not automatic. Proposed dividends mean that the
company still has to pay out the amounts that it has estimated for the
financial year-end to the relevant parties.
6.3 Company financial statements (statement of

comprehensive income and statement of
financial position)
Example 1
Receiver of Revenue (income tax)
This is a current liability and will therefore appear in the statement of
financial position.
Income tax
This is an expense and will therefore appear in the income statement.
Shareholders for dividends
This is a current liability and will therefore appear in the statement of
financial position.
Dividend on ordinary shares
This is an expense and will therefore appear in the income statement.
Retained income / earnings
This is part of the shareholders’ equity and will therefore appear in the
statement of financial position.
Below is a list of transactions that must be analysed according to the
accounting equation. Note transactions 1–6 build upon each other:
Transaction 1: Made two provisional tax payments of R20 000 each,

one in June and one in December. (Assume that the
balance in the bank account on 1 January was R50
000.)
Transaction 2: The total income tax for the year in accordance with
the tax assessment was estimated to be R43 800.
Transaction 3: The company has 100 000 ordinary shares of R1 each
in issue. An interim dividend of 5 cents per share was
declared and paid to shareholders.
Transaction 4: The directors recommended a final dividend of 7 cents
per share.
Transaction 5: The balance on the retained income account from last
year was R25 000.
Transaction 6: The net profit / income for the year amounted to R75
000.
Transaction 1: Made two provisional tax payments of R20 000

each for the year.
How to treat a provisional tax payment
Current government legislation requires companies to make provisional
tax payments to the Receiver of Revenue during the financial year. The
first provisional tax payment is made six months after the beginning of
the accounting period.
The second provisional tax payment is made at the end of the
accounting period and the same accounting treatment will apply as for
the first provisional payment.
June
Transaction Assets = + Account Account

Owner’s Liabilities debit credit
equity
1 – 20 – 20 000 Receiver Bank
000 of
Revenue
December

equity
1 – 20 – 20 000 Receiver Bank
000 of
Revenue
Transaction 2: The total income tax for the year in accordance

with the tax assessment was estimated to be R43 800.
How to treat a tax assessment
The tax assessment for the year indicates the amount of tax the
company must pay for the year, that is, the tax expense for the year.

equity
Previous – 40 – 40 000 Receiver Bank
transaction 000 of
1 Revenue
2 – 43 800 + 43 800 Income Receiver
tax of
(expense) Revenue
Bal/totals – 40 – 43 800 + 3 800
000
Extract from the statement of comprehensive income
(inclusive of transactions 1–2 only)

Income tax 43 800
The income tax expense of R43 800 for the year is shown in the
income statement.
Extract from the statement of financial position
Current assets
Bank R10 000 (R50 000 – R40 000)
Current liabilities
Receiver of Revenue R3 800
The balance of R10 000 represents what is left in the bank account
after making the two provisional tax payments.
The balance of R3 800 in the Receiver of Revenue (income tax)
account reflects the amount still owed to the Receiver.
Transaction 3: The company has 100 000 ordinary shares of R1

each in issue. An interim dividend of 5 cents per share was
declared and paid to shareholders.
How to treat an interim dividend
If the company is in a sound financial position, the directors have the
right to declare and pay interim dividends during the year. Interim
dividends must be taken into account when the final dividend for the
year is determined.
When dividends are declared, it implies that the company has just
created a liability. Once these dividends have been paid out, they are
converted into an expense. Dividends may only be declared out of
profits available for distribution after provision has been made for
income tax due.
Calculation: 100 000 shares × 0,05 = R5 000

equity
3 –5 – 5 000 Dividends Bank
000 on
ordinary
shares

Income tax R43 800
Dividends on ordinary shares R5 000
Current assets
Bank R5 000 (R10 000 – R5 000)
Current liabilities
Transaction 4: The directors recommended a final dividend of 7

cents per share.
How to treat a declaration of a final dividend
A final dividend is declared at the end of the accounting period, but has
not yet been paid to the shareholders.
Calculation: 100 000 shares × 0,07 = R7 000

equity
Previous –5 – 5 000 Dividends Bank
transaction 000 on
3 ordinary
shares
4 – 7 000 – 7 000 Dividends Shareholders
on for dividends
ordinary
shares
Bal/totals –5 – 13 000 + 7 000
000

Income tax R43 800
Dividends on ordinary shares R12 000 (R5 000 + R7 000)
Current assets
Bank (R10 000 – R5 000) R5 000
Current liabilities
Shareholders for dividends R7 000
The balance of R7 000 on the shareholders for dividends account

reflects the amount still owing to shareholders. The R5 000 interim
dividend is not shown, since it has been declared and paid.
Transaction 5: The balance on the retained income account from

last year was R25 000.
Transaction 6: The net profit/income for the year amounted to R75

000.
How to appropriate/distribute the net profit earned and how to
determine the amount of net profit that is retained for the year
Once the profits have been calculated, the first slice must go to the
Receiver of Revenue in the form of taxation.
Thereafter, profits are divided between reserves, preference dividends
and ordinary dividends, and the remainder is retained in the company
(as retained earnings).
(calculation of net profit retained for the year)
Net profit before taxation 75 000

Less: Taxation 43 800
Net profit after taxation 31 200
Less: Dividends on ordinary shares 12 000
Net profit retained for the year 19 200
Add: Net profit retained at the beginning of the year 25 000
Net profit retained for the year 44 200
Current assets
Bank (R10 000 – R5 000) R5 000
Current liabilities
Shareholders for dividends R7 000
Example 2
The following trial balance has been extracted from the books of
account of Ben Ltd as at 31 December 20x0:
Debit Credit
Administrative expenses 2 370 000
Authorised and issued shares
Ordinary shares of R1 each 800 000
10% preference shares of R1 each 200 000
Trade and other payables 1 580 000
Trade and other receivables 2 790 000
Selling and distribution expenses 900 000
Investment 700 000
Interest income 120 000
Furniture and fittings (carrying value) 60 000
Plant and equipment (carrying value) 3 000 000
Interim ordinary dividends paid 80 000
Preference dividends paid 10 000
Retained profit (1 January 20x0) 3 000 000
Purchases 8 000 000
Sales 13 200 000
Share premium 380 000
Inventory (1 January 20x0) 2 000 000
19 910 000 19 910 000
1. Stock at 31 December 20x0 is R2 400 000.

2. Taxation based on the profit for the year is estimated at R530 000.
3. The directors proposed a final ordinary dividend of R0,20 per
ordinary share. (Remember the preference dividend as well.)
Required
Prepare the financial statements of Ben Ltd.
Solution
Ben Ltd
Statement of comprehensive income for the year ended 31
December 20x0
Sales 13 200 000

Cost of sales (7 600 000)
Gross profit 5 600 000
Operating expenses (3 270 000)
Operating profit 2 330 000
Interest and other income 120 000
Earnings before interest and taxation (EBIT) 2 450 000
Taxation (530 000)
Net profit after taxation 1 920 000
Preference dividends (10 + 10) (20 000)
Earnings available to ordinary shareholders 1 900 000
Ordinary dividends (80 + 160) (240 000)
Retained profit for the year 1 660 000
Retained profit (1 January 20x0) 3 000 000
Retained profit (31 December 20x0) 4 660 000
Ben Ltd
Statement of financial position as at 31 December 20x0
R R
Assets
Non-current assets 3 760
000
Property, plant and equipment 3 060
000
Other investment 700 000

000
Inventory 2 400
000
Trade and other receivables 2 790
000
Total assets 8 950
000
Shareholders equity
Authorised and issued share capital 1 000
000
Ordinary shares 800 000
10% preference shares 200 000

Retained profit 4 660
000

000
Trade and other payables 1 580
000
Receiver of Revenue 530 000
Shareholders for dividends (160 + 170 000
10)
000
Analysis is the process of examining the information on the financial

statements. Interpretation is using the analysed information to make
informed business decisions. This is considered the last phase in the
accounting cycle.
The aim of analysing the financial statements is to assess the financial

health of the business and to assist management in making informed
decisions in areas such as profit planning, pricing, working capital
management, financial structure and so on. The historical data contained in
the financial statements is used as the basis for evaluating the future
prospects of the company.

The information obtained from analysing the financial statements must be
compared with a benchmark so that the information can be interpreted
and evaluated. Possible benchmarks for comparison are as follows:
previous years, budgets, similar companies, industry results or other
accepted norms.

Financial statements may be analysed using the following methods:
Comparisons of financial statements

– Comparative financial statements compare the financial statements
for a required period of time, for example five or 10 years. The trend
over the years can then be calculated and analysed.
– Indexed financial statements – the first year is shown as the base
year (set as 100%) and the subsequent years and figures are shown as
percentages of that year. This gives the reader a good overview of the
growth or decline from the base year to a certain date.
– Common size statements – each item on the statements is stated as a
percentage of the total of the specific section. For example, in the
statement of financial position, current and non-current assets will be
stated as a percentage of the total assets; in the statement of profit or
loss and other comprehensive income, the figures will be stated as a
percentage of revenue.
Ratio analysis: it compares items or examines the relationships

between items on a financial statement. Ratios illustrate relationships
between different aspects of an organisation’s operations and provide
relative measures of the financial condition and performance of the
organisation. Ratio analysis can be performed using time-series or
cross-sectional analysis, or a combination of both:
– Cross-sectional analysis involves the comparison of different firms’

financial ratios at the same point in time.
– Time-series analysis involves the comparison of a company’s current
to its past performance and the evaluation of developing trends.
Calculation of ratios
– Liquidity ratios
– Efficiency ratios
– Profitability ratios
– Solvency ratios
Only selected ratios will be covered in more detail. Financial ratios are a
quick and easy way of assessing a business’s financial state. A ratio
expresses the relationship between two figures on the financial statements.
An organisation’s liquidity is very important to its operations. Lenders and

suppliers who provide products and services on credit are concerned about
these ratios. Liquidity ratios indicate the ability of the organisation to
generate and conserve cash from its working capital in order to meet its
short-term debts. Working capital refers to the current assets and current
liabilities, which are directly related to the operating activities of an
organisation.
Ratio Formula What does the ratio measure?

1. Current assets
It indicates the business’s ability to
Current liabilities
Current settle short-term obligations (current
ratio liabilities) using short-term assets
(current assets).
2. Quick Current assets – Inventory
The quick ratio is basically the
ratio/acid current ratio excluding stock, as
Current liabilities
test ratio stock is the hardest to convert into

cash in the short term. It measures
the immediate debt-paying ability of
the company.
These ratios measure how efficiently assets and liabilities have been
utilised within the business. These ratios can calculate the turnover of
receivables, the repayment of liabilities and the general use of inventory
and machinery.

1. Debtors Credit sales
The debtors turnover ratio
Trade receivables
turnover indicates the number of times
debtors are covered by credit
sales.
2. Trade receivables
× 365 This ratio shows how long
Credit sales
Receivable debtors take to pay in days.
days
(debtors’
collection
period)
3. Inventory Cost of sales
This ratio indicates how many
Inventory
turnover times inventory on hand has
been sold during the year. This
ratio may indicate whether there
is an over- or under-investment
in inventory.
4. Days' Inventory
× 365 This ratio indicates how many
Cost of sales
inventory on days inventory spends on the
hand shelf before it is sold. A long
shelf life is not good for liquidity
because it ties up cash.
5. Creditors Credit purchases
The credit turnover ratio
Trade payables
turnover indicates how many times
creditors are paid during the
year.
6. Payable Trade payables
× 365
This ratio indicates how long in
Credit purchases
days days the business takes to repay
(creditors’ the creditors. Dramatic increases
payment in this ratio may indicate liquidity
period) problems.
Note: Where the average value can be calculated if the opening and closing
value is given, then the average value must be used in the ratio.
Profit is an important measure of an organisation’s success. An

organisation needs profit to survive, as well as to ensure continued support
and funding from equity and debt providers. Profitability ratios deal with
the return of profit on the capital invested in a company.
Ratio Formula What does

the ratio
measure?
Gross Gross prof it
×
100 The gross
profit profit margin
Revenue 1
margin ratio
expresses
the gross
profit as a
percentage
of revenue.
the ratio
measure?
Operating Operating prof it
×
100 The
profit Revenue 1
operating
margin profit is the
net profit
after
accounting
for operating
expenditure
but before
finance cost,
tax and
investment
income. The
operating
profit margin
is the
operating
profit
expressed as
a percentage
of revenue.
Net profit Prof it af ter tax
×
100
The net profit
Revenue 1
margin margin
expresses
the net profit
as a
percentage
of revenue. It
looks at the
relationship
between
profits
earned and
sales
generated.
the ratio
measure?
Return on Net prof it bef ore interest and tax
×
100 This ratio
assets indicates
Total assets 1
whether the
assets of the
business are
being used
effectively to
produce a
reasonable
profit.
Return on Net prof it af ter tax and pref erence dividends
×
100 The return on
equity equity ratio
Ordinary shareholders’ equity 1
expresses
the
relationship
between the
profit
attributable to
ordinary
shareholders
and the
capital
invested by
ordinary
shareholders.
the ratio
measure?
Return on Net prof it bef ore interest and tax
×
100 The return on
capital capital
Capital employed 1
employed employed
ratio
expresses
the
relationship
between the
profits
earned and
owner’s
capital
invested plus
long-term
financing.
The net profit
amount is
before
interest paid
if it is
assumed that
the interest
paid relates
only to long-
term
liabilities.
6.8 Solvency ratios
These ratios measure the organisation’s ability to repay its long-term debts,
which include the repayment of capital and the payment of interest.
Interest Earnings bef ore interest and tax
times the operating profit will
cover cover interest expense. The more
Interest expense
ratio coverage, the safer it is to borrow

funds.
Debt to Long-term debt
This ratio measures the level of
Equity
equity financial risk. Debt financing
ratio creates an obligation that has to
be paid whether or not the
organisation can afford it.
Statement of comprehensive income of Sencam Ltd for the year

ended 31 December 20x3
20x3 20x2
R R
Sales 3 782 000 3 355 000
Cost of sales (2 571 (2 382
760) 050)
Opening inventory 1 525 000 1 403 000
Purchases 2 022 760 2 504 050
Goods available for sale 3 547 760 3 907 050
Closing inventory 976 000 1 525 000
Gross profit 1 210 240 972 950
Operating expenses (644 648) (822 280)
Operating profit 565 592 150 670
Interest and other income 92 720 45 750
Profit before interest expense and taxation 658 312 196 420
(EBIT)
Interest expense (91 500) (73 200)
20x3 20x2
Profit before taxation 566 812 123 220
Taxation (150 792) (54 900)
Profit after taxation* 416 020 68 320
*Without minority interest, this is also equal to earnings attributable to

shareholders in this example.
Statement of financial position of Sencam Ltd at 31 December

20x3
20x3 20x2
Assets R R
Non-current assets 2 330 200 2 549 800
Property, plant and equipment 2 025 200 2 305 800
Other investments 305 000 244 000
Current assets 1 695 800 1 982 500
Inventory 976 000 1 525 000
Trade and other receivables 622 200 457 500
Cash and cash equivalents 97 600 nil
Total assets 4 026 000 4 532 300
Equity and reserves 2 305 800 2 025 200
Share capital 1 220 000 1 220 000
Accumulated profit 1 085 800 805 200
Non-current liabilities
Interest-bearing borrowings 610 000 488 000
Current liabilities 1 110 200 2 019 100
Trade and other payables 1 061 400 1 311 500
Current tax payable 48 800 36 600
Bank overdraft nil 671 000
20x3 20x2
Total: equity and liabilities 4 026 000 4 532 300
20x3 20x2
1. Sales consist of:
Credit sales 2 989 000 2 501 000
Cash sales 793 000 854 000
R3 782 000 R3 355 000
2. Purchases consist of:
Credit purchases 1 512 800 2 200 880
Cash purchases 509 960 303 170
R2 022 760 R2 504 050
3. The following balances are available for 31 December 20x1:
Trade and other receivables R384 300
Trade and other payables R1 342 000
Inventory R1 403 000
4. For 20x1 the following information is given:
Sales R2 501 000
Cost of sales R1 586 000
Required
Calculate all the liquidity, efficiency, profitability and solvency ratios for
20x3 and 20x2, and indicate whether there is an improvement or
decline in each ratio.
Note: Round off calculations to two decimal places where necessary
and assume 365 days in the year.
Solution
Liquidity ratios
Current ratio
Current assets
Current liabilities
20x3 20x3
1695 800 1982 500
1110 200 2 019 100
= R1,53 : R1 = R0,98 : R1
Improvement from 20x2 to 20x3
Quick ratio
Current assets – inventory
Current liabilities
20x3 20x2
1695 800–976 000 1982 500–1525 000
1110 200 2 019 100
719 800 475 500

= =
1110 200 2 019 100
= R0,65 : R1 = R0,23 : R1
Efficiency ratios
Debtors’ turnover
Credit sales
Trade receivables
20x3 20x2
2 989 000 2 501 000
(622 200+457 500)/2 (457 500+384 300)/2
2 989 000 2 501 000

= =
539 850 420 900
= 5,53 times = 5,94 times
Decline from 20x2 to 20x3

Debtors’ collection period
Trade receivables
× 365
Credit sales
20x3 20x2
(622 200+457 500)/2 (457 500+384 300)/2

= × 365 = × 365
2 989 000 2 501 000
539 850 420 900

= × 365 = × 365
2 989 000 5 501 000
= 66 days = 61 days
Inventory turnover
Cost of sales
Inventory
20x3 20x2
2 571 760 2 382 050
(976 000+1 525 000)/2 (1 525 000+1 403 000)/2
2 571 760 2 382 050

= =
1 250 500 1 464 000
Inventory days
Inventory
× 365
Cost of sales
20x3 20x2
(976 000+1 525 000)/2 (1 525 000+1 403 000)/2

× 365 × 365
2 571 760 2 382 050
1 250 500 1 464 000

= × 365 = × 365
2 571 760 2 382 050
= 177 days = 224 days

Creditors’ turnover
Credit purchases
Trade payables
20x3 20x2
1 512 800 2 200 880
(1 061 400+1 311 500)/2 (1 311 500+1 342 000)/2
1 512 800 2 200 880

= =
1 186 450 1 326 750
Creditors’ payment period
Trade payables
× 365
Credit purchases
20x3 20x2
(1 061 400 +1 311 500)/2 365 (1 311 500 +1 342 000)/2 365
× ×
1 512 800 1 2 200 880 1
1 186 450 365 1 326 750 365

= × = ×
1 512 800 1 2 200 880 1
= 286 days = 220 days
Profitability ratios
Gross margin
Gross prof it
× 100
Revenue
20x3 20x2
1 210 240 100 972 950 100

× ×
3 782 000 1 3 355 000 1
= 32% = 29%
Net margin
Prof it af ter tax

× 100
Revenue
20x3 20x2
416 020 100 63 320 100

× ×
3 782 000 1 3 355 000 1
= 11% = 2,04%
Operating profit margin
Operating prof it
× 100
Revenue
20x3 20x2
565 592 100 150 670 100

× ×
3 782 000 1 3 355 000 1
= 14,95% = 4,49%
Return on assets
Net prof it bef ore interest and tax

× 100
Total assets
20x3 20x2
658 312 100 1964 200 100

× ×
4 026 000 1 4 532 300 1
= 16,35% = 4,33%
Return on capital employed

× 100
Capital employed
20x3 20x2
566 812 +91 500 100 123 220 +73 200 100
× ×
2 305 800 +610 000 1 2 025 200 +488 000 1
658 312 100 196 420 100

= × = ×
2 915 800 1 2 513 200 1
= 22,58% = 7,82%
Return on equity

× 100
Capital employed
20x3 20x2
416 020 100 63 320 100

× ×
2 305 800 1 2 025 200 1
= 18,04% = 3,37%
Solvency ratios
Interest cover ratio
Earnings bef ore interest and tax

× 100
Interest expense
20x3 20x2
658 312 196 420
91 500 73 200
Debt to equity ratio
Long-term debt: equity
20x3 20x2
610 000 : 2 305 800 488 000 : 2 025 200
= 0,26 : 1 = 0,24 : 1
TUTORIAL EXERCISES
Exercise 1
Read through the following statements and select the most appropriate
option:
1.1 The two basic measures of liquidity are

a. inventory turnover and current ratio
b. current ratio and quick ratio
c. gross profit margin and ROE
d. current ratio and total asset turnover
1.2 The _________ ratio may indicate the firm is experiencing

stockouts and lost sales.
a. creditors’ payment period
b. inventory turnover
c. debtors’ collection period
d. quick ratio
1.3 The _________ ratio may indicate poor collections procedures or
a lax credit policy.
a. creditors’ payment period
b. inventory turnover
c. debtors’ collection period
d. quick ratio
1.4 The _________ ratios are primarily measures of return.

a. liquidity
b. activity
c. debt
d. profitability
1.5 Operating profits are defined as

a. gross profits minus operating expenses
b. sales revenue minus cost of goods sold
c. earnings before depreciation and taxes
d. sales revenue minus depreciation expense
1.6 _________ analysis involves the comparison of different firms’

financial ratios at the same point in time.
a. Time-series
b. Cross-sectional
c. Marginal
d. Combined
1.7 _________ analysis involves comparison of current to past

performance and the evaluation of developing trends.
a. Time-series
b. Cross-sectional
c. Combined
d. Quantitative
Exercise 2
The following information was taken from the books of ABC Ltd:
31/12/20x3 31/12/20x2
R R
Inventory 150 000 120 000
Purchases 765 000 680 000
Trade and other payables 200 160 114 224
Investments 60 000 60 000
Furniture 35 000 60 000
Vehicles 75 000 30 000
Sales 900 000 750 000
Customs and excise 30 000 25 000
Net income before interest and taxation 84 000 65 000
Bank overdraft 41 320 50 000
R6 000 interest was paid during the year, while no interest was
received.
All purchases are on credit and 25% of the sales are for cash.
Assume 365 working days per annum.
Required
Calculate the following for the year ended 31 December 20x3:
2.1 Net margin (round off to two decimal places)

2.2 Debtors’ collection period (round off to the nearest whole number)
2.3 Acid test ratio (round off to two decimal places)
2.4 Gross margin (round off to two decimal places)
2.5 Creditors’ payment period (round off to the nearest whole number)
2.6 Days’ inventory on hand (round off to the nearest whole number)
2.7 Current ratio (round off to two decimal places)
Exercise 3
Part A
The following information has been extracted from the recently
published account of Crown Ltd:
Statement of financial position as at 28 February
20x2 20x1
R’000 R’000
Fixed assets 3 700 2 860
Current assets 3 900 3 380
Inventory 1 280 980
Cash and cash equivalents 160 240
Total assets 7 600 6 240
Capital and reserves 4 090 3 350

Ordinary share capital 1 600 1 600
Reserves 2 490 1 750
Long-term liabilities 1 600 1 200

Debentures 1 600 1 200
Current liabilities 1 910 1 690
Trade and other payables 1 500 1 380
Taxation 60 40
Dividends 130 110
Total equity and liabilities 7 600 6 240
Extracts from profit and loss account

20x2 20x1
R’000 R’000
Sales (credit) 22 400 19 500
Cost of sales 16 920 13 650
Net profit before tax 930 640
This after charging:
Depreciation 720 560
Debenture interest 130 102
Interest on bank overdraft 30 18
Audit fees 40 20
Net profit after tax 466 320
Required
Calculate the following ratios for Crown Ltd for 20x1:
(Assume a 365-day year and round off calculations to two decimal
places.)
3.1 Return on capital employed
3.2 Gross margin
3.3 Current ratio
3.4 Debtors’ collection period
3.5 Inventory turnover
Part B
The following ratios are those calculated for Sencam Ltd based on its
published accounts for 20x2, and also the latest industry average
ratios:
Sencam Ltd 28 February Industry

20x2 average
Return on capital 19,16% 18,50%
employed
Net margin 4,87% 4,73%
Gross margin 24,46% 35,23%
Current ratio 2,04:1 1,90:1
Debtors’ collection 40 days 52 days
period
Inventory turnover 13,22 times 18,30 times
Required
3.6 Explain what each ratio indicates (measures).
3.7 Identify whether there is an improvement or decline in the ratio
compared to the industry average.
Exercise 4
Part A
TK Ltd has been in operation for three years and produces antique
furniture for the export market. The most recent set of accounts for the
company is set out below:
Statement of comprehensive income for the year ended 30
November 20x3
R’000 R’000
Sales 2 600
Gross profit 980
Less: Operating expenses 660
Interest on loan 78
Selling and distribution expenses 408
Administration expenses 174
Net profit before taxation 320
Less: Taxation 95
Net profit after taxation 225
Less: Ordinary dividends 160
Retained profit for the current year 65
Add: Retained profit at the beginning of the year 300
Retained profit at the end of the year 365
Statement of financial position as at 30 November 20x3
R’000 R’000 R’000

Cost Accumulated Book
depreciation value
Non-current assets
Freehold land and buildings at 228 – 228
cost
Plant and machinery 942 180 762
1 170 180 990
Inventory 600
Trade debtors 820
Total assets 2 410
Capital and reserves 1 065
Ordinary shares of R1 each 700
Retained profits 365
Non-current liabilities 200
Loan SD Bank 12% p.a. 200
Trade creditors 665
Taxation 48
Bank overdraft 432
Required
Calculate the following ratios:
4.1 Return on capital employed
4.2 Return on equity
4.3 Gross profit margin
4.4 Net profit margin
4.5 Return on assets
Round off to the nearest whole number.
Part B
The following ratios have been taken from the books of TK Ltd over the
past years of trading, together with the relevant industry averages:
Ratios 20x2 Industry

1. Current ratio 1,9 2
2. Acid test (quick ratio) 0,8 1
3. Inventory turnover 4 times 6 times
4. Debtors’ collection period (days) 51 days 40 days
5. Creditors’ payment period (days) 61 days 50 days
Required
4.6 For each of the above five ratios, answer the following:
a. What does the ratio measure?
b. State whether there is an improvement or decline in the ratio in
comparison with the industry average.
4.7 Comment on the company’s overall liquidity position in
comparison with industry.
Exercise 5
Part A
Business A and business B are both engaged in retailing, but seem to
take different approaches to this trade according to the information
available. Based on the ratios given below, determine which of the two
businesses is performing better.
Ratio Business Business

A B
Profitability
(a) Return on capital employed (ROCE) 20% 17%
(b) Return on ordinary shareholders’ funds 30% 18%
(ROSF)
(c) Net margin 12% 10%
Liquidity
(d) Debtors’ collection period 63 days 21 days
(e) Creditors’ payment period 50 days 45 days
(f) Inventory turnover period 52 days 25 days
Required
5.1 Explain what each of the above ratios (a)–(f) measures.
5.2 In terms of profitability and liquidity for each of the ratios (a)–(f)
given above, indicate which business is performing better.
Example Business A Business B

Current ratio R2 : R1 R1,50 : R1
Answer
Business A
Part B
The financial statements for Harridges Ltd are given below for the two
years ended 30 June 20x2 and 20x1. Harridges Ltd operates a
department store in the centre of a small town.
Harridges Ltd
Profit and loss account for the years ended 30 June 20x2/20x1
20x2 20x1
R’000 R’000
Sales (all credit) 2 600 3 500
Cost of sales 1 560 2 350
Gross profit 1 040 1 150
Less: Expenses
Overheads 260 200
Depreciation 150 250
Operating profit 310 350
Less: Interest payable 50 50
Profit before taxation 260 300
Less: Taxation 105 125
Profit after taxation 155 175
Less: Dividends proposed 65 75
Profit retained for the year 90 100
Add: Retained income at the beginning of the year 260 350
Retained income at the end of the year 350 450
Statement of financial position as at 30 June
20x2 20x1
R’000 R’000 R’000 R’000
Assets
Non-current assets 1 265 1 525
Inventory 250 400
Trade and other receivables 105 145
Cash at bank 380 115
Total assets 2 000 2 185
Capital and reserves
Share capital at R1 per share 490 490
Retained income 350 450
1 100 1 200
Non-current liabilities
Loan AB Bank 500 500
Trade and other payables 235 300
Shareholders for dividends 65 75
Accrued expenses 100 110
Total equity and liabilities 2 000 2 185
Required
Calculate the following ratios for 20x2 only (assume a 365-day year):
5.3 Net margin (round off to the nearest whole number)

5.4 Acid test ratio (round off to two decimal places)
5.5 Debtors’ collection period (round off to the nearest whole number)
5.6 Days’ inventory on hand (round off to the nearest whole number)
Exercise 6
The following ratios have been taken from the books of Mkhize Ltd over
the past three years of trading, together with the relevant industry
averages:
Ratio 20x0 20x1 20x2 Industry

average
1. Days' inventory on 30 40 65 35 days
hand days days days
2. Debtor’s collection 60 90 120 60 days
period days days days
3. Gross margin 33% 50% 66% 45%
4. Return on equity 15% 20% 24% 18%
Required
Part A
For each of the above ratios, answer the following:
6.1 What does the ratio measure?
6.2 State whether there is an improvement or decline in the ratio in
comparison with the industry average.
Part B
6.3 If you were considering investing in Mkhize Ltd, which of the above
ratios would you be interested in and why?
Exercise 7
Calculate the following ratios for years 20x2 and 20x1 by using the
selected information below. Discuss your findings and offer detailed
reasons for the change in the ratios from the one year to the next.
7.1 Gross profit margin
7.2 Operating profit margin
7.3 Return on total assets
7.4 Current ratio
7.5 Debt to equity ratio
20x2 20x1
R R
Revenue 777 000 663 000
Net operating profit / (loss) 93 000 48 000
Gross profit 312 000 298 000
Operating costs (101 000) (150 000)
Total assets 969 000 879 000
Interest-bearing borrowings 572 000 555 000
Total current assets 94 000 89 000
Total equity 330 000 265 000
Total current liabilities 67 000 59 000
The current portion of interest-bearing borrowings included in current

liabilities is R34 000.
Exercise 8
The financial statements of Marimuthu Ltd contained, inter alia, the
following information for the years 20x3 and 20x2:
Statement of comprehensive income 20x2 20x3
R R
Credit sales 2 400 000 3 000 000
Cost of sales 1 200 000 1 680 000
Gross profit 1 200 000 1 320 000
Administrative expenses 440 000 480 000
Selling expenses 480 000 600 000
Net profit before tax 280 000 240 000
Tax 120 000 100 000
Net profit after tax 160 000 140 000
Dividends 80 000 140 000
Accumulated profit for year 80 000 –
Statement of financial position 20x2 20x3

information
R R
Share capital (ordinary shares R2 par value) 400 000 400 000
Reserves 160 000 160 000
Long-term loans 280 000 440 000
840 000 1 000
000
Property, plant and equipment 600 000 844 000
Inventory 200 000 336 000
Bank 40 000 –
Creditors (400 (780 000)
000)
840 000 1 000
000
Required
Calculate the following ratios for 20x3 only; assume 365 days in a year:
8.1 Current ratio
8.2 Acid test ratio
8.3 Inventory turnover
8.4 Debtors’ collection period
8.5 Gross profit to turnover (gross margin)
8.6 Net profit to shareholders’ equity (return on equity)
8.7 Net profit to capital employed (return on capital employed)
8.8 Return on assets
Note: Where necessary round off to two decimal places.
7 Bank reconciliation
Outcomes
understand the general principles of control over cash

compare the cash journals with the bank statement
prepare an adjusted bank account in the general ledger and a bank
reconciliation statement.
Chapter outline
It is important to check accounting entries regularly to ensure accuracy and

control. Cash is the lifeblood of any organisation and poor cash management
can ultimately lead to an enterprise’s demise.
The checking of the cash journals and the bank statements on a monthly basis
confirms the balance of cash held at the bank.

All money received is recorded in the cash receipts journal and all money paid
out is recorded in the cash payments journal. At the end of the month the
totals of these two journals are posted to the bank account in the general
ledger. The bank account is a current asset, therefore all receipts are debited;
that is, they increase the bank balance. All payments are credited in the bank
account; that is, they decrease the bank balance.

The bank also records all the transactions that affect our bank balance, and at
the end of the month it sends us a copy of these transactions in the form of a
bank statement.
The main difference between the way we record transactions and the way the
bank records transactions is that the bank statement will be the mirror image
of the cash journals. The bank credits to increase and debits to decrease our
bank balance. This is opposite to what we do in the general ledger. The reason
for this is that the bank views our account as a liability. From its point of view
it owes us the money which is in our bank account. The bank follows the rule:
to increase a liability, credit, and to decrease a liability, debit.
Clearly the cash journals and the bank statements are reflecting the same
entries, and therefore in essence should have the same closing balance. If the
closing balance in our records does not agree with the closing balance in the
bank statement, a bank reconciliation must be conducted.
Many of the discrepancies are simply caused by time delays.
Items not appearing in Items not appearing on the bank statement

the business cash
journals
1. Bank charges, including 1. Deposits made but not yet recorded by the
service fees, cash deposit bank because they were made close to
fees, cost of chequebooks, statement date. They were not processed by
etc. the bank in time and will therefore only appear
on the following month’s bank statement.
2. Payments made by the 2. Cheques issued but not recorded by the
bank for stop orders or bank because they have not been presented to
debit orders, e.g. the bank for payment
insurance premiums
3. Deposits made directly
into our bank account by a
debtor, e.g. rental
4. Dishonoured cheques
(R/D cheques) previously
deposited in good faith by
the business
5. Interest on overdraft
These items do not These items do not appear in the bank’s
appear in the business’s books and must therefore be entered on the
books and must bank reconciliation statement.
therefore be entered into
the general ledger bank
account.
Any errors that have Any errors made by the bank must be
been made in the cash corrected on the bank reconciliation
journals must be statement.
corrected in our books.
1. Compare the closing balance in the general ledger bank account with the
closing balance in the bank statement. If they are not the same, then
continue with step 2.
2. Compare the cash journals and the bank statement and circle any item that
does not appear in both sets of records.
3. Items that appear on the bank statement but not in the cash journals must
be entered into the general ledger bank account.
4. Items that appear in the cash journals but not on the bank statement must
be entered on the bank reconciliation statement.
5. Any errors that have been made in the cash journals must be corrected in
the general ledger bank account.
6. Any errors made by the bank must be corrected on the bank reconciliation
statement.
The following is the bank reconciliation for May 20x1, the bank statement
for June 20x1 and a summary of the cash records for June 20x1 for SDB
Ltd:
General ledger
Bank
Date Detail Fol Amount
1 June 20x1 Balance b/d R2 353,50
Cash receipts journal for June 20x1 CRJ 6

04 Deposit 800
10 Deposit 1 700
15 Deposit 2 100
25 Deposit 1 500
30 Deposit 1 100
7 200
Cash payments journal for June 20x1 CPJ 6

01 Cheque 185 900
04 Cheque 186 510
10 Cheque 187 1 414
17 Cheque 188 440
25 Cheque 189 1 134
30 Cheque 200 516
4 914
Bank reconciliation statement as at 31 May 20x1

Balance as per bank statement 2 826,50
Add: Outstanding deposit 1 232,00
Less: Outstanding cheques
No. 180 (770,00)
No. 183 (935,00)
Balance as per general ledger bank account 2 353,50
SAVINGS BANK
Bank statement
Date Code Cheque Cheques and Deposits Balance
no. other debits R R
R
May R2
31 826,50
Jun 1 232,00 4
01 058,50
185 900,00 3
158,50
SF 4,50 3
154,00
03 183 935,00 2219,00
SF 4,50 2
214,50
05 800,00 3
014,50
11 SF 7,00 1 700,00 4
707,50
12 187 1 414,00 3
293,50
SF 7,00 3
286,50
16 2 100,00 5
386,50
17 188 440,00 4
946,50
SF 4,00 4
942,50
Rent 500,00 5
442,50
26 1 500,00 6
942,50
27 RD 1 200,00 5
(James) 742,50
SF 6,00 5
736,50
28 189 1 134,00 4
602,50
SF 6,00 4
596,50
Explanation of abbreviations:
SF – service fees CB – chequebook printing
SO – stop order OI – overdraft interest
RD – cheque unpaid
Required
1. Adjust the general ledger bank account.

2. Prepare a bank reconciliation statement as at 30 June 20x1.
Solution
General ledger
Bank
20x1 20x1
R2 R4
June 01 Balance b/d June 30 Payments
353,50 914,00
30 Receipts 7 200,00 Bank charges 39,00
Rental Debtors (RD
500,00 1 200
income cheque)
Balance c/d 3 900,50
10 053,50 10 053,50
July 01 Balance b/d 3 900,50
Method 1: Double entry

Bank reconciliation statement as at 30 June 20x1
Debit Credit
Credit balance as per bank statement R4 596,50
Credit: Outstanding deposit 1 100,00
Debit: Outstanding cheques
No. 180 R770,00
No. 186 510,00
No. 200 516,00
Debit balance as per bank account 3 900,50
5 696,50 5 696,50
totals are equal
Method 2: Arithmetic
Bank reconciliation statement as at 30 June 20x1
Balance as per bank statement R4 596,50

Add: Outstanding deposit 1 100,00
Less: Outstanding cheques 1 796,00
No. 180 R770,00
No. 186 510,00
No. 200 516,00
Balance as per bank account 3 900,50
TUTORIAL EXERCISES Bank reconciliation
Exercise 1
Below is a list of statements. Indicate whether the statements are true or
false. If the statement is false, then rephrase the statement in order to
make it true.
1.1 Bank reconciliation is a verification process.
1.2 Bank reconciliation is important for control over costs.
1.3 Many of the discrepancies between the business’s records and the
bank’s records are caused by time delays.
1.4 The bank’s records and the business’ records are mirror images of
each other.
1.5 Payments made by the bank on clients’ behalf include debit orders
and stop orders.
1.6 Any errors made by the bank must be corrected in the cash journals.
1.7 Any errors made by the business must be corrected in the bank
reconciliation statement.
1.8 A dishonoured cheque is a cheque that has been marked “refer to
drawer” due to insufficient funds in the debtors’ account.
1.9 A stale cheque is an old cheque that cannot be cashed due to its age.
1.10 A cheque is considered stale if it is more than six months old and it
must be cancelled.
Exercise 2
The following information was taken from the books of ABC Enterprises for
October 20x0:
Bank reconciliation statement as at 30 September 20x0
R
Balance according to bank statement 261
Add: Outstanding deposits 140
Less: Outstanding cheques: No. 102 66
104 68
108 500
Unfavourable balance according to bank account –233
Cash receipts journal for October 20x0
Day Details Bank (R)

8 Deposit rent received 984
25 Deposit fees earned 1 339
31 Deposit fees earned 651
2 974
Cash payments journal for October 20x0:
Date Cheque no. Payee Details Amount (R)

5 126 W. Raymond Creditors 398
6 127 H. Kor Rent paid 394
8 128 Makro Stock 1 602
10 129 Makro Stock 438
11 130 SW Motors Repairs 313
12 131 A. James Legal services 144
15 132 Municipality Electricity 58
21 133 D. Dunn Salaries 738
25 134 Telkom SA Telephone 616
4 701
Bank statement as at October 20x0
Date Description Debit (R) Credit Balance (R)

9/30 Balance b/f 261 Cr
9/30 Deposit 140 401 Cr
10/8 Deposit 984 1 385 Cr
10/12 Cheque 126 398 987 Cr
10/14 Cheque 127 394 593 Cr
10/15 Cheque 128 1 602 1 009 Dr
10/15 Service fees 5 1 014 Dr
10/15 Service fees 40 1 054 Dr
10/15 Chequebook fees 4 58 Dr
10/16 Cheque 132 58 1 116 Dr
10/25 Deposit 1 339 223 Cr
10/26 Cheque 133 738 515 Dr
10/28 Stop order – Mutual 95 610 Dr
10/31 Cheque 102 66 676 Dr
The stop order for R95 on 28 October 20x0 on the bank statement was
debited in error by the bank to the account of ABC Enterprises. The stop
order was for ZA Traders.
Required
2.1 The bank account in the general ledger balanced at 31 October 20x0.
2.2 The bank reconciliation statement as at 31 October 20x0.
Exercise 3
The following information was extracted from the accounting records of
XYZ Ltd:
Abridged cash receipts journal for December 20x1
Date Details Bank (R)

04 D. Duma 656,00
09 S. Sibiya 1 312,00
14 Rent received 984,00
21 P. Pillay 1 695,76
28 G. Govender 602,34
31 S. Brewer 602,08
5 852,18
Abridged cash payments journal for December 20x1
Date Details Cheque no. Bank (R)

05 P. Paul P1260 796,84
06 Rent expense P1270 787,20
08 Stock P1280 3 204,56
10 Happy Traders P1290 877,40
11 Beach Motors P1300 626,16
12 Greenfingers Garden Services P1310 288,64
15 Rates and taxes – municipality P1320 116,12
21 Wages P1330 1 476,00
30 Telephone – post office P1340 1 233,28
9 406,20
The bank reconciliation statement at 30 November 20x1 was as follows:

Bank reconciliation statement as at 30 November 20x1
R
Favourable balance as per bank statement 522,50
Less: Outstanding cheques
P1020 131,20
P1040 137,04
P1080 1 000,46
P1250 399,84
Add: Outstanding deposit 280,12
Balance as per bank account (865,92)
The bank statement from BNF Bank was received and read as follows:
Bank statement as at December 20x1
Date Details Cheques Debit Deposits Credit Balance

(R) (R) (R)
01 Balance 522,50 Cr
02 Deposit 280,12 802,62 Cr
05 Deposit 656,00 1 458,62
Cr
06 P1260 796,84 661,78 Cr
07 P1270 787,20 125,42 Dr
09 P1280 3 204,56 3 329,98
Dr
11 Deposit 1 312,00 2 017,98
Dr
12 SF 20,00 2 037,98
Dr
CB 29,52 2 067,50
Dr
15 Deposit 984,00 1 083,50
Dr
16 P1320 116,12 1 199,62
Dr
22 Deposit 1 695,76 496,14 Cr
23 P1330 1 476,00 979,86 Dr
24 SO (SPCA) 164,00 1 143,86
Dr
26 CU (R. 492,00 1 635,86
Rudolf) Dr
27 OI 110,54 1 746,40
Dr
28 P1020 131,20 1 877,60
Dr
30 SO (B. 65,60 1 943,20
Square) Dr
Explanation of abbreviations:
SF – service fees
SO – stop order
CU – cheque unpaid/RD
CB – chequebook printing
OI – overdraft interest
Required
3.1 Adjust the general ledger bank account.
3.2 Prepare the bank reconciliation statement as at 31 December 20x1.
Exercise 4
On 30 April 20x1 C. Kippen’s bank account in the general ledger appeared
as follows:
General ledger
Bank
20x1 20x1
Apr 30 Receipts CRJ1 20 850,00 Apr 30 Payments CPJ1 R10 720,95
His bank statement showed a favourable balance of R6 901,20. The

bookkeeper compared the subsidiary journals and the bank statement and
noted the following:
1. The following cheques have not been presented at the bank:
GT34762 R412,83
GT34789 R1 324,62
2. A deposit of R4 382,10 is not reflected on the bank statement.

3. Cheque no. GT312713 in favour of R. Cambridge is stale and must be
cancelled, R1 215.
4. The bank incorrectly debited Kippen’s bank account with a cheque for
R810 drawn by P. Kippen, and a stop order for R405 in the name of
Kippen Ltd.
5. Cheque no. PX34764 in favour of a creditor, P. Payne, was entered in
the cash payments journal as R42,52 instead of R425,25.
6. The following charges have not been recorded in the books of C.
Kippen:
Interest on bank overdraft R100,47

Service fees R100,00
Required
4.1 Adjust the general ledger bank account.
4.2 Prepare the bank reconciliation statement as at 30 April 20x1.
Exercise 5
The following information was obtained from the books of Gloss
Distributors after comparing the cash book with the bank statement on 30
April 20x4:
1. Balance on bank statement, R22 100 credit.

2. Balance in general ledger bank account on 1 April 20x4, R8 300 debit.
3. Pencil total of cash receipts journal, R26 456.
4. Pencil total of cash payments journal, R16 438.
5. A deposit of R4 000 does not appear in the cash receipts journal, but
was made directly into the bank account of Gloss Distributors by a
client.
6. Bank charges on bank statement amount to R463.
7. Interest received on bank statement, R125.
8. The following cheques were written out on 30 April 20x4 but were not
on the bank statement: cheque no. 301 for R450 and cheque no. 302
for R1 570.
9. An amount of R550 was written in the cash receipts journal instead of
the cash payments journal.
10. Insurance policy premium R900 was paid by debit order.
11. No entry has been made in the company’s book in respect of a cheque
returned by the bank marked “refer to drawer”. The cheque was for
R280 and was received from S. van Wyk in settlement of his account.
12. The bank had erroneously credited Gloss Distributors’ account with an
amount of R380.
Required
Prepare the following:
5.1 A general ledger bank account properly balanced off
5.2 A bank reconciliation statement as at 30 April 20x4
Exercise 6
Galvin Traders received their bank statement on 28 February 20x2 and
compared it with its cash receipts journal and cash payments journal. The
following facts came to light:
1. The bank statement had a favourable balance of R362 on 28 February

20x2 and the bank account in the general ledger had a credit balance
of R1 240 on 28 February 20x2.
2. A cheque for R146 from B. Bankrupt, a debtor, was received from the
bank marked “refer to drawer”, and has not been redeposited.
3. A deposit of R400 for rent received was made directly into the bank
account of the enterprise by a tenant.
4. A deposit of R1 420 was recorded as R1 240 in the cash receipts
journal. The deposit was for cash sales.
5. A deposit of R400 made on 28 February 20x2 does not appear on the
bank statement.
6. Insurance premiums to the value of R120 were paid by debit order. The
amount appears on the bank statement, but was not recorded in the
cash payments journal.
7. The following cheques were not presented to the bank for payment by
28 February 20x2:
No. 208 R150 (drawn on 1 July 20x1 in favour of a creditor, N. Noop)

No. 421 R35
No. 425 R1 120
8. Cheque no. 418 for an amount of R10 appears on the bank statement
as R1.
9. Cheque no. 101 for R220 drawn by Galvin Ltd was erroneously
included in Galvin Traders bank statement.
10. A cash purchase for R1 180 made with cheque no. 412 drawn on 13
February 20x2 is shown in the cash payments journal as R1 810.
11. Bank charges of R36 appear on the bank statement, but were not
recorded in the cash payments journal.
Required
6.1 Prepare the bank account of Galvin Traders in the general ledger.
6.2 Prepare a bank reconciliation statement as at 28 February 20x2.
Exercise 7
The following information was extracted from the accounting records of GB
Traders for the month of April 20x1:
1. On 1 April 20x1 the bank account showed a debit balance of R770,72.

2. On 30 April 20x1 the bank statement showed a credit balance of
R119,11.
3. The column subtotals of the cash receipts journal on 30 April 20x1,
before the cash receipts journal was compared with the bank
statement, were as follows:
Sundry Cost Sales VAT Debtors Discount Bank

accounts of allowed
sales
R1 R2 R4 R44 R1 R5 750 R7
288,91 216,75 433,50 335 015,00 123,26
4. The column subtotals of the cash payments journal on 30 April 20x1,

before the cash payments journal was compared with the bank
statement, were as follows:
Sundry Wages Trading Debtors Creditors Discount Bank

accounts stocks received
R3 R36 R3 – R1 R6 745 R7
151,30 000 074,81 258,40 777,06
5. The bank statement for April 20x1 was compared with the cash
receipts journal and cash payments journal for April 20x1. The
following differences were found:
The following bank charges appeared on the bank statement only:

service fees of R12,40, levy on debit transactions of R4,00 and cash
handling fees of R4,90.
The bank statement showed an unpaid cheque for R95,43 received
from R. Wilson, a debtor, in settlement of his account. The cheque
was dishonoured due to insufficient funds.
A stop order for R64,64 in favour of the Permanent Insurance
Company for an insurance premium appeared in the bank statement
only.
A deposit of R620,00 appeared in the bank statement only. This
amount was rental which was deposited into GB Traders’ current
account by CP Chemist.
The bank debited GB Traders’ current account with cheque no. 917
for R231. This cheque was drawn by GB Hotel.
A deposit of R744,83, dated 30 April 20x1, did not appear on the
bank statement.
6. The following cheques had not been presented for payment by 30 April
20x1:
No.184, issued on 16 February 20x1 for R85,40
No. 391, issued on 28 April 20x1 for R306,84
No. 393, issued on 30 April 20x1 for R147,15
Required
Draft the following for the month of April 20x1:
7.1 A bank account properly balanced off
7.2 A bank reconciliation statement
8 Value-added tax (VAT)
Outcomes
convey basic background knowledge of VAT

calculate VAT
calculate mark-ups on cost price and on selling price
calculate selling prices (inclusive and exclusive of VAT).
Chapter outline
8.1 Introduction
8.4 The VAT system
8.4.1 Input tax
8.4.2 Output tax
8.1 Introduction
Value-added tax (VAT) is a system of taxation that was

implemented on 30 September 1991. It is levied whenever a
product is sold or a service is rendered, with a few exceptions
(exempt supplies). The government raises revenue by requiring
that certain traders, known as vendors, register for VAT in order
to charge VAT on taxable supplies of goods or services. The
South African Revenue Services (SARS) is the government
organisation which administers the VAT Act and ensures that the
tax is collected.
It is compulsory for a person to register if he runs a business

where his total value of taxable supplies exceeds or is likely to
exceed R1 million for a 12-month period. A person may apply
for voluntary registration, provided that the minimum threshold
of R50 000 has been exceeded in the past 12-month period.
Persons who are liable to register, and those who have registered
voluntarily, are referred to as vendors. Vendors have to perform
certain duties and take on certain responsibilities, such as issuing
tax invoices where required, including VAT in all prices quoted,
ensuring that VAT is collected on taxable transactions and that
they submit returns, and making payments on time.
VAT is paid on the supply of goods or services in South Africa

and also on goods imported into South Africa. VAT is levied at
the standard rate of 15% from 1 April 2018. Prior to this date,
VAT was levied at 14%. There are certain goods and services
which are either exempt or which are subject to tax at the zero
rate.
A standard-rated supply is a supply of goods or services which

is subject to VAT at the rate of 15%. As a general rule, the supply
of all goods and services is taxable at the standard rate, unless it
is specifically zero rated or exempt:
Zero-rated supplies. There are some goods where VAT is

levied at 0%. An input tax deduction can be claimed against
zero-rated supplies in the same manner as supplies at 15%.
These include fuel levy goods, certain basic foodstuffs, such as
graded maize meal and brown bread, and certain exported
goods or services. Certain basic foodstuffs are zero rated,
provided they are not supplied for immediate consumption,
such as a glass of milk served in a restaurant, or added to a
standard-rated supply.
Exempt supplies. No VAT is levied on these goods, that is, no
output tax and no input tax deductions are allowed against
these supplies. They include medical and trade union
contributions, educational services, residential
accommodation, etc.
(Note: Zero-rated and exempt supplies will not be dealt with any
further.)
8.4 The VAT system
The mechanics of the VAT system are based on a subtractive or

credit input method which allows the vendor to deduct the tax
incurred on the organisation’s inputs (input tax) from the tax
collected on the supplies made by the organisation (output tax).
The vendor submits a VAT 201 return to SARS every tax period,
where the input tax incurred is offset against the output tax
collected and the balance is paid to SARS by the 25th day of the
tax period concerned. The VAT collected is paid over to SARS
every two months, unless the value of taxable supplies in a 12-
month period exceeds R30 million. In such instances, the vendor
must submit returns electronically on a monthly basis. Certain
farming enterprises are allowed to pay VAT on a biannual basis
and small businesses with taxable supplies of less than R1,5
million in a 12-month period may pay their VAT every four
months.
8.4.1 Input tax

This is the tax that the vendor himself has borne in respect of
goods or services supplied to him. There are some expenses upon
which input tax is not allowed, such as the acquisition of motor
cars and entertainment.
8.4.2 Output tax

This is the tax which the vendor charges on the supply of goods
or services in the course of business.

This is the difference between the output tax and input tax.
Where a vendor’s outputs exceed his inputs, VAT will be payable
on the difference, and where a vendor’s inputs exceed his
outputs, a refund will be paid.
VAT charged on supplies made (output tax) – VAT paid

to your suppliers (input tax) = the amount of VAT
payable / refundable
Example 1
Vendor Selling Input Output Tax due to

price tax tax SARS
Farmer R100 0 R15 R15
Manufacturer R500 R15 R75 R60
Wholesaler R700 R75 R105 R30
Retailer R1 000 R105 R150 R45
R195 R345 R150
VAT inclusive. When an amount is inclusive of VAT, it means

that the VAT is included in the amount. For example, an
amount of R1 150 is VAT inclusive. To calculate the VAT
amount, the following formula can be used:
% VAT rate VAT inclusive amount

VAT = ×
100+%VAT rate 1
15 R1150
= ×
100+15 1
= R150
VAT exclusive. When an amount is exclusive of VAT, then it
means that the amount does not include VAT. For example,
an amount of R1 000 is excluding VAT. To calculate the VAT
amount, the following formula can be used:
% VAT rate amount excluding VAT

VAT = ×
100 1
15 R1000
= ×
100 1
= R150
Example 2
Mr Hayne purchases computer hardware components for R1
000 (excluding VAT) from a computer hardware manufacturer,
and assembles a computer which he sells to Miss Cami for
R1 710 (including VAT). Miss Cami then installs software
programs and sells the computer to Miss Senaysh (the end
user) for R3 420 (including VAT).
In a VAT system, the tax is levied as follows:
Input Output VAT payable to

tax tax SARS/refundable
to vendor
Supplier of 15/100 R150
hardware × R1
components 000
= R150
Mr Hayne 15/100 15/115 R223 – R150 =
× R1 × R1 R73
000 710
= R150 = R223
Miss Cami 15/115 15/115 R446 – R223 =
× R1 × R3 R223
710 420
= R223 = R446
Miss Senaysh is the end user,
therefore there is no further VAT.
Total amount of VAT collected by R446
SARS is the amount of VAT charged
on the final sale to Miss Senaysh, the
end user.
Note the formulae used, that is, if the amount is VAT inclusive
or exclusive.
Once the input and output VAT amounts have been
calculated, they can be recorded in the ledger accounts as
follows:
SARS: VAT payable
Input VAT R223 Output VAT R446
Balance c/d R223
R446 R446
Balance b/d R223
VAT can lead to overpricing of goods if it is not excluded from

mark-up calculations. When goods are purchased and the cost of
goods purchased has been established, the merchandiser must
decide on a pricing policy, which requires a mark-up. A mark-up
is the difference between the selling price and the cost price of
goods. It can be expressed as a percentage on either the cost price
or the selling price. Whatever the mark-up is calculated on is
100%.
The following formula can be used to calculate the marked price.

Note that the term “marked price” refers to the price including
VAT and the term “selling price” refers to the amount which is
received excluding VAT.
Cost price + Mark-up (on cost / selling price) = Selling

price + VAT = Marked price
Using the formula below, you can calculate any of the missing
amounts, provided that you have a known value and its rate (%)
to use:
% of unknown (what you want to calculate) Rand value of known
×
% of known (what you are using to calculate unknown) 1

When the mark-up is on cost price, then cost price becomes
100%. The selling price becomes 100% plus the percentage
mark-up. To calculate VAT or the marked price, the selling price
must be designated as 100% (see Table 8.1).
Table 8.1
Cost Mark-up (on Selling VAT @ Marked price

price cost) 10% price 15% (VAT inclusive)
R100 R10 R110 R16,50 R126,50
100% 10% 110%
100% 15% 115%
The following can be calculated using Table 8.1:
Selling price using cost price
Rand value Rate (%)

Cost price R100 100%
Selling price ? 110% (100% + 10%)
% of unknown Rand value of known

Selling price = ×
% of known 1
% of selling price Rand value of cost price

= ×
% of cost price 1
110% R100
= ×
100% 1
= R110
Mark-up using selling price
Rand value Rate (%)

Selling price R110 110% (100% + 10%)
Mark-up ? 10%

Mark-up = ×
% of known 1
% of mark-up Rand value of selling price

= ×
% of selling price 1
10% R110
= ×
110% 1
= R10
VAT using marked price

Rand value Rate (%)
Marked price R126,50 115% (100% + 15%)
VAT ? 15%

VAT = ×
% of known 1
% of VAT Rand value of marked price

= ×
% of marked price 1
15% R126,50
= ×
115% 1
= R16,50

If goods are marked up on selling price, then on a percentage
basis the selling price equals 100%. Cost price equals 100%
minus the percentage mark-up. For the purpose of VAT, the
selling price is always 100%.
Table 8.2
Cost 30% mark-up (on Selling VAT @ Marked price

price selling price) price 15% (VAT
inclusive)
R77 R33 R110 R16,50 R126,50
70% 30% 100%
100% 15% 115%
The following can be calculated using Table 8.2:
Cost price using selling price

Rand value Rate (%)
Cost price ? 70% (100% – 30%)
Selling price R110 100%
% of unknown rand value of known

Cost price = ×
% of known 1
% of cost price rand value of selling price

= ×
% of selling price 1
70% R110
= ×
100% 1
= R77
TUTORIAL EXERCISES
Exercise 1
Listed below are multiple-choice questions. Select the most
appropriate answer.
1.1 Which of the following is not a rate of VAT?

a. Zero rate
b. Standard rate of 15%
c. Exempt goods
d. Standard rate of 16%
1.2 A vendor does not have to register for VAT if

a. his total value of taxable supplies exceeds or is likely
to exceed R1 million for a 12-month period
b. his total value of taxable supplies exceeds or is likely
to exceed R50 000 for a 12-month period
c. his total value of taxable supplies is less than R50
000 for a 12-month period
d. his total value of taxable supplies exceeds or is likely
to exceed R100 000 for a 12-month period
1.3 Which one of the following statements is incorrect?

a. Output tax is that which the vendor charges on the
supply of goods or services in the course of
business.
b. Input tax is the tax which the vendor himself has
borne in respect of goods or services supplied to him.
c. Certain basic foodstuffs are zero rated, such as a
glass of milk served in a restaurant.
d. No output tax and no input tax deductions are allowed
against exempt supplies.
1.4 Nitin and Riya buy goods to the value of R900, including
VAT, from Builders House. How much VAT have they
paid?
a. R900,00
b. R110,53
c. R117,39
d. R774,00
1.5 Avesh and Su registered for VAT several years ago.

Their business has expanded in the past 12 months
and has generated a turnover of R31 million. How
frequently must they submit a VAT return?
a. Every six months
b. Every month
c. Every two months
d. Biannually
Exercise 2
Calculate the VAT included in the following amounts:
2.1 R1 150
2.2 R598
2.3 R184
Exercise 3
Answer the following questions relating to cost, mark-up and
selling prices (ignore VAT):
3.1 Levashnee sells her product for R1 260. If her mark-up
percentage on cost is 40%, what is her cost price?
3.2 Wesley bought a table for R640. If his gross margin is
40%, how much must he sell it for?
3.3 Elaine buys a frame for R650 and sells it for R845 to
Ashley. What is her mark-up percentage on cost?
Exercise 4
Sencam Stores marks its goods up by 20% on cost. It
receives R2 300 from Riya Boutique for goods sold. Calculate
output tax and cost of goods sold.
Exercise 5
Complete the table:
Cost price % mark-up Selling price

R100 50% on selling price ?
? 40% on cost price R210
R280 ? (% on cost) R364
Exercise 6
Complete the table:
Cost % mark-up Selling VAT Marked
price price (15%) price
R2 000 20% on cost A B C
R2 000 20% on selling D E F
price
G 25% on cost R3 000 H I
J 40% on cost K L R9 591
R4 500 25% on selling M R900 N
price
Exercise 7
The following transactions occured between 1 February 2018
- 28 February 2018:
A VAT-registered farmer sells 10 Starking apples to a VAT-
registered factory for R2 each. No VAT is charged by the
farmer to the factory, as the supply of fresh fruit is zero rated.
Since all the farming supplies purchased were subject to VAT
at the zero rate, the farmer did not have any input tax to
deduct.
The factory also buys cans from another vendor for R29,90
(including 14% VAT). It manufactures 20 cans of apple pieces
and sells them to a hypermarket for R4,56 each (including
14% VAT).
The hypermarket sells 15 of the cans to its customers for
R6,84 each (inclusive of VAT). Since the hypermarket’s
customers are the final consumers and are not registered for
VAT, there is no input or output tax for these customers.
Required
7.1 Illustrate the above scenario of input and output tax.
7.2 Calculate the total amount paid to SARS.
14/03/2018
Tax invoice VAT No. 442 00010895
Ginger biscuits R 13.99
Cott/Cheese R 15.99
Cott/Cheese R 15.99
Tomatoes, pkt R 6.99*
Choc One 60g R 5.49
Plastic bag 24L R 0.39
Veg pie R 9.99
Yoghurt s/berry 175ml R 5.79
Yoghurt plain 175ml R 5.49
L/F yoghurt 175ml R 5.49
Cheddar cgs /kg R 22.93
Teabag R/Bos R 19.99
Ice cream vanilla R 19.99
Lemon shampoo R 15.99
Balance due R186.55
Rate VAT TOTAL
14% 22.05 157.51
*0% 0.00 6.99
Exercise 8
Camishka’s mum gives her R200 and a shopping list and
sends her to the supermarket. When she is done paying for
her shopping, she checks her till slip and thinks that the VAT
shown on the till slip is incorrect. She calculates 14% of the
balance due to be R26,12. Shown here is the till slip.
Required
Help Camishka by answering the following questions:
8.1 Why are the tomatoes indicated with a *?
8.2 What is the total cost of the items that are VAT inclusive?
8.3 Is 14% of this total R22,05 or R26,12?
8.4 Show how the balance due was calculated.
8.5 Explain why Camishka is incorrect in believing the VAT is
wrong.
Exercise 9
Complete the table below by calculating the missing amounts:
Amount 100,00 10,00 4,50 354,39

(R)
VAT (R) 15,00 4,73 27,14
Total 20,46 115,00 11,50 5,18
(R)
Exercise 10
Identify the mistakes on the following till slip:
19/03/2018
Tax invoice VAT No. 442333888109

Milk 2L R 17.99*
Apples 2,5kg R 20.99*
Carrier bag 24L R 0.40
Carrier bag 24L R 0.40
Sunflower oil 250ml R 14.99*
Salted chips R 7.99
Brown bread loaf R 6.99*
Brown bread loaf R 6.99*
Sauce Peri Peri R 13.99
Balance due R90.73
EFT Credit Card R 90.73
TAX-CODE TAXABLE TAX VALUE
Zero VAT R0 R0.00*
VAT R79.59 R11.14
Total tax R11.14
CHANGE R0.00
9 Cost classification and terminology
Outcomes
At the end of this chapter students should be able to classify costs into
their various categories.
Chapter outline

9.2 Cost classification in relation to the product or period
9.3 Cost classification in relation to volume of production (cost behaviour)
9.3.1 Fixed costs

Costs can be defined in a number of ways, depending on one’s point of
view. For the purpose of cost and management accounting, a cost is defined
as follows:
A cost is a resource that is sacrificed or foregone in order to achieve a

specific objective. In other words, costs are incurred to ensure a future
profit.
9.2 Cost classification in relation to the product or

period
The process of classifying costs and expenses begins by relating them to

the different phases in a business’s operation. In a manufacturing
organisation, the total operating cost consists of manufacturing and non-
manufacturing costs.

These are costs that are associated with the manufacturing of certain
products, which include direct materials, direct labour and manufacturing
(factory) overheads. Direct material and direct labour may be combined
into a classification called prime cost. Direct labour and manufacturing
overheads may be combined into another classification called conversion
cost, which represents the cost of converting direct material into finished
products.
Direct materials are all materials that form an integral part of the
finished product and that can be included directly in calculating the cost
of the product, for example crude oil to make gasoline, wood used to
make furniture, and so on.
Direct labour is labour expended to convert direct materials into the
finished product, for example the wages of the carpenter in the furniture
factory, the wages of assembly line workers in a car plant, and so on.
Manufacturing overheads, also called factory overheads, may be defined
as the cost of indirect materials, indirect labour and all other
manufacturing costs that cannot be allocated directly to a product, for
example factory rent, depreciation on plant and equipment, factory
maintenance and repairs, water and electricity for the factory, and so on.
Indirect materials are those materials needed for completing the product
but their consumption is minimal or the tracing is so complex that
treating them as direct materials is futile or uneconomical, for example
nails, screws, glue and factory supplies such as lubricating oils,
consumable materials, and so on.
Indirect labour is labour expended that does not directly affect the
production of the finished product, for example the wages of supervisors,
maintenance workers, security guards, and so on.
Direct material + Direct labour = Prime cost
Direct labour + Manufacturing overheads = Conversion cost
Direct material + Direct labour + Factory overheads = Total

manufacturing cost

These are costs that are associated with a specific accounting period and
not specific products. These costs include marketing (selling and
distribution) expenses and administrative expenses, since they are incurred
in generating sales in a given accounting period, but are not linked to
specific units sold. These costs are treated as expenses of the period in
which they are incurred because they are presumed not to benefit the future
periods. They are simply all the operating costs in the income statement.
Marketing expenses begin at the point where manufacturing has been

completed and the product is in a saleable condition. They include
selling and delivery expenses, such as sales salaries, commissions, travel
expenses, advertising, and so on.
Administrative expenses are incurred in directing and controlling the
organisation. They include the salary of the CEO, office expenses,
depreciation on office equipment, legal expenses, and so on.
9.3 Cost classification in relation to volume of

production (cost behaviour)
Because costs do not remain the same, it is vital to understand how they
behave and what factors affect their behaviour. Below are three behavioural
patterns exhibited by costs. It is important to note that these behavioural
patterns are affected by the level of activity (volume) and time.
Behavioural patterns exhibited by costs are
fixed
variable
semivariable, semifixed or mixed.
9.3.1 Fixed costs

A fixed cost is a cost that remains constant in total, regardless of changes in
the level of activity, but on a per-unit basis it varies/changes with the level
of activity.
The monthly rental charge for a photocopy machine is R20 000.
Monthly rental Number of copies made during Average cost per

cost the month copy
R20 000 200 R100
R20 000 625 R32
R20 000 2 000 R100
Note: This monthly rental cost of R20 000 will be incurred regardless of
the number of copies made during the month. Other examples of fixed
costs include the salaries of production managers, property tax, rent and
insurance.
In this graph, the monthly rental is the same regardless of the
production volume.

A variable cost is a cost that varies/changes in total in direct proportion to
the variation in the level of activity, but on a per-unit basis it remains
constant.
A company produces external hard drives and each hard drive requires
a component that costs R80.
Number of hard Cost per Total variable cost for the

drives component hard drives
1 R80 R80
Number of hard Cost per Total variable cost for the
drives component hard drives
500 R80 R40 000
1000 R80 R80 000
Note: The total cost increases and decreases as the activity level
increases and decreases, but the variable cost expressed on a per-unit
basis is constant, that is, R80 per component.
Examples of variable costs are raw materials, sales commission,
production wages and packing costs.

A semivariable cost is also known as a semifixed or mixed cost. It is a cost
that contains both a variable portion and a fixed portion. The fixed portion
of the mixed cost is the basic charge for having a service ready and
obtainable. The variable portion represents the charge made for the actual
use of the service.
A company leases equipment used in its manufacturing facility. The
lease agreement requires a monthly lease payment of R20 000, plus 90
cents for each hour that the equipment is operated during the month.
Examples of semivariable costs are repairs and maintenance.
Mixed costs must be separated into their fixed and variable portions for
decision making. There are three methods used to separate a mixed cost.
These are the high-low method, scattergraph method and least-squares
method (regression analysis). The scattergraph and least-squares methods
are beyond the scope of this book. The high-low method uses the difference
between the highest and lowest activity and their corresponding costs, in
order to determine the variable portion of the semivariable cost. The
formula used is:
Change in cost ÷ Change in activity

A company has incurred the following maintenance costs over a 12-

month period:
Months Maintenance hours Maintenance costs R

January 90 5 300
February 50 4 500
March 70 4 900
April 55 4 600
May 60 4 700
June 75 5 000
July 95 5 400
August 65 4 800
September 80 5 100
October 85 5 200
November 40 4 300
December 45 4 400
The maintenance cost is a semivariable cost and the production

manager has asked you to separate it into its fixed and variable portion
using the high-low method.
Solution
Step 1
Find the highest activity level and the corresponding cost, then find the
lowest activity level and the corresponding cost. Use the formula to
determine the variable portion. Because the formula is measuring the
change in the cost and the change in the activity, it represents the
variable portion of the semivariable cost. Only variable costs will
change with the level of activity.
Change in cost ÷ Change in activity
= (R5 400 – R4 300) ÷ (95 – 40)
= R1 100 ÷ 55
= Variable rate is R20 per maintenance hour
Step 2
Determine the fixed portion of the semivariable cost, using the following
formula:
Fixed cost = Total cost – Variable cost
= R4 300 – (R20 × 40 maintenance hours)
= R4 300 – R800
= R3 500
Note: You can apply the formula to determine the fixed cost using either
the lowest or highest activity levels with their corresponding costs.

In evaluating the performance of a manager, an important step is to classify
costs that are controllable by that manager. Costs that are uncontrollable by
that manager are generally irrelevant to evaluations of the manager’s
performance, and the manager should not be held responsible for them.
If a particular level of management has power to authorise/allow a cost ,it

is considered controllable, and if a particular level of management does not
have the power to authorise a cost, it is considered non-controllable.

When deciding among a number of possible alternatives or actions, it is
important to identify the costs and revenues that are relevant to the choice.
Consideration of irrelevant items can be a significant waste of time and
resources.

A cost is relevant if it is going to affect a decision being taken.
Opportunity, differential/incremental and avoidable costs are all considered
to be relevant costs.
9.6.1.1 Opportunity cost

An opportunity cost may be defined as the value of the potential benefit
that is lost or sacrificed when one course of action is chosen above the
competing course of action.
Example 1
Wesley is employed on a part-time basis at a chain store. His rate of
pay is R500 per week. He would like to spend a week with his
grandparents on their farm but he has no leave available. If he takes a
week’s leave anyway, he would lose R500. This R500 in lost wages will
be termed an opportunity cost.
Example 2
Paul is an administrative officer for a company that pays him a salary of
R150 000 per annum. He would like to further his current qualification
and is thinking about leaving the company and returning to university to
study full-time. If he returns to university, he would have to give up his
R150 000 salary. The foregone salary would be an opportunity cost, that
is, the cost of seeking higher education.
Opportunity costs are not recorded in the books, but must be considered by
managers when making decisions.
9.6.1.2 Differential/incremental cost

A cost that is present under one option but is absent in total or in part under
another option is known as a differential cost, that is, the difference in total
cost between alternatives.
Differential/incremental revenue is the difference in revenue between the

two alternatives.
9.6.1.3 Avoidable cost

Any cost that can be avoided is relevant to the decision-making process.
This is the cost of an activity or business sector that can be avoided if that
activity or business sector did not exist. All costs are considered avoidable,
except
sunk costs
future costs that do not differ between alternatives at hand.
Unavoidable costs must be eliminated from the decision at hand.
A company produces two products, Trix and Trex. Product Trex is

currently making a loss. Should the company drop the product?
Option Option Difference

1 keep 2 drop increase
product product or
Trex (R) Trex (R) decrease
(R)
Sales 80 000 0 (80 000)
Less: Variable cost 55 000 0 55 000
Marginal income 25 000 0 (25 000)
Less: Fixed costs 39 750 18 000 21 750
* Rental 6 000 6 000 0
Salaries and wages 12 000 0 12 000

Advertising 9 750 0 9 750
* Depreciation on factory equipment 3 000 3 000 0
* Administrative expenses 9 000 9 000 0
Net profit/loss (14 750) (18 000) (3 250)
* Irrelevant/unavoidable costs
Do not drop product Trex since the net loss will increase by R3 250.

Irrelevant costs are costs that remain the same regardless of the decision
taken.
9.6.2.1 Sunk costs

A sunk cost is a cost that has already been incurred and that cannot be
changed by any decision made now or in the future. Since sunk costs
cannot be changed by any present or future decision, they should not be
used in analysing future courses of action. All fixed costs are sunk costs,
for example depreciation.
A company has recently spent R100 000 on developing a new product.

The money cannot be recovered even if a decision is taken to abandon
further development of the new product. The cost is therefore irrelevant
to future decisions concerning the product. It is a sunk cost.
TUTORIAL EXERCISES
Exercise 1
Identify the most suitable answer from the options provided.
1.1 Fixed costs are conventionally deemed to be

a. constant per unit of output
b. constant in total when production volume changes
c. outside the control of management
d. unaffected by inflation
1.2 Variable costs

a. are not affected by changes in production volume
b. include examples such as supervisors' salary, rent, insurance
on property, etc.
c. remain constant per unit of output
d. decrease per unit as production activity increases
1.3 A cost whereby revenue is forfeited or sacrificed because one

alternative is selected above another, and that is not a cost that
can be obtained from the accounting system, is referred to as
a. a differential cost
b. an incremental cost
c. an opportunity cost
d. a sunk cost
1.4 Ditz Manufacturing Company has the following sales and cost data
for job order 653:
Direct materials used R400 000

Direct labour R200 000
Factory overheads (50% variable) R250 000
Selling and administrative expenses (60% variable) R320 000
1.4.1 The prime cost is

a. R450 000
b. R600 000
c. R850 000
d. R400 000
1.4.2 The total manufacturing cost is

a. R450 000
b. R600 000
c. R850 000
d. R1 170 000
1.4.3 The total variable cost is

a. R570 000
b. R600 000
c. R317 000
d. R917 000
1.5 A company has recently spent R80 000 on research on a new

product. Since then, it has decided that it is not feasible to
continue with the production of the new product. The R80 000
that has been spent is referred to as
a. a differential cost
b. an incremental cost
c. an opportunity cost
d. a sunk cost
1.6 Controllable costs are

a. costs that contain both a fixed portion and a variable portion
b. not included in overhead costs
c. the direct responsibility of a particular manager
d. seldom excessive and often lower than normal
1.7 The term “conversion costs” refers to

a. the sum of all raw material costs and direct labour costs
b. the sum of all direct labour costs and factory overhead costs
c. a cost that varies in total, but remains constant on a per-unit
basis
d. costs that are associated with the manufacturing of products
Exercise 2
Classify the items below as product or period costs. If you have
classified an item as a product cost, indicate whether it is direct
materials, direct labour or manufacturing overheads. If you have
classified an item as a period cost, indicate whether it is a
marketing/selling or an administrative cost.
2.1 Raw materials used to manufacture products
2.2 Wages of workers who handle material during the production
process
2.3 Advertising costs
2.4 Depreciation on a vehicle used by the managing director
2.5 The production manager’s salary
2.6 Lease payments on manufacturing equipment
2.7 Lease payments on vehicles used by sales personnel
2.8 Depreciation on manufacturing equipment
2.9 Rent on factory building
2.10 Cleaning material used by production workers
Exercise 3
ABC Manufacturing Company had the following data for the month of
May 20x1:
Direct materials R200 000

Manufacturing overheads R150 000
Selling and administrative expenses (70% variable, 30% fixed)R240 000
Manufacturing overheads is a mixed cost and is based on the number of

units produced. The manufacturing overhead costs for the last few
months are given below:
Months Production in Manufacturing overhead

units costs
January 7 000 R160 000
February 5 000 R140 000
March 8 000 R170 000
Months Production in Manufacturing overhead
units costs
April 9 000 R180 000
May 6 000 R150 000
Required
Calculate the following costs:
3.1 Prime cost
3.2 Conversion cost
3.3 Product cost
3.4 Period cost
3.5 Total variable cost
3.6 Total fixed cost
Exercise 4
Below are a number of costs that might be incurred in a service, trading
or manufacturing company. Indicate whether the cost involved would be
variable, fixed or semivariable (mixed):
4.1 Leather used to manufacture basketballs
4.2 Cleaning material used in the factory
4.3 Wages of assembly line workers who are paid per hour
4.4 Salary of factory supervisor
4.5 Depreciation on factory plant and machinery
4.6 Electrical costs of running machinery
4.7 Rental of factory building
4.8 Rates and taxes on factory building
4.9 Manufacturing equipment leased at a flat rate per month plus an
additional cost based on the number of hours that the machine is
operated during the month
4.10 Telephone costs (including line rental)
4.11 X-ray film used in a medical centre
4.12 Buns used to make hamburgers at a fast-food outlet
4.13 Maintenance of plant and machinery charged at a flat rate per
month plus an additional cost based on the number of
maintenance hours worked
4.14 Shipping costs of a manufacturer where no monthly contract exists,
i.e. the manufacturer is charged per product shipped
4.15 Advertising for a retailer where a monthly contract exists
4.16 Commission paid to sales personnel
4.17 Insurance on office building
Exercise 5
The cost accountant of XYZ Manufacturers identified the following
expenses applicable to its operations:
5.1 Cost of oils used to lubricate production machinery
5.2 Motor vehicle licences for lorries
5.3 Depreciation on factory plant and equipment
5.4 Cost of chemicals used in the laboratory
5.5 Commission paid to sales representatives
5.6 Salary of the secretary to the managing director
5.7 Trade discount given to customers
5.8 Holiday pay of machine operators
5.9 Salary of security guard in raw material warehouse
5.10 Fees to advertising agency
5.11 Rent of finished goods warehouse
5.12 Salary of scientist in the laboratory
5.13 Insurance of the company’s premises
5.14 Salary of supervisor working in the factory
5.15 Cost of printer cartridges in the general office
5.16 Protective clothing for machine operators
Required
Classify costs according to the following cost terms. Each expense can
only be classified once: production overheads, selling and distribution
overheads, administrative overheads, research and development
overheads.
Exercise 6
Classify costs according to the following cost terms: product, period,
fixed, variable, mixed, sunk and opportunity.
Cost item Variable Fixed Mixed Period Direct Indirect Sunk Opportunity
cost cost cost cost product product cost cost
cost cost
Example: Salary X X X
of the company’s
managing
director
6.1 Wood used
in the
manufacturing
of tables
6.2 Wages of
assembly line
workers, who
are paid per
hour
6.3 Rental on
manufacturing
facility
6.4 Salary of
production
manager
6.5 Overtime
premiums
paid to
assembly line
workers
6.6 Depreciation
on
manufacturing
equipment,
using the
straight-line
method of
depreciation
Cost item Variable Fixed Mixed Period Direct Indirect Sunk Opportunity
cost cost cost cost product product cost cost
cost cost
6.7 Salary of the
distribution
clerk in
finished
goods
warehouse
6.8
Commissions
paid to
salespersons
6.9 Cost of car

licences for
vehicles used
by sales
personnel
6.10 Trade
discount
granted to
customers
6.11 Rental
income
foregone on
factory space
6.12 Salary of
storeman in
raw materials
warehouse
6.13 Electricity
used for
operating
machinery
6.14 Photocopier
in the general
office, leased
at basic
monthly
charge plus
an additional
amount for
each copy
made
6.15 Advertising
costs
budgeted at
R400 000 per
annum
Exercise 7
In an attempt to reduce expenses, ABC Ltd is thinking of changing its
marketing method from retailer distribution to direct sales distribution.
Present costs and revenues are compared with projected costs and
revenues:
Retailer distribution Direct sale distribution

(present) R (proposed) R
Income 1 050 000 1 200 000
(revenue)
Costs of goods 525 000 600 000
sold
Advertising 140 000 67 500
Sales 0 50 000
commissions
Warehouse 75 000 120 000
depreciation
Other expenses 90 000 90 000
Total costs 830 000 927 500
Net profit 220 000 272 500
Required
Should ABC Ltd change its marketing method from retailer distribution
to direct sales distribution? Calculate the differential income and also
indicate which are relevant and irrelevant costs.
10 Materials
Outcomes
distinguish between direct and indirect materials

demonstrate knowledge of the various stock control levels
calculate the economic order quantity and value of stock on hand using FIFO (first-
in-first-out method) and the weighted average method of stock valuation.
Chapter outline

10.1.5 Inventory
10.3 Stock control
10.3.3 Stock out costs
10.3.4 Lead time
10.4.1 The perpetual and periodic inventory control systems
10.4.2 First-in-first-out method
Material, labour and overheads are the three cost elements that make up the cost of any
job or product. In subsequent modules we will focus on a precise classification for each
cost element.
Material can be classified as direct and indirect.

Direct material is the raw material that is converted into a finished product by the
manufacturing process. This material is visible in the final product, that is, it can
(easily) be physically traced to the final product, for example steel in the manufacturing
of a motor vehicle and wood in the manufacturing of a table.

Indirect material is material used in the manufacturing process that contributes to the
conversion of the direct material. This material cannot be physically (easily) traced to
the final product, for example the chemicals in iron ore for the manufacturing of steel,
and glue used in the manufacturing of a table.

Work in progress is the raw material that has been partially converted in the production
process. This material therefore cannot be classified as raw material or as a finished
product. Work in progress consists of a portion of all three cost elements – material,
labour and overheads.

Finished goods are products that have passed through the entire production process and
have been completed.
10.1.5 Inventory
This term includes all the material (direct and indirect), work in progress and finished
goods that the enterprise has at any given point in time.
Accounting entries for recording the purchasing and issuing of materials are similar to
those used in financial accounting records for a perpetual inventory system. It is also
based on the double-entry principle, which requires that there should be a
corresponding credit entry for each debit entry. A control account for inventory is kept
in the general ledger. A separate computerised inventory system is usually kept that
contains the details for each inventory type. A physical inventory count is done and
compared with the computerised inventory system on a periodic basis. The total
balance of all inventories in the inventory system is reconciled monthly to the inventory
control account in the general ledger. The material inventory control account is debited
as materials are received, and the accounts payable account or bank account (whichever
is applicable) is credited. Both direct and indirect materials may be recorded in the
material inventory control account.
When raw material is issued to production, direct material is recorded as work in

progress (WIP) and indirect material as manufacturing overheads. All consumables,
like stationery issued to the sales department, will be allocated to non-manufacturing
overheads. Material and supplies (indirect material) requisitions are recorded as
follows:
Debit Credit
WIP [direct material] xxx
Manufacturing overheads [indirect material] xxx
Non-manufacturing overheads [other consumables] xxx
Material inventory control xxx
All returns from production or other departments to stores result in credits in the WIP
account and / or the manufacturing overheads account and in debits to the material
inventory control account. Material returns are recorded as follows:
Debit Credit
Material inventory control xxx
WIP [direct material] xxx
Manufacturing overheads [indirect material] xxx
Non-manufacturing overheads [other consumables] xxx
The following balances were taken from the books of Caminaysh Ltd on 1 March
20x1:
Material inventory control (Dr) R12 500

WIP (Dr) R16 000
Accounts payable (Cr) R30 000
Transactions during March 20x1:

Material purchased on credit R30 000
Material issued:
Direct material R27 500
Indirect material R2 000
The company uses a perpetual inventory system to record its inventory.
Required
Prepare the journal entries and the ledger accounts for the month.
Solution
The journal entries for the above-mentioned transactions are:
Debit Credit
Material inventory control R30 000
Accounts payable R30 000
Recording of material purchased
WIP R27 500
Manufacturing overheads R2 000
Material inventory control R29 500
Recording of material issued
The ledger account for the above-mentioned transactions is:

Material inventory control
Balance b/d R12 500 WIP R27 500
Accounts payable 30 000 Manufacturing overheads 2 000
Balance c/d 13 000
42 500 42 500
Balance b/d 13 000
10.3 Stock control
Stock control is the system that a firm uses to control its investment in stock, which
includes
recording and monitoring stock levels

forecasting future demand
deciding when to order and how much to order.
There are usually three reasons for holding inventory:
1. Transaction motive – this refers to holding inventory for daily usage in the
production process.
2. Precautionary motive – this refers to holding extra inventory when future demand
is uncertain and / or the supply is unreliable, for example a material used in
production is going to be discontinued by the supplier.
3. Speculative motive – this refers to holding more or less inventory than usual,
because a change in the supplier’s price is anticipated, for example a fuel price
increase.
The main objective of stock control is to minimise in total the costs associated with
stock. These costs can be classified into three groups: carrying costs, ordering costs and
stock-out costs.

Carrying costs are those costs associated with the storage of the stock. These include
storage charges (rent, heating and lighting, air-conditioning and refrigeration)

stores staffing
stores equipment and maintenance
security and insurance
stocktaking, stock recording and audit costs
material handling costs
obsolescence and deterioration
theft, evaporation and vermin damage
interest on capital invested in the stock.
The carrying costs can be calculated as:
Average stock × Carrying cost per unit

Ordering costs are those costs associated with obtaining the stock. These include
administrative costs of purchasing

transportation costs.
The ordering costs are calculated as:
Number of orders × Cost per order
The number of orders can be calculated as:
Annual demand ÷ Order size
10.3.3 Stock-out costs

Stock-out costs are those costs associated with not having sufficient stock to meet the
customers’ needs. These costs tend to be intangible and include
the loss of contribution and profit owing to being out of stock

loss of future sales
cost of stoppages in production caused by stock outs
extra costs of having to meet urgent small orders.
10.3.4 Lead time

Lead time is the time taken from when an order is placed with the supplier, to when it
arrives on the business’s premises.

EOQ is the optimum quantity that should be ordered that will minimise the total
combined ordering and carrying costs.
2 × Annual requirement × Order cost

EOQ = √
Carrying or holding cost per unit

ROL is the level of stock at which another order (replenishment order) should be
placed. The reorder level depends on the lead time and the usage during the lead time.
It allows for the worst situation to occur without the danger of running out of stock, that
is, it provides for the situation where the business is running at maximum production
and the supplier takes the maximum delivery time. It is calculated as follows:
Maximum usage × Maximum lead time
or
(Average usage × Average lead time) + Safety stock

MinSL is the amount of stock that is kept to cover the possibility that there may be an
increase in demand and problems with the ordering and the delivery of goods. It is a
buffer to guard against stock-outs. It is also referred to as safety stock. It is calculated
as follows:
Max usage × Min lead time

MaxSL is the amount of stock for which storage spaces would be required. It is used to
indicate to management when stocks have risen too high.

AveSL reflects the average stockholding for the year. It is calculated by taking the order
size or EOQ divided by 2.
Figure 10.1 Diagrammatic illustration of the various stock control levels
Demand is 200 units per week

Lead time = 5 weeks
EOQ = 1 200 units
ROL = 1 400 units
MinSL (safety stock) = 400 units
MaxSL = 1 600 units
AveSL = 1 000 units
ILLUSTRATIVE EXAMPLE Calculation of EOQ
ABC Motor Corporation Ltd produces approximately 180 motor vehicles a day. In
half of these vehicles a specific type of air filter is used. The company works 360
days a year, on average. The cost of carrying one air filter in stock for the year
amounts to R10 and the cost of placing an order is R50.
Required
a) Calculate the EOQ for the air filters. Round off to the nearest whole number.
b) Calculate the ordering and carrying costs.
Solution
2×Annual requirement Order cost
a) EOQ = √
Carrying or holding cost per unit
2×(90×360)×R50
= √
R10
2×32 400×R50
= √
R10
3 240 000
= √
R10
= 569.2 air f ilters
= 570 air f ilters (round of f to the next whole number)
b) Ordering costs = Number of orders × Cost per order
= 32 400/570 × R50
= 57 orders × R50
= R2 850
Carrying costs = Average stock × Carrying cost per unit
= 570/2 × R10
= R2 850
10.4.1 The perpetual and periodic inventory control systems

In Chapter 4 you were briefly introduced to the periodic and perpetual inventory
methods in calculating the cost of sales. In this chapter we will expand on these
concepts. Most companies would either use a periodic or perpetual method of recording
inventory and calculating cost of sales.
In a perpetual inventory system, inventory accounts are updated after each transaction,
i.e. inventory quantities are continuously updated. In a periodic inventory system, on
the other hand, the value of ending inventory is determined at the end of each
accounting period by a physical stock count.
The perpetual inventory system has a number of advantages over the periodic inventory
system, for example, gross profit can be determined without an inventory count.
Secondly, the physical inventory on hand can be checked against the trading inventory
account. The inventory account reflects the inventory on hand at any moment in time.
Thirdly, individual items of inventory can be more easily monitored, especially if one
has a computerised system that updates the inventory records at the till.
A purchases account is used when the periodic method of recording inventory is in

operation. Whenever goods are bought they are debited to the purchases account and
when goods are sold they are credited to the revenue account. A separate inventory
account is kept but is not used at all during the year. Its sole function is to keep a record
of the opening inventory at the beginning of the year. It is only adjusted at the end of
each financial year.
A cost of sales account is used when the perpetual method of recording inventory is in
operation. When goods are purchased they are entered into the trading inventory
account and when goods are sold they are entered into the sales account, debiting the
bank or the debtor. In addition, a credit entry is made to the trading inventory account,
thus keeping a perpetual record of the inventory on hand. An entry is also made into the
cost of sales account, which therefore keeps a permanent and up-to-date record of the
cost price of the goods that have been sold.
Table 10.1 Differences between a perpetual and a periodic inventory

system
Perpetual Periodic inventory system

inventory
system
Inventory These accounts The cost of sales account does not exist during
account and are continuously the accounting period. It is shown as a closing
cost of sales updated during entry at the end of the accounting period and
account the accounting determined as a balancing figure or by using the
period. following formula:
Opening inventory
+ Purchases
− Closing inventory
The value of ending inventory is determined at
the end of each accounting period by a physical
stock count.
Purchases, There is no Purchases are recorded in the purchases

purchase purchases account and directly debited to the inventory
returns, and account. account. Purchase returns are directly credited to
purchase the inventory account.
allowances
accounts
Perpetual Periodic inventory system
inventory
system
Sale of goods Recording is Recorded via a single journal entry.
made via two
journal entries:
(1) recording the
sales value of
inventory
(2) recording the
cost of goods
sold
Closing entry Closing entries Closing entries not required for inventory
only required to account.
update inventory
and cost of goods
sold account.
The following example will illustrate the typical journal entries under a periodic and
perpetual inventory system.
The following transactions were extracted from the records of Zeus Enterprises:
Opening inventory R5 000

Bought goods on credit for R1 000
Bought goods for cash R600
Sold goods on credit for R300 (cost R200)
Sold goods for cash R400 (cost R267)
Closing inventory R6 000
Record the transactions under both the periodic and perpetual methods by means of
journal entries and calculate the gross profit.
The terms “accounts receivable” and “accounts payable” are used for debtors and
creditors respectively.
Periodic inventory method Perpetual inventory method

Dr Cr Dr Cr
R R R R
Purchases 1 000 Trading inventory 1 000
Accounts payable 1 000 Accounts payable 1 000
Purchases 600 Trading inventory 600
Bank 600 Bank 600
Accounts receivable 300 Accounts receivable 300
Revenue 300 Revenue 300
Bank 400 Cost of sales 200
Revenue 400 Trading inventory 200
Bank 400
Revenue 400
Cost of sales 267
Trading inventory 267
Calculation of gross profit:
R R R
Revenue 700 Revenue 700
Less: Cost of sales 600 Less: Cost of sales 467
Opening inventory 5 000 Gross profit 233
Add: Purchases 1 600
Cost of goods available for sale 6 600
Less: Closing inventory 6 600
Gross profit 100
Note: Various accounts are affected under each method. Under the perpetual method,
there is an inventory loss of R133, which must be taken to the income statement as an
expense, i.e.:
Inventory
R R
Balance b/d 5 000 Cost of sales 200
Creditors 1 000 Cost of sales 267
Bank 600 Inventory loss 133*
Balance b/d 6 000
6 600 6 467
*This credit side would be R133 less than the debit side. The adjusting journal entry
would be:
Dr Inventory loss R133
Cr Trading inventory R133
To calculate the value of stock on hand at the end of a given period, the following
methods will be covered:
First-in-first-out method (FIFO)

Weighted average method
10.4.2 First-in-first-out method (FIFO)
PERIODIC INVENTORY
A physical stock count is done at the end of the accounting period to determine the
inventory on hand (closing balance). Using the FIFO method to compute the cost of
ending inventory, the cost of most recent purchases is used, after which the cost of
goods sold can be computed.
PERPETUAL INVENTORY
According to this method, the material that is purchased first is used (issued) first. That
is, the oldest stock is issued first at the price at which it was originally purchased.
Consequently, the stock on hand at the end of the financial period (closing stock) will
be valued at the cost of the more recently acquired material, which is in line with the
current market values.
PERIODIC INVENTORY
When using the weighted average method, the weighted average unit cost is used to
calculate the cost of goods sold and the cost of ending inventory. The weighted average
unit cost is computed using the following formula:
Total cost of units available f or sale
Number of units available f or sale
PERPETUAL INVENTORY
According to this method, the new material that is purchased is added to the material
already in stock. An average price must be determined after each purchase by dividing
the total cost of stock on hand by the total number of units on hand.
ILLUSTRATIVE EXAMPLE Stock valuation

The following transactions have been concluded in respect of a particular stock item
for the month of February 20x1:
1 Stock on hand: 100 units at R10,00 per unit
3 Issued stock: 40 units
4 Received stock: 160 units at R12,00 per unit
7 Returned stock to the supplier: 20 units received on 4 February 20x1.
Required
Calculate the value of the closing stock for the month of February 20x1 using the
following methods of stock valuation:
FIFO
Weighted average
Where necessary, round off to two decimal places.
Solution
Periodic inventory
The solution to the example will depend on the basis that is used to value inventory,
i.e. FIFO or weighted average, and whether periodic or perpetual inventory is used.
However, the number of units on hand will remain the same irrespective of which
method is used.
FIFO: Periodic inventory
February Units Cost per unit (R) Total (R)

01 Opening inventory 100 10,00 1 000
04 Purchases 160 12,00 1 920
07 Returns (20) 12,00 (240)
Goods available 240 1 680
Issues (140)
Closing inventory 100 1 200
Weighted average: Periodic inventory
February Units Cost per unit (R) Total cost (R)

01 100 10,00 1 000
04 160 12,00 1 920
07 (20) 12,00 (240)
240 2 680
Weighted average unit cost = R2 920 / 260 units

= R11,1667 per unit
Units available for sale 240

Less: Units sold (40 + 40 + 20 + 40) 140
Units in ending inventory 100
Cost of goods sold: 140 units × R11,17 = R1 563,80

Cost of ending inventory: 100 units × R11,17 = R1 117
Solution
Perpetual inventory
Stores ledger card (FIFO)
Date Received Issued Balance

Feb Units
Price Amount Units
Price Amount Units
Price Amount
R R R R R R
01 100 10,00 1 000

03 40 10,00 400 60 10,00 600
04 160 12,00 1 920 60 10,00 600
160 12,00 1 920
05 40 10,00 400 20 10,00 200
160 12,00 1 920
06 20 10,00 200 Nil Nil Nil
40 12,00 480 120 12,00 1 440
07 (20) 12,00 (240) 100 12,00 1 200
Closing stock value = R1 200

Total cost of issues = R1 480 (R400 + R400 + R200 + R480)
Total cost of stock purchased = R1 680 (R1 920 – R240)
Stores ledger card (weighted average)
Date Received Issued Balance

Feb Units
Price Amount Units
Price Amount Units
Price Amount
R R R R R R
01 100 10,00 1 000

03 40 10,00 400 60 10,00 600
04 160 12,00 1 920 220 11,45 2 520
05 40 11,45 458 180 11,45 2 061
06 60 11,45 687 120 11,45 1 374
07 (20) 12,00 (240) 100 11,34 1 134
Calculations
4 February 20x1 total cost ÷ total number of units
= (R600 + R1 920) ÷ (60 + 160)
= R2 520 ÷ 220 units
= R11,45
7 February 20x1 total cost ÷ total number of units

= (R1 374 – R240) ÷ (120 – 20)
= R1 134 ÷ 100 units
= R11,34
Closing stock value = R1 134

Total cost of issues = R1 545 (R400 + R458 + R687)
Total cost of stock purchased = R1 680 (R1 920 – R240)
TUTORIAL EXERCISES
Exercise 1
1.1 Racquets Unlimited is planning to stock two new products next year. The
following information is made available:
The expected annual demand for Standard Racquets will be 100 000 racquets,
and the cost to place each order is R15. The total holding cost for one of these
racquets is R5 per year (including interest). The expected demand for Deluxe
Racquets will be 2 500 racquets a week, and the cost to place each order is
R16. The handling costs for one of these racquets is R9 per racquet. An
additional R1 per racquet will be incurred for theft and fire insurance for Deluxe
Racquets. Assume that there are 52 weeks in a year and that the expected
warehouse rent is R450 000 a year.
The Economic Order Quantity for Racquets Unlimited of the proposed new
racquets is as follows:
(1) Standard Racquets: 775 racquets; Deluxe Racquets: 645 racquets

1.2 The warehouse presents you with the following information on a specific model
of cellular device for the month ended 31 July 20x1. The company uses the
FIFO method of inventory valuation.
DateTransaction details
July
1 Opening inventory 300 units at R40 each
2 Bought 250 at 5% discount of the price per unit of opening inventory.
6 Issued 350 units to production.
10 Bought 50 units at R47 each, 10% of the purchase price per unit is freight
charged, which was paid for this order.
25 Returned to supplier 10 units bought on 2 July 20x1.
29 Bought 25 units at R49 each.
1.2.1 The value of the inventory on 2 July 20x1, assuming that there was a fire
at the warehouse and half of the inventory bought on 2 July 20x1 was
destroyed, is
(1) R16 570
(2) R21 500
(3) R16 750
(4) R20 500
1.2.2 The value of the inventory issued to production on 6 July 20x1 is

(1) R14 000
(2) R13 900
(3) R31 900
(4) R21 900
1.2.3 The value of the inventory on 31 July 20x1 is

(1) R1 225
(2) R2 585
(3) R11 300
(4) R11 030
Exercise 2
A manufacturing company uses 3 500 units of raw material XT per week. The cost of
ordering one unit of XT amounts to R45 and the storage and holding costs
associated with one unit are as follows:
Cost per unit per annum R

Interest on funds invested 5,00
Insurance 7,60
Municipal charges 10,40
Miscellaneous 7,00
30,00
Assume that there are 52 weeks in the year.
Required
Calculate the EOQ for raw material XT. Round off to the nearest whole number.
Exercise 3
Bicycles Ltd, a manufacturing company that produces and sells various types of
bicycles, has provided you with the following information. The minimum production of
bicycles is 51 per week and the maximum production is 153 per week. The company
purchases the bicycle wheels from an external supplier at a cost of R20 per wheel.
The cost of placing an order is R35 and the cost of carrying one wheel in stock for
the year is 25% of the cost of one wheel.
Required
Calculate the EOQ in respect of wheel stock, assuming that there are 52 weeks in
the year. Round off to the nearest whole number.
Exercise 4
The following information is available for the month of January 20x1 concerning raw
material WG, which is used in the manufacturing of widgets.
Opening stock 1 160 units at R3,50 each

Received stock 2 500 units at R4,20 each
16 180 units at R2,25 each
Issued stock 6 300 units
20 370 units
Required
Calculate the value of the closing stock of raw material WG for the month of January
20x1, using the following methods of stock valuation:
4.1 FIFO
4.2 Weighted average
Exercise 5
Retailers Ltd had the following transactions regarding a particular stock item for the
month of April 20x1:
1 Opening inventory 30 units at R50

2 Sold 10 units.
7 Purchased 20 units at R75 each.
20 Sold 55 units.
30 Sold 12 units.
The company requires a 20% mark-up on cost price.
Required
For the month of April 20x1:
5.1 Calculate the gross profit using FIFO.
5.2 Calculate the value of closing inventories using the weighted average inventory
method.
Exercise 6
The following transactions have been concluded in respect of a particular stock item
for the month of June 20x1:
1 Stock on hand: 100 units at R10,00 per unit

6 Received stock: 100 units at R20,00 per unit
28 Returned stock to the supplier: 10 units received on 6 June 20x1
Note: The business uses a mark-up of 20% on cost.
Required
Determine the value of closing stock, cost of sales and gross profit, using FIFO.
Exercise 7
The following transactions took place in the books of XYZ Ltd with regard to stock
item PTL for the month of September 20x1:
1 Balance of 20 at R15,10 each

5 Purchased 20 at R17,00 each.
9 Sold 5 at R35,00 each.
15 Purchased 7 at R19,50.
25 Returned 3 to the supplier, which had originally cost R15,10 each.
28 Purchased 10 at R19,50.
Required
For the month of September 20x1:
7.1 Calculate the value of closing inventories using the weighted average inventory
method.
7.2 Calculate the gross profit generated on the stock item PTL. Where necessary,
round off to two decimal places.
Exercise 8
Manufacturers Ltd has provided you with the following information for the month of
November 20x1 regarding a part that is used during the manufacturing process:
1 Stock on hand comprised the following purchases:

Purchases of 25 October 20x1
(80 units at R12 each, total cost of R960)
Purchases of 30 October 20x1
(800 units at R12,40 each, total cost of R9 920)
5 Issued to production 640 units.
9 Purchased 800 units at R12,80 each, total cost of R10 240.
Freight charges on these purchases amounted to R80.
15 Issued 1000 units.
20 Purchased 1200 units at R12,60 each, total cost of R15 120.
25 Returned to the supplier 240 units purchased on 20 November 20x1.
Required
For the month of November 20x1:
8.1 Calculate the cost of issues to production and value of closing inventories using
FIFO.
8.2 Calculate the value of closing inventories using the weighted average method of
stock valuation.
Exercise 9
Sica Ltd presented information about the material purchases and issues for the
month of June 20x1. They use a perpetual inventory system.
Date
8 Direct materials issued R4 100

10 Issued from factory maintenance supplies R275
14 Returned direct materials to the warehouse R1 400
18 Purchased raw materials on credit R17 900
21 Returned raw materials bought on credit to supplier R5 200
Required
Record the above transactions using journal entries.
Exercise 10
Sencam Ltd provides you with the following information regarding its inventory:
Annual usage 208 000 units

Interest rate 9,5%
Cost price per unit R22 per unit
Stock holding cost R7 per unit
Ordering cost R25 per order
Maximum weekly usage 4 000 units
Minimum weekly usage 3 000 units
Maximum lead time 6 weeks
Minimum lead time 2 weeks
Calculate the following:
10.1 EOQ
10.2 Number of orders per year
10.3 Safety stock
10.4 Average stock
10.5 Reorder point
Exercise 11
Zeus Enterprises uses a periodic inventory system and accounts for inventory at the
end of each accounting period by doing a physical stock count. The first-in-first-out
method is applied to compute the cost of ending inventory.
The following information regarding inventory is provided for the year 20x1:
Feb 01 Opening Inventory 200 units @ R18 per unit

Feb 11 Purchases 300 units @ R20 per unit
Sept 16 Purchases 400 units @ R22 per unit
Nov 14 Purchases 100 units @ R24 per unit
On 31 December 20x1, after doing a physical stock count, there are 300 units on
hand.
Required
Using the first-in-first-out (FIFO) method, compute the following:
11.1 Cost of closing inventory at 31 December 20x1
11.2 Cost of goods sold during the year 20x1
Exercise 12
Bubbles Enterprises uses a periodic inventory system. Accounting for inventory at
the end of each accounting period is done by doing a physical stock count. The
weighted average method is applied to compute the cost of ending inventory. The
following information is available regarding one of its products for December 20x1:
Date Transaction details

December
01 Opening balance 100 units @ R10,20
06 Purchases: 400 units @ R10,45
07 Sales: 200 units
14 Sales: 250 units
27 Sales: 700 units
28 Sales: 100 units
Required
Compute inventory cost at 31 December 20x1 using the weighted average method.
11 Labour
Outcomes
distinguish between direct and indirect labour

calculate an employee’s remuneration
apply various incentive schemes
ascertain the labour recovery rate for the business.
Chapter outline
11.2.1 Salaries
11.2.2 Hourly wages
Labour is the physical and / or mental effort used to manufacture a product or provide a service.
It can be classified as either direct or indirect.

Direct labour is the labour cost that can be physically traced to the creation of a specific product
in a “hands-on” sense (such as assembly line workers in a plant).

Indirect labour is the labour cost that cannot be physically traced to the creation of a specific
product, for example factory supervision and maintenance wages.
There are three basic types of remuneration methods. A business entity can choose to apply one
of these methods or they can use a combination.
11.2.1 Salaries
A salary is a fixed amount paid to an employee on a monthly basis. The employees that normally
receive salaries include managerial staff, supervisors and administrative workers.
11.2.2 Hourly wages

Workers are paid a specific rate based on the numbers of hours spent at work:
Hourly wages = Hours worked × Rate of pay per hour
Although workers are paid per hour, their output is also monitored by their immediate supervisor.
This is to ensure that they are not being paid merely for being present at work.

Under the piecework system, employees are paid in accordance with the actual number of units
that they have produced:
Piecework pay = Number of units produced × Rate of pay per unit
This system can only be applied if the employee’s output can be determined with certainty.

Remuneration can be classified as basic, gross and net wages. Basic remuneration is the normal
wages that an employee earns.
11.2.4.1 Gross wages

The gross wage includes the basic wage, overtime, bonus and allowances. There are two types of
overtime that can be calculated for an employee: normal overtime and double overtime. Normal
overtime is the overtime worked after hours during the week and on a Saturday. It is remunerated
at one and a half times the normal rate. Double overtime is overtime that is worked on a Sunday
or a public holiday. It is remunerated at two times the normal rate.
An employee may be entitled to an annual bonus, as well as various other allowances, which can
include a cellphone allowance, car allowance, etc. These allowances would be dependent upon
the type of job that the employee is required to do.
11.2.4.2 Net wages

The net wage is an employee’s take-home pay after all the deductions have been considered.
There are numerous deductions that impact on an employee’s wage, such as pension, pay as you
earn, the Unemployment Insurance Fund, medical aid, etc.
11.2.4.3 Pension fund

The purpose of a pension fund is to provide an investment for an employee’s retirement. Only
permanent employees contribute to a pension fund. According to the South African Income Tax
Act, an employer is allowed to deduct 7,5% from an employee’s basic wage and pay it over to a
specified pension fund. The employer also contributes to the pension fund on the employee’s
behalf. Pension is the first deduction that is made.
11.2.4.4 Pay as you earn (PAYE)

The government charges its citizens and business entities taxation. The purpose of this taxation
process is to cover government expenditure. Pay as you earn refers to the personal tax that
individuals pay over to the South African Revenue Services (SARS). The amount that is charged
to individuals is stipulated in the tax tables. These tables change from year to year. For the
purpose of this book you will always be given a percentage to work with. PAYE is calculated as a
percentage of taxable income.
Taxable income = Basic wage – Pension fund contributions
11.2.4.5 Unemployment Insurance Fund (UIF)

The Unemployment Insurance Act of 2001 protects workers who become unemployed. It covers
individuals who are out of work, as well as those who cannot work due to pregnancy and
prolonged illness. According to the act, employers are entitled to deduct 1% of an employee’s
basic wage and pay it over to the fund. The contributions to the UIF are compulsory for the
employer and employee. The government also contributes to this fund.
11.2.4.6 Medical aid fund
The purpose of a medical aid fund is to subsidise individuals who may encounter unexpected
medical expenses. This is made possible due to a large number of people contributing to the
fund.
Format for the net wage calculation
R R
Basic wages xxx
Add: Normal overtime xxx
Add: Double overtime xxx
Add: Bonus xxx
Add: Allowances xxx
Gross wage xxx
Less: Pension fund (xxx)
Taxable income xxx
Less: Other deductions (xxx)
Pay as you earn (PAYE) xxx
Unemployment Insurance Fund xxx
Medical aid xxx
Net wage xxx
Note: The employees must complete their normal working hours before qualifying for overtime.

As part of the fringe benefits, employers may contribute to various funds on the employee’s
behalf, for example pension and unemployment insurance.
Note: The employer’s contributions are not considered when we calculate the employee’s net
wage. These contributions are paid directly to the relevant funds.

There are three main journal entries involved in the recording of wages. These are as follows:
A journal entry to record the employee’s gross wage, net wage and deductions.
A journal entry to record the employer’s contributions.
A journal entry to record the total payments.
Recording the employee’s gross wage, net wage and deductions

Recording the employer’s contributions
Debit Credit
Wages account xxx
Pension fund xxx
Unemployment Insurance Fund xxx
Medical aid fund xxx
Recording the total payments
Debit Credit
Wages payable xxx
Pension fund (employer and employee contributions) xxx
SARS (PAYE) xxx
Unemployment Insurance Fund (employer and employee contributions) xxx
Medical aid fund (employer and employee contributions) xxx
Bank xxx
ILLUSTRATIVE EXAMPLE Net wage and accounting entries
Miss Mungal is an employee of Manufacturing Ltd. She works in the assembly department and
receives an hourly rate of pay of R30. The normal working week consists of 40 hours, from
Monday to Friday.
Monday 10 hours
Tuesday 10 hours
Wednesday 7 hours
Thursday 12 hours
Friday 8 hours
Saturday 5 hours
Sunday 5 hours
Normal overtime is calculated at time and a half, while overtime worked on Sundays and
public holidays is calculated at double the normal rate of pay. Contributions to the relevant
funds are as follows:
Pension fund at 7,5% of basic wage; the employer contributes to this fund on a rand-for-
rand basis.
Medical aid totals R150 per week, of which 40% is paid by the employer and the balance by
the employee.
Unemployment Insurance Fund (UIF) at 1% of basic wage; the employer contributes to the
fund on a rand-for-rand basis.
The PAYE rate is 18% of taxable income.
Required
Calculate the net wage of Miss Mungal for the week ended 28 February 20x1 and prepare all
the necessary journal entries. Where necessary, round off to two decimal places.
Solution
Net wage of Miss Mungal for the week ended 28 February 20x1
R R
Basic wage (40 hours × R30) 1 200,00
Normal overtime (13 hours × R30 × 1,5) 585,00
Double overtime (5 hours × R30 × 2) 300,00
Gross wage 2 085,00
Less pension (R1 200 × 7,5%) 90,00
Taxable income 1 995,00
Less other deductions 461,10
PAYE (R1 995 × 18%) 359,10
Medical aid (R150 × 60%) 90,00
UIF (R1 200 ×1%) 12,00
Net wage 1 533,90
Calculation of employer contributions
Pension fund contributions R90,00

Unemployment Insurance Fund R12,00
Medical aid fund (R150 × 40%) R60,00
Total employer contributions R162,00
Accounting entries
Recording employee’s gross wage, net wage and deductions
Debit (R) Credit (R)
Wages account (gross wage amount) 2 085,00
Wages payable (net wage amount) 1 533,90
Pension fund 90,00
SARS (PAYE) 359,10
Unemployment Insurance Fund 12,00
Medical aid fund 90,00
Recording employer contributions
Debit (R) Debit (R)

Wages account 162,00
Pension fund 90,00
Unemployment Insurance Fund 12,00
Medical aid fund 60,00
Recording the total payment
Debit (R) Credit (R)

Wages payable 1 533,90
Pension fund (R90 + R90) 180,00
SARS (PAYE) 359,10
Medical aid (R90 + R60) 150,00
Unemployment Insurance Fund (R12 + R12) 24,00
Bank 2 247,00
The main purpose of an incentive scheme is to increase productivity. Employees are rewarded for
time saved or additional units produced in the form of a bonus. There are various incentive
schemes that exist. This book will focus on the following four schemes:
Halsey bonus scheme

Halsey-Weir bonus scheme
Rowan premium bonus scheme
Taylor’s differential piecework
The Halsey, Halsey-Weir and Rowan premium bonus schemes reward employees based on the
time that they save. The bonus is calculated as a percentage of time saved.
Time saved = Time allowed – Time worked

Under this method the bonus calculated is based on half of the time saved.
Bonus = ½ of time saved × Wage rate

Under this method the bonus calculated is based on a third of the time saved.
Bonus = ⅓ of time saved × Wage rate

Under this method the bonus calculated is based on the percentage derived from dividing the
time worked by the time allowed.
Time worked
Bonus = × Time saved × Wage rate
Time allowed

The standard required for the completion of a job is recorded. An employee’s performance is
then measured against this standard / benchmark in order to determine whether or not a bonus
has been earned. An employee’s performance can fit into one of three categories: it can be below
standard, standard or above standard. The employer will determine what percentage the
employee should earn under each one of these categories.
The rate per unit for the standard time is calculated as follows:
Hours worked
Rate per unit = × Wage rate per hour
Standard units
Bonus = Units produced × Rate per unit × Standard percentage given
ILLUSTRATIVE EXAMPLE Incentive schemes: Halsey, Halsey-Weir and Rowan

premium bonus schemes
The following information is provided for three employees of Incentive Manufacturing Ltd for
the week ended 5 October 20x1. These employees work in different departments and it was
decided by the company’s management to apply various types of incentive scheme,
depending upon the employee’s job title. The employees are M. Naicker, S. Zunckel and P.
Msomi.
For the week ended 5 October 20x1 they each worked 40 hours and produced the following
number of units: 2 218, 2 000 and 1 864 respectively.
Other relevant information:
The standard production for all employees is 40 units per hour. The normal rate of pay is R80
per hour and the piecework rate is R5 per unit.
Required
a) Calculate the weekly wages for each employee if a piecework incentive scheme is used.
b) Calculate the bonus that must be paid to each of the employees if the following incentive
schemes are used:
M. Naicker – Halsey incentive scheme

S. Zunckel – Halsey-Weir incentive scheme
P. Msomi – Rowan incentive scheme
Solution
a)
Employee Calculation Bonus

M. Naicker 2 218 units × R5 per unit = R11 090
S. Zunckel 2 000 units × R5 per unit = R10 000
P. Msomi 1 864 units × R5 per unit = R9 320
b) Time allocated: Actual units ÷ Standard production per hour
Employee Calculation Time allocated / allowed

M. Naicker 2 218 ÷ 40 55,45 hours
S. Zunckel 2 000 ÷ 40 50,00 hours
P. Msomi 1 864 ÷ 40 46,60 hours
M. Naicker S. Zunckel P. Msomi

Time allocated / allowed 55,45 hours 50,00 hours 46,60 hours
Less: Actual time taken 40,00 hours 40,00 hours 40,00 hours
Time saved 15,45 hours 10,00 hours 6,60 hours
M. Naicker
Halsey incentive scheme : (50% × Time saved × Wage rate per hour)
: (50% × 15,45 hours × R80)
: R618,00
S. Zunckel
Halsey-Weir scheme : (⅓ × Time saved × Wage rate per hour)
: (⅓ × 10,00 hours × R80)
: R266,67
P. Msomi
Rowan premium bonus scheme: ((Time worked ÷ Time allowed) × (Time saved × Wage rate
per hour))
: [(40 ÷ 46,60 × 6.60 hours × R80)]
: R453,22
ILLUSTRATIVE EXAMPLE Incentive scheme: Taylor’s differential piecework
Productivity Ltd uses the Taylor’s differential piecework system to reward employees for
increased production. The company has used a time and motion study to determine the
standard time allowed, which was 95 units per hour. A normal working day consists of eight
hours and workers are paid R35 per hour.
Management has set the bonus percentages as follows:
A bonus of 10% for work that is below standard

A bonus of 85% for work that is standard and above
Two employees, Peter and Paul, produced 700 and 900 units respectively on a specific day.
Required
Calculate the bonus, as well as the gross wage, for the two employees for the day.
Solution
Standard production is 760 units per day (8 hours × 95 units).
The rate per unit for the standard time is calculated as follows:
Hours worked × Wage rate per hour
=
Standard units
8 hours×R35
=
760 units
= R0,37 per unit (rounded)
Bonus = Units produced × Rate per unit × Standard percentage given
Peter
Bonus (700 units × 0,37 × 10%) R 25,90
Basic wage (700 units ÷ 95 units per hour × R35) R257,89
Gross wage for the day R283,79
Paul
Bonus (900 units × 0,37 × 85%) R283,05
Basic wage (900 units ÷ 95 units per hour × R35) R331,58
Gross wage for the day R614,63
The purpose of the labour recovery rate is to ascertain what the business entity is spending on
each employee. The formula used is as follows:
Total annual labour cost

Labour recovery rate =
Total annual productive hours

The productive hours relate to the actual working hours for all the employees for the year.

The annual labour cost includes all the items that the business entity pays for, that is the basic
wage, bonus, allowances, as well as all the fringe benefits.
ILLUSTRATIVE EXAMPLE Labour recovery rate
StitchIt Ltd is a company that operates within the clothing industry. They produce a wide range
of clothes for the whole family. The company is well known for their good quality of clothing.
They employ four pattern designers, one for each range of clothing. These pattern designers
work eight hours a day for five days a week and are paid at a rate of R75 per hour. They also
receive the following fringe benefits:
A bonus equal to four weeks of normal earning

A housing allowance of R600 per employee per month
A clothing allowance of R500 per employee per quarter
The company also contributes to the following funds on the employees’ behalf: pension at
7,5% and Unemployment Insurance Fund at 1% of normal earnings.
The pattern designers are entitled to three weeks’ vacation leave for the year. The calendar for
the current year indicates that there are 13 public holidays. Idle time is anticipated to be 3% of
available time. Assume that there are 52 weeks in the year.
Required
a) Annual productive hours
b) Total annual labour cost
c) Hourly recovery rate
Solution
a) Annual productive time Hours
Number of hours in a year (52 w × 40 hours p / w × 4 employees) 8 320
Less: Vacation hours (3 w × 40 hours × 4 employees) (480)
Less: Public holidays (13 days × 8 hours p / day × 4 employees) (416)
Available productive hours 7 424
Less: Idle time (3% × 7 424) (222,72)
Annual productive hours 7 201,28
b) Annual labour cost R’s

Basic wage (40 hours × R75 × 4 employees × 52 weeks) 624 000
Add: Annual bonus (40 hours × R75 × 4 employees × 4 weeks) 48 000
Add: Housing allowance (600 × 12 months × 4 employees) 28 800
Add: Clothing allowance (500 × 4 quarters × 4 employees) 8 000
Add: Pension fund contributions (7,5% × 624 000) 46 800
Add: UIF contributions (1% × 624 000) 6 240
Annual labour cost 761 840
c) Hourly recovery rate
= Annual labour cost ÷ Annual productive hours
= R761 840 ÷ 7 201,28
= R105,79
Payroll accounting is the system used by employers to keep track of their employees’ wages and
salaries, bonuses, fringe benefits, etc. Computerised payroll systems comprise software packages
that provide an efficient way of organising, storing and maintaining data on all employees.
The computerised payroll system performs the same function as the manual system, but there are
various advantages of using the computerised system, as opposed to the manual system:
It saves time and resources.

It allows for the accessing of data and the updating of information electronically.
It decreases the rate of errors, since the processing is done by a computer.
Some payroll software packages can be integrated with other functions within the
organisation, such as the time clock system. The date and time are imported into the payroll
system as the employee swipes his electronic card.
There are various payroll accounting software packages on the market to suit the needs of the
business. Small and medium-sized businesses can purchase off-the-shelf software, while larger
businesses have the option of having the payroll accounting software package tailored to their
needs.
In the manual system the salaries and wages journals are drafted and posted to the general ledger.
Each of these journals will be discussed in more detail.

The salaries journal is drafted on a monthly basis and is used to record the gross salary, employee
deductions, net salary, as well as the employer contributions for each salaried employee. The
cash payment journal is then drafted to record the payments made to the employees, as well as
the payments to the relevant funds. The totals of the aforementioned journals are then posted to
the general ledger.
ILLUSTRATIVE EXAMPLE: Salaries journal and posting
Workers Ltd has three salaried employees. Mr Govender, the manager, Mrs Yearwood, the
factory supervisor, and Mr Nzuza, the administrative assistant. The monthly gross salary per
employee is R45 000, R33 000 and R30 000 respectively.
The following deductions are made from each employee’s gross salary: 7,5% to the Workers’
Pension Fund; 5% to the Feel Good Medical Aid Scheme, and 1% to the Unemployment
Insurance Fund. The employer also contributes to the Workers’ Pension Fund and the
Unemployment Insurance Fund on a rand-for-rand basis for each employee. The PAYE
deduction is 18% of taxable income.
Required
Based on the information provided, draft the salaries journal and cash payments journal of
Workers Ltd for the month of April 20x2 and post to the relevant general ledger accounts.
Solution
Salaries journal of Workers Ltd for April 20x2 SJ1

Employee Gross Deductions Net Employer contributions
salary Pension Medical UIF Receiver of Total salary Pension UIF Total
fund 7,5% aid 5% 1% revenue (PAYE) fund
18%
Govender 45 3 375,00 2 250,00 450,00 7 492,50 13 31 3 375,00 450,00 3
000,00 567,50 432,50 825,00
Yearwood 33 2 475,00 1 650,00 330,00 5 494,50 9 23 2 475,00 330,00 2
000,00 949,50 050,50 805,00
Nzuza 30 2 250,00 1 500,00 300,00 4 995,00 9 20 2 250,00 300,00 2
000,00 045,00 955,00 550,00
108 8 100,00 5 400,00 1 17 982,00 32 75 8 100,00 1 9
000,00 080,00 562,00 438,00 080,00 180,00
Workings
Employee contributions
Pension fund: 7,5% of gross salary
Govender R45 000 x 7,5% = R3 375
Yearwood R33 000 x 7,5% = R2 475
Nzuza R30 000 x 7,5% = R 2 250
The employer would contribute the same amount as the employees to the pension fund.
Medical aid scheme: 5% of gross salary
Govender R45 000 x 5% = R2 250

Yearwood R33 000 x 5% = R1 650
Nzuza R30 000 x 5% = R 1500
UIF: 1% of gross salary
Govender R45 000 x 1% = R450

Yearwood R33 000 x 1% = R330
Nzuza R30 000 x 1% = R300
The employer would contribute the same amount as the employees to the Unemployment
Insurance Fund.
PAYE: 18% of taxable income

Gross salary – Pension = Taxable income
Govender (R45 000 – R3 375) x 18% = R7 492,50

Yearwood (R33 000 – R2 475) x 18% = R5 494,50
Nzuza (R30 000 – R2 250) x 18% = R4 995,00
Cash payments journal of Workers Ltd for April 20x2 CPJ1

Day Details Sundry Bank
R R
30 Creditors for salaries 75 438,00 75 438,00
# Workers’ Pension Fund (8100 + 8100) 16 200,00 16 200,00
Feel Good Medical Aid Scheme 5 400,00 5 400,00
# Unemployment Insurance Fund (1080 + 1080) 2 160,00 2 160,00
Receiver of Revenue (PAYE) 17 982,00 17 982,00
# Inclusive of employee and employer contributions
General ledger of Workers Ltd

Creditors for salaries
30 Bank CPJ1 75 30 Salaries (net 75
April 438 April salaries) SJ1 438
20x2 20x2
Pension fund
30 Bank CPJ1 16 30 Salaries SJ1 8
April 200 April 100
20x2 20x2
Pension fund 8
contribution SJ1 100
16 16
200 200
Medical aid scheme
April 400 April 400
20x2 20x2
Unemployment Insurance Fund
April 160 April 080
20x2 20x2
UIF contributions 1
SJ1 080
2 2
160 160
Receiver of Revenue (PAYE)
April 982 April 982
20x2 20x2
Salaries
30 Sundry (gross salaries) SJ1 108
April 000
20x2
Pension fund contributions
30 Pension fund SJ1 8
April 100
20x2
UIF contributions
30 UIF SJ1 1
April 080
20x2
Bank
30 Creditors for 75
April salaries CPJ1 438
20x2
Pension fund CPJ1 16
200
Medical aid scheme 5
CPJ1 400
Unemployment 2
Insurance fund CPJ1 160
Receiver of revenue 17
(PAYE) CPJ1 982

The wages journal is similar to the salaries journal, except that it is drafted on a weekly basis, not
a monthly basis. It is used to record the basic wages, overtime, employee deductions, net wage as
well as the employer contributions for each employee. The cash payments journal is then drafted
to record the payments made to the employees as well as the payments made to the relevant
funds. The totals of the aforementioned journals are then posted to the general ledger.
ILLUSTRATIVE EXAMPLE: Wages journal and posting
Assemble It Ltd produces electrical components for use within the manufacturing industry. The
workers within the assembly department are Mr Moodley, Mrs Nyawo and Mr Naidoo. A
normal working week consists of eight hours a day from Monday through to Friday. Overtime
on weekdays and on Saturdays is considered normal overtime and is remunerated at time and
a half. Overtime worked on a Sunday or public holiday is considered double overtime and is
remunerated at twice the normal rate. The following information relates to the three employees
for the week ended 31 October 20x6.
Employee Hours worked Hourly rat

Monday Tuesday Wednesday Thursday Friday Saturday Sunday
Mr Moodley 8 8 10 7 8 2 0 R50
Mrs Nyawo 8 12 8 8 8 0 3 R45
Mr Naidoo 8 8 8 6 8 4 2 R55
Deductions are as follows:
Medical aid contributions per week

– Mr Moodley R 150
– Mrs Nyawo R 120
– Mr Naidoo R 145
Unemployment Insurance Fund Employees contribute 1% of their basic wage to the
Unemployment Insurance Fund. The employer contributes an equal amount to the fund on
the employee’s behalf.
Pension fund Employees contribute 8% of their basic wage to the pension fund, while the
employer contributes 10% to the fund on their behalf.
PAYE is 15% of taxable income.
Required
Based on the information provided, draft the wages journal and cash payments journal of
Assemble It Ltd for the week ended 31 October 20x6 and post to the relevant general ledger
accounts.
Solution
Wages Journal of Assemble It Ltd for the week ended 31 October 20x6
Employee Normal time Overtime Gross Deductions Net Employer
wage wage contributions
Hours Total Hours Total Pension Medical UIF Receiver Total Pension UIF T
fund 8% aid 1% of fund
Revenue
(PAYE)
15%
Moodley 40 2 3 225 2 225 160 150 20 309,75 639,75 1 200 20
000 585,25
Nyawo 40 1 7 540 2 340 144 120 18 329,40 611,40 1 180 18
800 728,60
Naidoo 40 2 4 385 2 585 176 145 22 361,35 704,35 1 220 22
200 880,65
6 1 7 150 480 415 60 1 000,50 1 5 600 60
000 150 955,50 194,50
Workings
Overtime
Normal overtime Double overtime Total overtime

Moodley 225 (3 × 1,5 × 50) 0 225
Nyawo 270 (4 × 1,5 × 45) 270 (3 × 2 × 45) 540
Naidoo 165 (2 × 1,5 × 55) 220 (2 × 2 × 55) 385
Pension fund: 8% of basic wage (employee contributions)
Moodley R2 000 × 8% = R160

Nyawo R1 800 × 8% = R144
Naidoo R2 200 × 8% = R176
Pension fund: 10% of basic wage (employer’s contributions)

The employer would contribute 10% to the pension fund on the employees’ behalf.
Moodley R2 000 × 10% = R200

Nyawo R1 800 × 10% = R180
Naidoo R2 200 × 10% = R220
UIF: 1% of basic wage (employee contribution)
Moodley R2 000 × 1% = R20

Nyawo R1 800 × 1% = R18
Naidoo R2 200 × 1% = R22
The employer would contribute the same amount as the employees to the Unemployment
Insurance Fund.
PAYE 15% of taxable income
Gross wage – Pension = Taxable income
Moodley (R2 225 – R160) × 15% = R309,75

Nyawo (R2 340 – R144) × 15% = R329,40
Naidoo (R2 585 – R176) × 15% = R361,35
Cash payments journal of Assemble It Ltd for the week ended 31 October 20x6 CPJ1
Day Details Sundry Bank
31 Oct Creditors for wages 5 194,50 5 194,50
# Pension fund (480 + 600) 1 080,00 1 080,00
Medical aid scheme 415,00 415,00
# Unemployment Insurance Fund (60 + 60) 120,00 120,00
Receiver of Revenue (PAYE) 1 000,50 1 000,50
General ledger of Assemble It Ltd

Creditors for wages
31 Bank CPJ1 5 31 Wages (net 5
Oct 194,50 Oct wages) WJ1 194,50
20x6 20x6
Pension fund
31 Bank CPJ1 1 080 31 Wages WJ1 480
Oct Oct
20x6 20x6
31 Pension fund 600
Oct contributions WJ1
20x6
1 080 1 080
Medical aid scheme
31 Bank CPJ1 415 31 Wages WJ1 415
Oct Oct
20x6 20x6
Unemployment Insurance Fund
31 Bank CPJ1 120 31 Wages WJ1 60
Oct Oct
20x6 20x6
31 UIF contributions 60
Oct WJ1
20x6
120 120
Receiver of Revenue (PAYE)
31 Bank CPJ1 1 31 Wages WJ1 1000,50
Oct 000,50 Oct
20x6 20x6
Wages
31 Sundry (gross wages) WJ1 7 150
Oct
20x6
Pension fund contributions
31 Pension fund WJ1 1 080
Oct
20x6
UIF contributions
31 UIF WJ1 120
Oct
20x6
Bank
31 Creditors for 5
Oct wages CPJ1 194,50
20x6
31 Pension fund 1
Oct CPJ1 080,00
20x6
31 Medical aid 415,00
Oct scheme CPJ1
20x6
31 Unemployment 120,00
Oct Insurance Fund
20x6 CPJ1
31 Receiver of 1
Oct Revenue (PAYE) 000,50
20x6 CPJ1
TUTORIAL EXERCISES
Exercise 1
Read the following statements carefully and indicate whether they are true or false:
1.1 Labour is the physical and/or mental effort used to manufacture a product or provide a
service.
1.2 A time-based wage system is based on the number of units an employee produces.
1.3 The purpose of an incentive wage system is to reduce total production costs per unit.
1.4 A payroll is a summary of an employee’s normal remuneration and overtime
remuneration, but it excludes all other deductions.
1.5 The cost of repairs to defective products is classified as an indirect manufacturing cost.
Answer the following multiple-choice questions:
1.6 Ethan is an employee who performs a specific task. His normal wage rate per hour is R32
and he works a normal day of eight hours. The company has set a standard of 150 units
per hour. On a given day Ethan produced 1 500 units within his eight-hour shift.
1.6.1 The time that Ethan saved was
a. 2 hours
b. 4 hours
c. 4,5 hours
d. 2,2 hours
1.6.2 The bonus that Ethan would receive under the Halsey bonus system is
a. R21,33
b. R32,00
c. R51,20
d. R23,20
1.6.3 The bonus that Ethan would receive under the Halsey-Weir bonus system is
a. R51,20
b. R32,00
c. R21,33
d. R23,20
1.6.4 The bonus that Ethan would receive under the Rowan bonus system is
a. R21,33
b. R32,00
c. R23,20
d. R51,20
1.7 Jayden is a production worker who works 48 hours per week and earns R2 100 per
month. He is entitled to four weeks’ normal leave per year, which he may take at any
time during the year. It is the company’s policy that workers do not work on the five
official public holidays. Management has learnt from past experience that the average
employee is absent on sick leave for at least three weeks per year.
1.7.1 The annual labour cost totals
a. R25 200
b. R25 200
c. R22 500
d. R20 500
1.7.2 The productive weeks for the year equal

a. 48 weeks
b. 44 weeks
c. 46 weeks
d. 47 weeks
1.7.3 The actual productive hours for the year total

a. 2 256 hours
b. 2 340 hours
c. 2 112 hours
d. 2 208 hours
1.7.4 The labour recovery rate is

a. R11,41
b. R10,77
c. R11,17
d. R11,93
Exercise 2
The following information was taken from the time sheet of Mr Curtis for the week ended 23
May 20x2.
Day Hours worked

Monday 8
Tuesday 8
Wednesday 8
Thursday 8
Friday 7
Saturday 4
Sunday 4
A normal working week is 40 hours, from Monday to Friday. Normal overtime is remunerated
at one and a half times, while double overtime is remunerated at twice the normal rate. The
hourly rate of pay is R62,50.
Mr Curtis contributes to the following funds:
Pension at 7,5% of his basic wage; the employer also contributes to this fund on a rand-for-
rand basis
Unemployment Insurance Fund at 1% of his basic wage
PAYE at 18% of taxable income
Medical aid at 12% of basic wages split between the employer and employee on a 60 : 40
basis respectively
Required
2.1 Calculate Mr Curtis’s net wage for the week ended 23 May 20x2.
2.2 Calculate the employer contributions.
Note: Where necessary, round off to two decimal places.
Exercise 3
A marketing company has employed a graphic design specialist. Her basic annual salary is
R360 000 and she is entitled to an annual bonus of R30 000. The company operates a 40-
hour week and employees are entitled to three weeks’ annual leave.
There are 13 public holidays annually. Idle time is equal to 3% of available productive time.
The company contributes 7,5% and 1% of the basic salary towards the pension fund and UIF,
respectively. Assume that there are 52 weeks in the year.
Required
3.1 Annual productive hours
3.2 Total annual labour cost
3.3 Hourly recovery rate
Exercise 4
ProduceIt Ltd manufactures a range of household appliances. They have three manufacturing
divisions. The following information relates to employee S. Gokul, who works in the assembly
division, for the week ended 27 June 20x4.
Day Hours worked

Monday 8
Tuesday 8
Wednesday 10
Thursday 12
Friday 8
Saturday 3
Sunday 3
52
OTHER RELEVANT INFORMATION

The normal working week is 40 hours, eight hours a day from Monday to Friday. Normal
overtime is remunerated at one and a half times the normal rate, while double overtime is
remunerated at twice the normal rate. The hourly rate of pay is R27,50.
The employee contributes 7,5% of his basic wage to the pension fund, while his employer
contributes 15% to this fund on his behalf. The PAYE deduction is 18% of taxable income.
The UIF contribution is 1% of the basic wage. The employee contributes 10% of his gross
wage to a medical aid scheme.
Required
4.1 Calculate the net wage due to S. Gokul for week ended 27 June 20x4.
4.2 Calculate the employer contributions.
Note: Where necessary, round off to two decimal places.
Exercise 5
A company pays its production workers R70 per hour. Each employee works eight hours a
day, for five days a week. They are entitled to three weeks’ paid vacation for the year. There
are 10 public holidays in the year and idle time is 2% of available productive hours. Assume
that there are 52 weeks in the year.
Fringe benefits based on normal earnings include a 5,5% contribution towards medical aid
and 7,5% towards a pension fund. Employees also receive a bonus equal to four weeks of
normal earnings.
The deductions for each employee consist of the following:
• PAYE 18% of taxable income

• Pension 7,5% of normal earnings
• Medical aid 2,5% of normal earnings
• UIF 1% of normal earnings
Required
5.1 Calculate the following:
5.1.1 Annual hours available for production

5.1.2 Total annual labour cost per employee
5.1.3 Labour recovery rate
5.1.4 Weekly net pay of an employee
5.2 Prepare the journal entry to record the labour cost for the week.
Exercise 6
Efficiency Ltd produces various components for sale to the manufacturing industry. There has
been a decline in employee performance over the last six months. Management has decided
to use the Taylor’s differential piecework system to reward employees for increased production
and thereby increase employee motivation. A time and motion study conducted by the
company has revealed the standard time allowed for producing component CT6 to be 145
units per hour.
A normal working day consists of eight hours and workers are paid R52,50 per hour.
Management has set the bonus percentages as follows: a bonus of 20% for work that is below
standard and a bonus of 90% for work that is standard and above. Two employees, Kirsten
and Madison, produced 1 000 and 1 500 units respectively on a specific day.
Required
Calculate the bonus as well as the gross wage for the two employees for the day.
Exercise 7
Be Beautiful is a beauty spa that has three employees: a specialist nail technician, a hairstylist
and a receptionist. The receptionist is a salaried employee, while the nail technician and
hairstylist are paid based on their client numbers. The basic rate of pay per client is R80 and
R100 for the nail technician and the hairstylist respectively. They receive 1,5 times the normal
rate for a Saturday and double the normal rate for a Sunday and public holiday.
For the week ended 12 August 20x5 the number of clients who visited the spa were as
follows:
Monday Tuesday Wednesday Thursday Friday Saturday

(Public
holiday)
Miss C. Cutex 6 8 5 8 10 3
(Nail technician)
Mrs B. Straight 8 12 10 12 12 6
(Hairstylist)
The following deductions are applicable to the employees:
Pension: 7,5% of basic wage
Medical aid: R200 per week
PAYE: 18% of taxable income
UIF: 1% of basic wage
The employer contributions are on a rand-for-rand basis to the pension fund, as well as the
Unemployment Insurance Fund on the employees’ behalf.
Required
Based on the information provided, draft the wages journal and cash payments journal of Be
Beautiful for the week ended 12 August 20x5 and post it to the relevant general ledger
accounts.
Exercise 8
Starting Out is a printing business that was established about two years ago. They design and
print banners and invitations for parties and weddings, among other things. Mr Confused, a
first-year university student, has been assisting the business with its payroll accounting. Mr
Confused was not certain about how to correctly record the details of each salaried employee
in the salaries journal; consequently he made numerous errors. The company has approached
you – a recent graduate – to assist them in correcting the errors reflected in their records.
The business has four salaried employees whose details are as follows:
The Manager, Mr B. Busy: monthly salary of R50 000
The receptionist, Mrs R. Friendly: monthly salary of R10 000
The designer, Mr D. Sign: monthly salary of R20 000
The worker in the print room, Mr I. Copy: monthly salary of R15 000
The employee and employer contributions are as follows:

Pension fund: 8% of basic salary on a 40:60 percentage basis between the employee and
employer
UIF: 1% of basic salary by the employee and 1,5 % by the employer
Medical aid: 4% of basic salary by the employee
PAYE: 15% of the employees’ taxable income
Mr Confused recorded the aforementioned details incorrectly in the salaries journal for the
month of July 20x3.
Salaries journal of Starting Out for the month of July 20x3 SJ1
Employee Basic Deductions Net Employer
salary salary contributions
Pension Medical UIF Receiver of Total Pension UIF Total
fund 8% aid 4% 1% Revenue (PAYE) fund 1,5%
B. Busy 50 000 2 400 2 000 750 7 140,00 12 37 1 600 500 2
290,00 710,00 100
R. 10 000 480 400 150 761,60 1 8 320 100 420
Friendly 791,60 208,40
D. Sign 20 000 960 800 300 2 856,00 4 15 640 200 840
916,00 084,00
I. Copy 15 000 720 600 225 2 142,00 3 11 480 150 630
687,00 313,00
95 000 4 560 3 800 1 12 899,60 22 72 3 040 950 3
425 684,60 315,00 990
Required
8.1 Correct the errors and redraft the salaries journal.
8.2 Record the payments made in the cash payments journal.
8.3 Post to the relevant general ledger accounts.
12 Overheads and job costing
Outcomes
calculate the overhead absorption rates

use the calculated overhead absorption rate to calculate the total
cost of a job
calculate the over- or under-applied overheads.
Chapter outline

12.2.2 Steps involved in job costing and accounting entries
Overheads are all factory costs other than direct materials and direct
labour. Manufacturing overheads can be organised into three categories
as follows:
1. Indirect materials:
Cleaning material
Factory supplies, dyes
Glue, screws
Lubricants and coolants
Scrap and waste materials
2. Indirect labour:
Employer contributions which increase the total labour cost (that

is, employer contributions to pension funds, medical aid funds, the
Unemployment Insurance Fund and workmen’s compensation
insurance)
Wages of factory cleaners
General and casual labour
Idle time costs of direct labour
Overtime premiums
Shift premiums
Holiday pay and service bonus pay
Salaries of raw material handlers
Salaries of storemen
Wages of security guards in the factory
3. Other manufacturing overheads:
Depreciation on factory building, plant and equipment

Lease for factory plant and equipment
Fire and liability insurance for the factory
Municipal rates and taxes for the factory
Rent of factory building, warehouse, etc.
Electricity or power for the factory
Water for the factory
Telephone charges for the factory
We have learnt about materials and labour, and now overheads. These
three cost elements can now be added together to calculate the cost of a
product or job.
A job costing system is used by enterprises that produce different

products, jobs or batches using the same manufacturing facility. Each
product is made according to the customer’s specifications. Examples of
the industries that use a job costing system are as follows: printing,
construction, shopfitting, furniture manufacturing, jewellery design, etc.

Enterprises have to prepare quotations for jobs before the job is actually
complete. In essence they are trying to determine what the price of the
job should be on completion. The material and labour costs for jobs can
be determined with certainty, but the factory overhead costs cannot.
The enterprise has to estimate how much of the factory overhead costs
should be charged to specific jobs. This is done by means of overhead
absorption rates.
12.2.2 Steps involved in job costing and accounting entries
STEP 1: CALCULATE THE OVERHEAD ABSORPTION RATE

(OAR)
Overhead absorption rates must be calculated for each production
department involved in the production process. This allows the
overheads to be absorbed into the cost of the goods manufactured and
sold; that is, the overhead cost is added to the cost of the job as the job
passes through each production department.
OARs are used to estimate how much of the factory overheads must be
charged to specific products. Choosing the best OAR will be dependent
on whether the enterprise is capital intensive or labour intensive. For
example:
A suitable basis for capital-intensive enterprises would be machine

hours.
A suitable basis for labour-intensive enterprises would be labour
hours or labour cost.
Choosing the best OAR is not an easy task and therefore management
decides on what application rate to use after a thorough investigation of
estimated and actual overheads from previous years. Below are the six
common overhead absorption rates used to apply overheads when
quoting for jobs:
Budgeted overheads
Materials cost basis = × 100
Budgeted direct materials
= %of direct materials cost
Budgeted overheads
Units of production =
Budgeted units of production
= Rand rate per unit of production
Budgeted overheads
Machine hours basis =
Budgeted machine hours
= Rand rate per machine hour
Budgeted overheads
Direct labour hours =
Budgeted labour hours
= %per labour hour
Budgeted overheads
Direct labour cost = × 100
Budgeted labour cost
= %per labour cost
Budgeted overheads
Prime cost = × 100
Budgeted prime cost
= %of prime cost
STEP 2: CALCULATE THE COST PRICE OF THE JOB

To calculate the cost of the job, add up the following:
Direct materials + Direct labour + Overheads (applied to the

job) = Total cost of the job
Accounting entries
The three cost elements (Direct materials + Direct labour + Applied

overheads) are accumulated in the work in progress account in the
general ledger as follows:
Work in progress account (production account)

Direct materials xxx Finished goods account xxx
Direct labour xxx
Overheads (applied) xxx
xxx xxx
This work in progress account represents the production process where
all the costs to produce the products, both direct and indirect, are
accumulated. The end result of the production process is completed
products. Consequently the output of the production process is
transferred to the finished goods account, where it will then be sold.
Finished goods account

Work in progress xxx Cost of sales xxx
STEP 3: CALCULATE THE SELLING PRICE OF THE JOB

Total cost of the job + Mark-up = Selling price
STEP 4: DETERMINE IF OVERHEADS HAVE BEEN OVER- OR

UNDER-APPLIED
Budgeted An estimate or forecast of what overheads should be in a
overheads: future period
Applied The overheads that have been charged to various
overheads: jobs/products using an overhead absorption rate (OAR)
Actual The actual overheads incurred for the period
overheads:
At the end of the financial year, the applied overheads are totalled and
the actual overheads are totalled. If applied overheads are greater than
actual overheads, then the overheads have been over-applied; that is,
you have charged customers too much for overheads. The over-applied
overheads will decrease cost of sales. If the applied is less than the
actual, then the overheads have been under-applied; that is, you have
charged customers too little for overheads. The under-applied overheads
will increase cost of sales. Management strives to make applied
overheads and actual overheads equal; however, it is highly unusual for
this to happen. A marked difference between actual and applied
overheads is a good indicator for management that a more appropriate
OAR should be used to charge overheads to jobs.
Accounting entries
The overheads account in the general ledger would appear as follows:
Under-applied overheads
Overheads account
Actual xxx Work in progress (applied) xxx
Under-applied (increases xxx
cost of sales)
xxx xxx
Over-applied overheads
Overheads account
Actual xxx Work in progress (applied) xxx
Over-applied (decreases xxx
cost of sales)
xxx xxx
ILLUSTRATIVE EXAMPLE Job costing
The following information relates to a self-employed tiler for the

month of February 20x1. Two clients have requested that Mr Tiler
provide them with quotations as soon as possible. Mr Tiler has asked
you to assist him with preparing these quotations. The mark-up that
he requires on all jobs is 10% on cost.
The details of the two jobs are as follows:
Bathroom 1 Bathroom 2
Size of the bathroom 10 m2 20 m2
Materials cost R30 per m2 R35 per m2
Labour cost R50 per hour R50 per hour
Labour hours 3 hours 6 hours
The budgeted overheads for February 20x1 total R900 and the
budgeted labour hours for the month are nine hours. (Mr Tiler is
planning to go on holiday after he has completed these two jobs,
therefore the budgeted hours are only nine hours.) A suitable basis
for the absorption of overheads would be labour hours, since tiling is
labour intensive.
Where necessary round off to two decimal places.
Solution
Follow the four steps:
Step 1: Calculate the overhead absorption rate
Budgeted overheads
OAR: Direct labour hours =
Budgeted labour hours
= R900/(3 hrs + 6 hrs)
= R100 per direct labour hour
Step 2: Calculate the cost price of the job
Material cost (10 m2 × R30) R300 (20 m2 × R35) R700
Add: Labour cost (3 hrs × R50) R150 (6 hrs × R50) R300
Add: Applied overheads (3 hrs × R100) R300 (6 hrs × R100) R600
Total cost R750 R1 600
Accounting entries
Work-in-progress account (Bathroom 1)
Direct materials R300 Finished goods R750

account
Direct labour 150
Overheads (applied) 300
750 750
Work-in-progress account (Bathroom 2)
R700 Finished goods

account
Direct labour 300
Overheads (applied) 600
1 600 1 600
Step 3: Calculate the selling price of the job
Total cost R750 R1 600
Add: Mark-up of 10% 75 160
Selling price of the job 825 1 760
Step 4: Determine if overheads have been over- or under-applied

Using two scenarios, determine if the overheads have been over- or
under-applied:
Scenario 1: If the actual overheads for the month of February 20x1

totalled R1 000
Scenario 2: If the actual overheads for the month of February 20x1
totalled R800
Scenario 1 Scenario 2
Applied overheads (R300 + R600) R900 (R300 + R600) R900
Less: Actual overheads R1 000 R800
Under-applied (R100)
Over-applied R100
Only do steps 3 and 4 if they are listed as part of the requirement of
the question.
Accounting entries
Scenario 1: Under-applied overheads
Overheads account
Actual R1 000 Work in progress R900

(applied)
Under-applied R100
(increases cost of
sales)
R1 000 R1 000
Scenario 2: Over-applied overheads

Overheads account
Actual R800 Work in progress R900

(applied)
Over-applied R100
(decreases cost of
sales)
R900 R900
TUTORIAL EXERCISES
Exercise 1
1.1 List six examples of manufacturing overheads.
1.2 Distinguish between budgeted, actual and applied overheads.
1.3 What is the aim of overhead absorption?
1.4 What are over- or under-absorbed overheads?
1.5 How do we deal with over- or under-absorbed overheads?
Exercise 2
For each of the multiple-choice questions that follow, select the most
appropriate answer.
2.1 Which of the following is not a basis for absorbing manufacturing

overheads?
a. Direct labour hours
b. Direct materials cost
c. Machine hours
d. Conversion cost
2.2 The process of allocating overheads to jobs or products

produced is known as
a. overhead apportionment
b. overhead absorption
c. overhead allocation
d. none of the above
2.3 Over-applied overheads result when

a. budgeted overheads are more than actual overheads
b. actual overheads are less than applied overheads
c. budgeted overheads are less than actual overheads
d. actual overheads are more than applied overheads
2.4 Under-applied overheads result when

a. budgeted overheads are more than actual overheads
b. actual overheads are less than applied overheads
c. budgeted overheads are less than actual overheads
d. actual overheads are more than applied overheads
2.5 The following information relates to questions 2.5.1–2.5.3:
Budgeted manufacturing R2 000

overheads 000
Budgeted material cost R1 250
000
Actual overheads R1 750
000
Actual material cost R1 050
000
2.5.1 The overhead absorption rate based on the direct

material cost would be
a. 120% of direct materials cost
b. 150% of direct materials cost
c. 160% of direct materials cost
d. 140% of direct materials cost
2.5.2 The overheads applied for the period would be

a. R1 680 000
b. R1 860 000
c. R1 570 000
d. R1 608 000
2.5.3 The over- or under-applied overheads for the period

would be
a. over-applied by R250 000
b. under-applied by R250 000
c over-applied by R70 000
d. under-applied by R70 000
Exercise 3
A summary of the budget data for the finishing department of a
company for the 20x1 year is given below:
Manufacturing overhead costs R5 714 724

Units of production 2 745 000 units
Direct material costs R4 505 094
Direct labour costs R5 160 112
Direct labour hours 1 342 000 hours
Machine hours 515 450 hours
Required
Determine the manufacturing overhead absorption rates under each
of the following bases. Round off to the nearest two decimal places:
3.1 Units of production
3.2 Direct materials cost
3.3 Machine hours
3.4 Direct labour hours
3.5 Direct labour cost
3.6 Prime cost
Exercise 4
A manufacturing company in the furniture industry uses a job costing
system. The following are the budgeted figures for all jobs processed
during the current year:
Direct material costs R240 000

Direct labour costs R200 000
Manufacturing overhead costs R960 000
Direct labour hours 400 000 hours
The actual information relating to job 6815 during the year was as
follows:
Direct material cost R24 000

Direct labour cost R10 000
The company applies manufacturing overheads to jobs performed on

the basis of machine hours.
Required
4.1 Calculate the total manufacturing cost of job 6815.
4.2 State two factors that the company should consider when
deciding on the mark-up for its jobs.
Exercise 5
You are given the following information regarding the Bantex
Manufacturing Company:
Budgeted information:
Labour hours 72 000
Production costs:
Overheads R144 000
Actual information for March 20x3:
Job Direct materials Direct labour Direct labour

no. costs costs hours
5 R1 920 R1 760 1 600
6 R1 200 R1 440 1 520
Required
5.1 Calculate the predetermined overhead rates based on the
5.1.1 material cost basis

5.1.2 labour hours basis
5.2 Calculate the total costs of
5.2.1 job 5 if overheads are absorbed on the basis of material

cost
5.2.2 job 6 if overheads are absorbed on the basis of labour
hours
5.3 Calculate the selling price of the jobs if the mark-up is 20% on
cost.
Exercise 6
DT Ltd has two production departments, namely milling and
assembly. The company uses a job costing system and calculates a
predetermined overhead rate for each production department. The
milling department’s overhead absorption rate is based on machine
hours and the assembly department’s overhead absorption rate is
based on direct labour cost.
At the beginning of 20x2, the company made the following estimates:
Department
Milling Assembly
Direct labour hours 8 000 hours 75 000 hours
Machine hours 60 000 hours 3 000 hours
Manufacturing overhead costs R510 000 R800 000
Direct labour costs R2 000 R640 000
The job cost sheet for job 407, which was started and completed
during the year, showed the following:
Department
Milling Assembly
Direct labour hours 5 hours 20 hours
Machine hours 90 hours 4 hours
Direct materials costs R800 R370
Direct labour costs R45 R160
Required
6.1 Calculate the overhead absorption rates to be used in the milling
department and the assembly department.
6.2 Calculate the total cost of job 407 as well as the invoice price to
the customer if DT Ltd marks up all its jobs at 20% on the cost.
Exercise 7
XYZ Ltd has the following cost data for the year 20x1:
Description Production Finishing

department department
Materials used R100 000 R40 000
Direct labour R160 000 R120 000
costs
Overheads R192 000 R80 000
Required
7.1 The overhead rates to be used for the year 20x1, based on
direct labour costs for the production department and machine
hours for the finishing department
7.2 The total overheads to be applied to job 804, which amounted to
R6 000 in direct labour costs in the production department and
500 machine hours in the finishing department
7.3 The total cost of job 804, if the material cost for the job totalled
R4 000 and the labour cost totalled R6 000
7.4 The over- or under-applied overheads for job 804 if the actual
overheads applied to job 804 totalled R8 000 in the production
department and R9 200 in the finishing department
Exercise 8
WT Ltd had the following budgeted figures for 20x1:
Cutting Machining
Direct labour cost R320 000 R122 500
Cutting Machining
Manufacturing R504 000 R525 000
overheads
Direct labour hours 56 000 21 000
Machine hours 4 000 75 000
Overheads are applied to production as follows:

Cutting department – based on direct labour hours
Machining department – based on machine hours
At the end of the period the cost records for job 999 were as follows:
Cutting department Machining department

Material costs R80 000 R30 000
Direct labour costs R60 000 R25 000
Direct labour hours 4 600 1 700
Machine hours 350 6 250
The company sells all its products at cost plus 50%.
Required
8.1 The overhead absorption rates for each department
8.2 The total cost of job 999
8.3 The selling price of job 999
8.4 The over- or under-applied overheads for the cutting department
for the year, if the actual labour hours for the year totalled 52
000 and the actual overhead costs were recorded at R475 000.
13 Budgetary control
Outcomes
demonstrate an understanding of the master budget

draft operational, flexible and cash budgets.
Chapter outline
13.1 Introduction
13.2.1 Sales budget
13.4 Cash budgets
13.1 Introduction
Budgeting is planning one’s income and expenses for the

future. It is a plan expressed in monetary terms and is based
on the past experience of the business and on estimations.
An operational budget is a budget that is prepared for a

specific department or cost centre. All the operating budgets
are then combined into the master budget, which includes a
budgeted statement of profit or loss and other comprehensive
income and a budgeted statement of financial position.
Operating budgets are all interdependent; that is, information

concerning one is required for the preparation of the other.
Figure 13.1 illustrates the interrelationship between the
different budgets.
Figure 13.1 Diagram of the interrelationship of the
major budgets for a typical manufacturing concern
Operating budgets consist of the following smaller budgets:
13.2.1 Sales budget

The sales budget is the starting point for budgeting, because
inventory levels, purchases and operating expenses are geared
to the rate of sales activities. The sales budget is an estimate of
future sales, often broken down into both the number of units
to be sold and the expected sales in rand for the budget period.

The production budget looks at the number of completed
products that must be produced within the budget period. It is
based on the estimated sales for the budget period and also
takes into account the requirement for opening stock and
closing stock of finished goods.
The production budget looks only at the number of units to be

produced and not the costs associated with producing these
units. The subsequent budgets will look at the material, labour
and overhead costs of producing the units.

This budget looks at the quantity of raw materials that will be
used in producing the finished goods.

This budget looks at the quantity and the rand value of raw
materials that must be purchased in order to cope with the
usage of raw materials and the requirements for opening and
closing stocks of raw materials.

This budget looks at the labour hours required to produce the
finished products, as well as the rand value of these labour
hours.

This budget is a summary of all the indirect costs associated
with producing the completed products.

The sales expenditure budget looks at the costs associated
with the sales activities of the business for the budget period,
that is, the costs associated with obtaining the orders and costs
associated with executing the orders.
The administrative budget looks only at expenditure relating

to the business as a whole.

Inventory budgets should not be prepared separately, since the
figures are directly related to other operational budgets.
Examples of inventory budgets include
direct materials/raw materials

work in process
finished products.
ILLUSTRATIVE EXAMPLE Operational budgets
Wizz Ltd manufactures and sells two products, Wazz and

Zazz. In July 20x1, the budget department gathered the
following data in order to project sales and budget
requirements for 20x2:
20x2 Projected sales
The company is expected to sell the following:
83 000 units of Wazz at R250 each
22 000 units of Zazz at R450 each
20x2 Expected stocks in units

Product Expected 1 Jan 20x2 Desired 31 Dec 20x2
Wazz 16 000 25 000
Zazz 20 000 15 000
In order to produce one unit of Wazz and Zazz, the

following raw materials are used:
Raw material Unit Amount used per unit

Wazz Zazz
R kg 2 4
F kg 3 6
C unit – 3
Projected data for 20x2 in respect of raw materials is as

follows:
Raw Anticipated Expected stock Desired stock

material purchase price 1 Jan 20x2 31 Dec 20x2
R R25 24 000 kg 52 000 kg
F R15 35 000 kg 78 000 kg
C R10 3 000 units 1 000 units
Projected direct labour requirements for 20x2 and rates are
as follows:
Product Hours per unit Rate per hour

Wazz 6 hrs R9,50
Zazz 9 hrs R12,50
Overheads are applied at the rate of R6,50 per direct

labour hour.
Required
Based on the above projections and budget requirements
for 20x2 for Wazz and Zazz, prepare the following budgets
for 20x2:
1. Sales budget (units and rands)

2. Production budget (units)
3. Raw materials usage budget (units)
4. Raw materials purchases budget (units and rands)
5. Direct labour budget (hours and rands)
6. Budgeted value of closing stock of finished goods at 31
December 20x2 (in rands)
Solution
1. Sales budget
Units Price Total

Wazz 83 000 R250 R20 750 000
Wazz 22 000 R450 R9 900 000
R30 650 000
2. Production budget
Wazz Zazz
Expected sales in units 83 000 22 000
Add: Closing stock 25 000 15 000
108 000 37 000
Less: Opening stock 16 000 20 000
Number of units to be produced 92 000 17 000
3. Raw materials usage budget
R F C
Wazz (92 000 × 2; 184 000 276 000 0
3; 0)
Zazz (17 000 × 4; 68 000 102 000 51 000
6; 3)
252 000 378 000 51 000
kg kg units
4. Raw materials purchases budget

R F C
Raw materials 252 000 378 000 51 000
usage
Add: Closing stock 52 000 78 000 1 000
304 000 456 000 52 000
Less: Opening stock 24 000 35 000 3 000
280 000 421 000 49 000
× unit price R25 R15 R10
R7 000 R6 315 R490 000
000 000
5. Direct labour budget
Wazz Zazz
Production units 92 000 17 000
× Labour hours 6 hrs 9 hrs
552 000 hrs 153 000 hrs
× Wage rate R9,50 R12,50
R5 244 000 R1 912 500
6. Budgeted value of closing stock of finished goods

Wazz Zazz (R)
(R)
Raw material R (R25 per kg × 2; 4) 50 100
Raw material F (R15 per kg × 3; 6) 45 90
Raw material C (R10 per unit hour × 0 30
0; 3)
Labour (Wazz R9,50 per hour × 6 57 –
hrs)
(Zazz R12,50 per hour × 9 – 112,50
hrs)
Prime cost 152 332,50
Overheads (R6,50 per direct labour 39 58,50
hour × 6; 9)
Cost per unit R191 R391
Closing stock of finished goods 25 000 15 000
Total cost R4 775 R5 865
000 000
TUTORIAL EXERCISES Operational budgets
Exercise 1
Gadget Ltd manufactures one product known as Widget.
The following information relates to the preparation of the
budget for the year ended 31 March 20x4:
Sales budget details for product Widget:

Expected selling price per R100
unit
Expected sales in units 10 000
All sales are on credit terms.

Raw materials:
Widget requires five units of raw material S and 10

units of raw material O. S is expected to cost R3 per
unit and O R4 per unit.
All goods are purchased on credit terms.
Departments involved:
Two departments are involved in producing Widget,

namely the machinery and the assembly
departments. The following information is relevant:
Direct labour hours per Direct labour

unit of product rate per hour
Machinery 1 R6,00
Assembly 0,5 R8,00
1. The production overheads for the budget period are

expected to amount to R50 000 in the machinery
department and R50 000 in the assembly department.
2. Overheads are absorbed into finished products on the
basis of labour hours.
3. At 1 April 20x3 stocks were as follows:
Product Widget 800 units

Raw material S 4 500 units
Raw material O 12 000 units
All stocks at 31 March 20x4 are expected to increase by

10%.
Required
Prepare the following budgets for Gadget Ltd for the year
to 31 March 20x4:
1.1 Sales budget (in units and rands)
1.2 Production budget (in units)
1.3 Raw materials usage budget (in units)
1.4 Raw materials purchases budget (in units and rands)
1.5 Direct labour budget (in hours and rands)
1.6 Budgeted value of closing stock of finished goods as
at 31 December 20x4 (in rands)
Exercise 2
The following information was obtained from the financial
records of Action Ltd. Details of manufacturing for 20x3
include the following:
(a) Two types of product, namely product Ace (selling
price of R25 each) and product Base (selling price of
R35 each), are to be manufactured. The standard
composition is as follows:
Requirements per unit of finished product
Product Product
Ace Base
Material Tic (R1 per 1,5 kg 3 kg
kg)
Material Tac (R1,80 2 kg 1,5 kg
per kg)
Direct labour (R3 per 2 hours 3 hours
hour)
NOTE: EXPECTED CHANGES

The direct labour hours required per unit of finished
product are expected to increase by one hour for each
product in the month of May, because of the hiring of new
production workers. This will result in the hourly rate
decreasing by 10%.
There is also expected to be a 50% increase in the price of
material Tic and a 20 cent increase in the price of material
Tac in the month of May.
(b) Expected sales
May
Product Ace 6 000 units
Product Base 12 000 units
(c) Stock on hand (in units)
1 May 20x3 31 May 20x3

Product Ace 2 000 8 000
Product Base 4 000 10 000
Material Tic 30 000 kg 20 000 kg
Material Tac 20 000 kg 10 000 kg
(d) The production overheads for the budget period are

expected to amount to R216 000. Overheads are
absorbed into finished products on the basis of
labour hours.
Required
Prepare the following functional budgets for May:
2.1 Sales budget (in units and rands)
2.2 Production budget (in units)
2.3 Raw materials purchases budget (in units and rands)
2.4 Direct labour budget (in hours and rands)
2.5 Budgeted value of closing stock of finished goods as
at 31 December 20x4 (in rands)
Exercise 3
Shiloh Lang operates a dairy manufacturing business
called Sendairy. The company produces organic milk,
organic cheese, organic yoghurt and organic ice cream.
The company currently has 30 variants of organic ice
cream. The best-selling organic ice cream is Strawberry
Glaze, of which the sales have more than tripled during the
last six months. The following information relates to the
production of Strawberry Glaze for the month ended May
20x1:
The two main ingredients required for the production of
Strawberry Glaze are organic milk and organic mixed
berries. The organic milk produced by Sendairy is used in
the production of Strawberry Glaze. The mixed berries are
sourced from a local supplier that specialises in growing
organic berries.
The forecasted sales figure for Strawberry Glaze is 16 000
units at R40 each. Each unit of Strawberry Glaze requires
5 litres of organic milk and 4 kg of organic mixed berries to
produce. The company accountant calculated the cost of
organic milk to be R12 per litre. In addition, the organic
mixed berries are purchased at R11 per kg. The price of
organic mixed berries is expected to increase to R25 per
kg in June 20x1.
The company’s manufacturing process is 90% machine
intensive. Therefore, the company employs workers only to
package the final product. It takes 0,5 hours to package
the final product. These workers are remunerated at R45
per hour.
The inventory levels for the month of May 20x1 are:
01 May 20x1 30 May 20x1

Strawberry Glaze 4 000 units 7 000 units
Organic milk 56 000 litres 45 000 litres
Organic mixed berries 30 000 kg 36 000 kg
The budgeted manufacturing overheads are R20 000,

while the budgeted machine cost is R200 000. The
variable manufacturing overheads are absorbed on a
machine cost basis. The actual machine cost for the month
is R300 000. The fixed manufacturing overheads for the
month are R47 000.
Required
Draft the following budgets for the month of May 20x1:
3.1 Sales budget
3.2 Production budget
3.3 Direct materials usage budget
3.4 Direct materials purchases budget
3.5 Direct labour budget
3.6 Manufacturing overheads budget
A fixed budget is a budget that is prepared for one level of

activity and does not change when the level of activity
changes – it is static. Because fixed budgets are rigid in
nature, they cannot be used for cost control purposes unless
the activity achieved is exactly the same as planned.
Consequently, in practice most budgets are flexible.
A flexible budget is a budget that is designed to allow the cost

levels to be changed to suit the actual activity level. These
budgets are “flexed” or adjusted, so to speak, to correspond
with the actual activity level. Flexible budgeting therefore
requires a thorough understanding of cost behaviour.
Flexible budgeting is therefore useful for planning and cost

control. Actual costs for actual activity should always be
compared with budgeted costs for actual activity. For
example, it is meaningless to compare the actual costs
associated with producing 10 000 units with the budgeted
costs of producing 8 000 units. Like must be compared with
like.
Performance reports use the flexible budget approach to

determine variances (differences) which are used in cost
control.
ILLUSTRATIVE EXAMPLE Flexible budgets and

performance
reports
Manufacturers Ltd produces a single product called

Gadget. Production varies widely, but the normal monthly
production level is 12 000 units. The following data is
available for April 20x1:
Cost budget for production level of 12 000 units
Cost Cost behaviour Budget
(R)
Direct labour Variable (R4 per unit) 48 000
Direct materials Variable (R7 per unit) 84 000
Production Mixed (20 000 fixed + R4 68 000
overheads per unit)
Administrative Fixed 54 000
overheads
Total budgeted 254 000
costs
The actual level of production for April 20x1 was 12 800

units and the actual costs were as follows:
R
Direct labour 56 400
Direct materials 87 000
Production overheads 69 600
Administrative overheads 54 600
Required
Prepare the following:
1. Flexible budgets for 10 000 and 14 000 units

2. A performance report for the month of April 20x1
indicating clearly whether the variances are favourable
or unfavourable
Solution
1. Flexible budgets
Cost Flexed Original Flexed
budget 10 budget 12 budget 14
000 units 000 units 000 units
Direct labour (R4 40 000 48 000 56 000
per unit)
Direct materials 70 000 84 000 98 000
(R7 per unit)
Production 60 000 68 000 76 000
overheads (20
000 fixed + R4
p/u)
Administrative 54 000 54 000 54 000
overheads
Total budgeted 224 000 254 000 284 000
costs
2. Performance report for the month of April 20x1

Cost Flexed Actual Variance
for 12 costs 12 (difference)
800 units 800 units
Direct labour (R4 51 200 56 400 (5 200)
per unit)
Direct materials 89 600 87 000 2 600
(R7 per unit)
Production 71 200 69 600 1 600
overheads (20 000
fixed + R4 p/u)
Administrative 54 000 54 600 (600)
overheads
Total costs 266 000 267 600 (1 600)
Analysis of results of performance report:
A negative variance indicates that the company has

overspent, while a positive variance indicates that it has
underspent.
The difference between the budget and the actual totals
is not significant, but a closer investigation of the
individual variances is necessary.
The labour and material variances are high in
comparison with the other variances. The company has
overspent on direct labour by R5 200 for the month;
possible reasons could be overtime premiums, increase
in wage rate, etc. The company has underspent on
material by R2 600; possible reasons could be quantity
discount (purchasing department negotiated skilfully with
supplier and got a good price).
The accuracy of the flexible budget and performance
report is dependent on the accuracy of the original cost
behaviour analysis.
Note: If the variable cost per unit is not provided, it must

be calculated as follows:
Variable cost per unit = Total costs ÷ Total

number of units
The cost per unit for all variable costs will be the same. By
definition a variable cost is a cost that varies in total, but on
a per unit basis it remains the same.
If a cost is a mixed cost, then it must be separated into its
fixed and variable portions as follows:
Highest cost – Lowest cost

Variable cost per unit =
Highest volume – Lowest volume
Fixed cost = Total cost– Variable cost
TUTORIAL EXERCISES Flexible budgets and

performance reports
Exercise 4
UTY Ltd produces one uniform product. The company
encounters wide fluctuations in activity levels from month
to month. The following departmental overheads budget for
the assembly department depicts expectations of currently
attainable activity of 61 000 units per month.
Budgeted costs based on normal production levels (61
000 units)
R
Indirect labour – variable 122 000
Supplies – variable 6 100
Power – variable 12 200
Repairs – variable 3 050
Other variable overheads 9 150
Depreciation – fixed 61 000
Other fixed overheads 30 500
244 000
Actual information for June 20x1 (48 800 unit level of

production)
R
Indirect labour – variable 120 475
Supplies – variable 6 100
Power – variable 11 956
Repairs – variable 2 379
Other variable overheads 6 100
Depreciation – fixed 61 000
Other fixed overheads 30 500
Required
4.1 Prepare flexible budgets for 48 800, 61 000 and 73
200 unit levels of production. (Three flexible budgets
should be prepared.)
4.2 Prepare a performance report for June 20x1.
(Compare actual figures to the 48 800 flexible budget
and show any variances.)
Exercise 5
The cost department of CY Manufacturing Company
prepared the following flexible budget for department 2 for
February 20x1:
Production quantity 4 5 6 000

800 400
Capacity utilisation 80% 90% 100%
Variable overheads: R R R
Indirect labour 1 1 2 000
600 800
Manufacturing supplies 1 2 2 400
920 160
Heat, power and light 240 270 300
Fixed overheads:
Maintenance 1 1 1 300
300 300
Total budgeted factory 5 5 6 000
overheads 060 530
The actual production for the month of February 20x1 was

5 700 units and actual factory overheads were as follows:
R
Indirect labour 1 880
Manufacturing supplies 2 325
Heat, power and lights 325
Maintenance 1 280
Total actual factory overheads 5 810
Required
Draft a performance report for the month of February 20x1
indicating clearly whether the variances are favourable or
unfavourable. Note: Round off final answers to the nearest
whole number.
Exercise 6
The managing director of HFSC Manufacturers is
concerned with the operating results for March 20x1. They
are producers and sellers of a single product called
Deluxe. You have recently attended a course on budgeting
and decide to use your experience by applying the
principles of flexible budgeting to the product currently
made and sold by your company. The following information
is made available:
Statement of profit or loss and comprehensive income
for the period March 20x1
Budget Actual
Units 45 000 40 000
Sales R1 800 000 R1 600 000
Less: Variable expenses 810 000 760 400
Direct materials 360 000 357 000
Direct labour 270 000 253 000
Variable overheads 135 000 110 400
Selling and administrative 45 000 40 000
Contribution 990 000 839 600
Less: Fixed expenses 750 000 753 200
Manufacturing overheads 405 000 408 200
Selling and administrative 345 000 345 000
Net profit 240 000 86 400
Required
Compile a flexible budget at actual activity level.
13.4 Cash budgets
Cash budgets help the enterprise anticipate its future cash

needs, which is of extreme importance since poor cash
management is a major reason for business failure. This
budget translates all the other budgets into cash terms and
shows in detail the pattern of actual cash received (inflows)
and actual cash paid (outflows) for the budget period.
The cash budget helps to highlight potential future difficulties;

that is, if cash is going to be exceptionally tight in a given
period, thereby giving management an opportunity to seek
alternative sources of finance.
The following are non-cash items (that is, there is no
movement in the cash balance) and should not appear in the
cash budget under any circumstances:
Depreciation
Provision for credit losses
Format of the cash budget
Opening cash balance for the period X

Add: Cash receipts for the period X
Total cash available X
Less: Cash payments for the period X
Closing cash balance for the period X
ILLUSTRATIVE EXAMPLE Cash budget
The following information has been provided for ABC Ltd:

The opening cash balance on 1 January was expected to
be R60 000. The budgeted sales (all credit) were as
follows:
R
November 160 000
December 180 000
January 150 000
February 150 000
March 160 000
An analysis of the records shows that debtors settle their
accounts according to the following pattern: 60% within the
month of sale, 25% in the month following sale and 15% in
the second month following sale.
An extract from the purchases budget was as follows:
R
November 120 000
December 110 000
January 90 000
February 110 000
March 110 000
All purchases are on credit and are paid for as follows:

90% in the month of purchase and the balance in the
month after purchase.
Wages are R30 000 per month and overheads are R40
000 per month (including R10 000 depreciation); these are
settled in cash every month.
Taxation of R16 000 has to be settled in February and the
company will receive a settlement of an insurance claim of
R50 000 in March.
Required
Prepare a cash budget for January, February and March.
Show all workings.
Solution
Workings
Receipts from sales
January cash
(R)
Nov (15% × 160 24 000
000)
Dec (25% × 180 45 000
000)
Jan (60% × 150 90 000
000)
159 000
February cash
(R)
Dec (15% × 180 27 000
000)
Jan (25% × 150 37 500
000)
Feb (60% × 150 90 000
000)
154 500
March cash (R)
Jan (15% × 150 22 500
000)
Feb (25% × 150 37 500
000)
Mar (60% × 160 96 000
000)
156 000
Payments for purchases

January cash
(R)
Dec (10% × 110 11 000
000)
Jan (90% × 90 000) 81 000
92 000
February cash
(R)
Jan (10% × 90 000) 9 000
Feb (90% × 110 99 000
000)
108 000
March cash (R)
Feb (10% × 110 11 000
000)
Mar (90% × 110 99 000
000)
110 000
Cash budgets of ABC Ltd

January February March
(R) (R) (R)
Opening balance 60 000 67 000 37 500
Add: Cash receipts
Receipts from sales 159 000 154 500 156 000
Insurance claim 50 000
Total cash available 219 000 221 500 243 500
Less: Cash payments
Purchases 92 000 108 000 110 000
Wages 30 000 30 000 30 000
Overheads (less 30 000 30 000 30 000
depreciation)
Taxation 16 000
Closing balance 67 000 37 500 73 500
TUTORIAL EXERCISES Cash budget
Exercise 7
EPC Company has the following information regarding its
business operations:
1. Opening cash balance on 1 September 20x1 was R22
250.
2. Sales are as follows (all sales are on credit):
July R125 000

August R150 000
September R200 000
October R300 000
November R120 000
3. Debtors’ terms are as follows:
– 25% of sales are collected in the month of the sale

– 70% in the month following the sale
– 3% in the second month following the sale
– The remainder is uncollectable
4. Merchandise purchases and expenses are as follows:
September October November

Merchandise R120 000 R175 R87 500
purchases 000
Salaries and R22 500 R25 000 R20 000
wages
Advertising R65 000 R72 500 R40 000
Rent payments R4 500 R4 500 R4 500
Depreciation R5 000 R5 000 R5 000
Merchandise purchases are paid in full in the month

following the month of purchase. Accounts payable
for merchandise purchases on 31 August that will be
paid during September total R90 000. All other
expenses are paid in the month incurred.
5. Equipment costing R5 000 will be purchased for cash
during September.
6. A loan of R20 000 will be made in September and
repaid in November.
7. Interest on the loan is calculated at R600 per month.
Required
Prepare a cash budget for the months of September and
October.
Exercise 8
The summary of EX Ltd’s transactions for June, July and
August 20x1 and its expected transactions for September
20x1 are as follows:
June July August September
Sales (20% R110 R90 R75 R60 000
cash; 80% 000 000 000
credit)
Purchases R27 R24 R18 R15 000
(30% cash; 000 000 000
70% credit)
Salaries and R42 R33 R30 R12 000
wages 000 000 000
Rental R600 R600 R650 R600
General R9 R8 R9 000 R7 000
expenses 000 000
Payments made R5 000
on loan
1. The bank overdraft at 1 August 20x1 amounted to R9

600.
2. Interest on a R6 000 investment at 10% per annum is
received every six months in March and September.
3. Credit sales are collected as follows:
40% in the month of sale
30% in the first month after the sale
28% in the second month after the sale
2% irrecoverable
4. Credit purchases are paid for within the month of
purchase in order to obtain a discount of 2%.
5. All other expenses are paid in cash.
Required
Prepare the cash budget for August and September 20x1.
Exercise 9
The following information is available concerning the
operations of Apec Ltd: The opening cash balance on 1
December is R10 000. Actual and projected sales and
purchases are as follows:
Sales Purchases
October R180 000 R100 000
November R250 000 R184 000
December R300 000 R183 750
January R150 000 R99 750
February R120 000 R170 000
All sales are on credit. A discount of 2% is given on sales if

payment is received within the first 10 days of the month
following sale. Cash is received from credit sales as
follows:
70% within the discount period (at the beginning of the
month following sale)
20% at the end of the month following sale
8% in the second month following sale
2% uncollectable
Purchases are paid for as follows:
50% in the month of purchase and the balance in the
month following the month of purchase. Total budgeted
marketing, distribution and customer service costs for
the year are R400 000. This amount includes
depreciation of R40 000. Marketing, distribution and
customer service costs are paid as incurred.
Required
Prepare cash budgets for December and January.
Exercise 10
CTG Ltd made the following estimates for the three months
ending 31 March 20x1:
January February March

(R) (R) (R)
Cash sales 28 000 25 000 28 000
Credit sales 72 000 60 000 48 000
Purchases 30 000 25 000 12 000
Salaries and wages 16 000 16 000 16 000
Rental 2 000 2 000 2 000
General expenses 15 000 15 000 15 000
Advertising 2 000 2 000 2 000
expenses
1. Credit sales are collected as follows:

60% in the month of sale
20% in the month following the sale
15% in the second month following the sale
5% written off as bad debts
2. All purchases are paid for in cash.
3. Salaries and wages are paid in the month incurred,
except for January, which are paid in February.
4. Rental for the use of premises is paid on a monthly
basis.
5. General expenses include an amount of R1 000 for
depreciation and are paid in the month incurred.
6. The favourable bank balance at 1 February 20x1 is R5
000.
7. A dividend of R15 000 will be paid in March.
8. Interest on a loan of R600 000 at 10% per annum is
payable every month.
9. Advertising will be incurred on a monthly basis and be
paid for in cash.
Required
Prepare the cash budget of CTG Ltd for February and
March 20x1.
Exercise 11
A supermarket operates on a cash-sale basis.
Management expects the next three months from January
to March 20x1 to demand some cash requirements beyond
the normal operational outflows. A monthly cash budget to
identify possible cash needs up to the end of March 20x1
must therefore be developed from the information and
projections which have been made available. A cash
balance of R28 700 is currently on hand and a balance of
at least R20 000 must be available at the beginning of
each month.
(a) Sales forecasts are:
January R180 000

February R240 000
March R210 000
April R240 000
The store has recently introduced a card system and 40%
of cash from sales each month is only received by the
middle of the following month.
(b) Cost of goods sold averages 75% of sales. Inventory
purchased during each month averages the cost of
sales for the following month. Inventory on hand on 1
December 20x0 amounted to R270 000. Inventory is
paid for as follows:
50% in the month of purchase

50% in the month following the month of purchase
(c) Operating expenses are projected as follows:

(i) Salaries and wages at 12% of sales, paid in
the month of sale
(ii) Other expenses at an average 10% of sales,
paid in the month of sale
(iii) Cash receipts expected from repayment of a
loan to an employee of R6 000 due in March
20x1
(iv) Repayment of short-term loan of R3 000 is due
in February 20x1.
(v) Repayments of long-term loans of R4 000
each are due in January and March 20x1.
(vi) A new refrigerator was purchased for R48 000
and four payments of R12 000 each are due in
February, March, April and May 20x1.
(vii) Depreciation on all equipment is written off at
the rate of R5 000 per month.
(viii) Interest income from an investment of R4 900
per month is expected.
(ix) A bonus of R52 500 is due to staff in January
20x1.
(x) Company tax payment of R14 000 is due in
March 20x1.
Required
Prepare the cash budget for the quarter ended 31 March
20x1.
14 Standard costing and variance
analysis
Outcomes
understand the use of a standard costing system

calculate material, labour and overheads variances
calculate sales variances
reconcile budgeted to actual profit.
Chapter outline
14.1 Introduction
14.1 Introduction
In Chapter 13, you were introduced to budgeting as a means of

planning, controlling and monitoring business activities. This
chapter continues the theme of control by the use of standard
costing and variance analysis.
In a manufacturing environment, it can be difficult to track down

the causes of variances unless a detailed analysis is carried out.
These variances can be identified and quantified by using a
standard costing system.
Used to improve planning and control, and to facilitate product

costing.
Forces planning, resulting in a more efficient operation with
less waste, eliminating overspending, excessive inventory,
wasted time, etc.
A standard is a benchmark or a norm for measuring
performance.
Standards fall into two categories:
– Ideal standards, which allow for no breakdowns or other

work interruptions.
– Practical or currently attainable standards, which can be
reached under efficient operating conditions without
extraordinary effort by properly trained and experienced
employees.
A standard cost prescribes performance and minimum

allowable costs. Each element of cost of production is broken
down and costed. For each product a standard cost card is
drawn up.
Setting standards. Historical data provide a good starting point
for determining standards for materials, labour and overheads.
This data must be adapted for changes in technology,
production methods, etc. Effective standard setting requires a
combined effort and the experience of all concerned to predict
future trends. These standards must be revised regularly.
Provides a good basis for cost comparisons, in particular with

the use of flexible budgets.
Enables managers to use management by exception whereby
their attention is focused only on those variances that are
significant, thereby saving management time.
Provides a basis for managerial performance evaluation and
determining bonuses.
Participation in setting standards and assigning responsibility
can have motivational effects on employees.
Standard costing systems tend to focus too heavily on cost

minimisation.
May encourage cost reduction, which can adversely affect
other areas of strategic importance.
Controlling one department’s costs may increase costs in other
departments.
Too much emphasis is placed on the cost and efficiency of
direct labour, which can be insignificant in the face of
increasing automation.
Variance analysis does not explicitly encourage continuous
improvement due to 12-month standards.
Standard costs become outdated quickly due to shorter product
life cycles.
The overall variance as learnt in flexible budgets can be broken

down in order to identify the effects on the volume and price of
resource inputs.
Variances arise when the actual quantity or price of a
production component differs from the standard quantity or
price.
Each production component can have a price (rate, budget or
spending) variance, and a quantity (efficiency or usage)
variance.
Costs that should have been incurred at the actual level of
activity according to the standard are compared with actual
costs incurred. The difference is the variance.
A favourable variance occurs when actual costs are less than
the standard costs at actual volume.
An unfavourable variance occurs when actual costs are more
than the standard costs at actual volume.
Figure 14.1 Diagrammatic illustration of variances
As mentioned previously, variance analysis is used by an

enterprise to exercise control over its costs. It is, however, just as
important to control sales as to ensure that planned profits are
achieved.
Sales variances are the opposite of production variances, because

they represent income and not costs. Therefore when the actual
sales are greater than the budgeted sales, the variance is
favourable and vice versa. We will cover only two sales
variances, namely sales price and sales quantity.

The sales price variance is the difference between the standard
price per unit and the actual price per unit for the number of units
sold in the period:
(AP – SP) × AQ

The sales quantity variance is the difference between the
budgeted number of units sold and the actual number sold valued
at the standard gross profit per unit.
(AQ – SQ) × Standard gross profit per unit
(Standard gross profit per unit = Standard selling price –

Standard cost price)
Explanation of abbreviations
AP – actual price
SP – standard price
AQ – actual quantity
SQ – standard quantity
WG Ltd manufactures products Widget and Gadget. The

following information is relevant to the two products:
Budgeted Budgeted Standard Actual Actual

sales production sales sales sales
(units) cost per price per (units) in
unit (R) unit (R) rands
Widget 1 200 10 20 1 100 19 800
Gadget 800 5 10 720 7 920
Total 2 000 1 820 27 720
Required
Calculate the following variances for each product and in total:
1. Sales price variance

2. Sales quantity variance
Where necessary round off to two decimal places.
Solution
1. Sales price variance
(AP – SP) × AQ
Widget = (R18* – R20) × 1 100 units = R2 200 U
Gadget = (R11* – R10) × 720 units = R720 F
Total sales price variance = R1 480 U
*R19 800 ÷ 1 100 U = R18
*R7 920 ÷ 720 U = R11
You sold each unit of Widget for R2 less and you sold
each unit of Gadget for R1 more.
2. Sales quantity variance
(AQ – SQ) × Standard gross profit per unit

Widget = (1 100 – 1 200) × (R20 – = R1 000
R10) U
Gadget = (720 – 800) × (R10 – R5) = R400 U
Total sales quantity variance = R1 400
U
You sold fewer units than expected for both Widget and
Gadget.

Price variance measures the effect on the cost of purchasing at a
price that is different from standard. This variance can arise due
to an unexpected price increase/decrease, inefficiency of
purchasing department, quality of material purchased, quantity of
material purchased, etc.
The material price variance is the difference between the standard

and the actual unit price of raw material multiplied by the actual
quantity of raw material:
(SP – AP) × AQ
Usage (quantity) variance measures the effect on the cost of

using a different quantity of material in production compared
with the standard quantity that should have been used for the
actual production output. This variance can arise due to the
efficiency (or lack thereof) of a production department, quality of
material, machine breakdowns, skill of workers, supervision, etc.
The usage variance is calculated by determining the difference

between the actual quantity of material used and the quantity that
should have been used for actual production, according to the
standard, multiplied by the standard price:
(SQ – AQ) × SP
Total direct materials variance is the difference between actual

total materials cost and the budgeted total materials cost, or the
total variance is the sum of the price and usage variance:
(AP × AQ) – (SP × SQ)
or
Price variance + Usage variance

Rate variance measures the effect on cost of paying a different
labour rate, compared with the standard. This variance is caused
by an unexpected wage increase/decrease, incorrect standards
established, skill of workers employed, etc.
The direct labour rate variance is the difference between the

standard hourly rate and the actual hourly rate multiplied by the
actual time used:
(SR – AR) × AH
Efficiency variance measures the effect on cost of using a

different number of direct labour hours, compared with the
standard hours that should have been used for the actual
production output. This variance is caused by the skill of
workers, quality of material, machine breakdowns, supervision of
workers, incorrect standards established, etc.
The direct labour efficiency variance is calculated by determining

the difference between the actual hours worked and the hours that
should have been worked to produce the output, according to the
standard, multiplied by the standard rate.
(SH – AH) × SR
The total labour variance is the difference between actual total

labour cost and the budgeted total labour cost, or the total
variance is the sum of the rate and efficiency variance:
(AR × AH) – (SR × SH)
or
Rate variance + Efficiency variance

Spending (rate) variance is a measure of the difference between
the actual variable overheads and the standard variable overheads
rate multiplied by actual activity. This variance is caused by
incorrect standards established, increase/decrease in the cost of
variable overheads, efficient (or inefficient) use of variable
overheads items, etc.
The variable manufacturing overheads rate variance is the

difference between the standard rate and the actual rate multiplied
by the quantity used of the allocation basis, which can be labour
hours, machine hours, etc. (if hours are used as basis):
(AR – SR) × AH
Efficiency variance measures the difference between the actual

activity and the standard activity allowed, given the actual output
multiplied by the standard variable overhead rate. This variance
is caused by efficient (or inefficient) use of time, quality of
material used, machine breakdowns, supervision of workers,
incorrect standards established, etc.
The variable manufacturing overhead efficiency variance is

calculated by determining the difference between the actual hours
worked and the hours that should have been worked to produce
the output, according to the standard, multiplied by the standard
rate (if the allocation base is time):
(SH – AH) × SR
Total variable manufacturing overhead variance is the

difference between actual total manufacturing overheads and the
budgeted total variable overheads, or the total variance is the sum
of the rate and efficiency variance:
(AR × AH) – (SR × SH)
or
Spending variance + Efficiency variance

Marginal costing system: Fixed manufacturing overheads are not
allocated to production, but written off as a period cost. Only a
fixed overhead expenditure variance is calculated. This variance
is caused by actual overhead costs being different from expected
and can arise due to an increase/decrease in salaries paid to
supervisors or other fixed overheads, overbudgeting for some
fixed expenses, etc. It is calculated as the difference between
actual fixed overheads and budgeted fixed overheads:
AFO – BFO
Absorption costing system: Besides the expenditure variance, a

volume variance which measures the utilisation of available
facilities is calculated. The volume variance occurs when
standard hours allowed for actual output are different from the
budgeted (normal) activity level planned for the period.
(BH – SH) × SR
or
(Actual units – Budgeted units) × SR
The following information has been extracted from the records

of Senayshia’s Beautiful Baskets for the month of March 20x1:
Standard cost card:
R
Materials 1,40 kg @ R4,10/kg 5,74
Direct labour 0.90 hours @ R4,50/hour 4,05
Variable overheads R2,20/hour @ 0,90 hours 1,98
Fixed overheads 6,34
18,11
Senayshia’s Beautiful Baskets

Performance report
Original Flexible
Actual Variance
budget budget
Volume 240 000 220 000 220 000
R6 000 R5 500 R5 060 R440
Sales U
000 000 000 000
Less: Cost of R4 346 R4 049
R4 111 000 R61 302 F
sales 400 698
Direct R1 377 R1 262 R1 252
R10 560 F
materials 600 800 240
R857
Direct labour R972 000 R891 000 R33 352 F
648
Variable R438
R475 200 R435 600 R2 970 U
overheads 570
Fixed R1 521 R1 521 R1 501
R20 360 F
overheads 600 600 240
R1 653 R1 389 R1 010 R378
Profit U
600 000 302 698
Variable overheads allocation is based on direct labour hours,

while fixed manufacturing overheads are allocated on the
basis of units produced, all at predetermined rates based on
budgeted costs and volumes.
Actual production costs:
Material 313 060 kg at R4 per kg

Direct labour 194 920 hours at R4,40 per hour
Required
Prepare a complete variance analysis.
Solution
Materials price variance = (SP – AP) × AQ

= [R4,10 – R4,00] × 313 060
= R31 306 (F)
Materials usage variance = (SQ – AQ) × SP
= [(220 000 × 1,40) – 313 060] ×
R4,10
= R20 746 (U)
Total material variance = Material price + Material usage
= 31 306 (F) + 20 746 (U)
= R10 560 (F)
Direct labour rate variance = (SR – AR) × AH
= [R4,50 – R4,40] × 194 920
= R19 492 (F)
Direct labour efficiency = (SH – AH) × SR
variance
= [220 000 × 0,90 – 194 920] ×
R4,50
= R13 860 (F)
Total labour variance = Labour rate + Labour efficiency
= 19 492 (F) + 13 860 (F)
= R33 352 (F)
Variable o/h expenditure = (SR – AR) × AH
variance
= (R2,20 – R2,25) × 194 920
= R9 746 (U)
Variable o/h efficiency = (Standard hours – Actual hours)
variance × Standard rate
= [198 000 – 194 920] × R2,20
= R6 776 (F)
Total variable overhead = (AH × AR) – (SH × SR)
variance
= (194 920 × R2,25) – (220 000 ×
0,90 × R2,20)
= 438 570 – 435 600
= R2 970 (U)
Fixed overheads = Budgeted cost – Actual cost
expenditure variance
= 1 521 600 – 1 501 240
= R20 360 (F)
Fixed overheads volume = (Actual units – Budget units) ×
variance Standard rate
= [220 000 – 240 000] × R6,34
= R126 800 (U)
Total fixed overhead = Actual cost – (Actual units × SR)
variance
= 1 501 240 – (220 000 × R6,34)
= 1 501 240 – 1 394 800
= R106 440 (U)
Sales price variance = (AP – SP) × AQ
= (R23 – R25) × 220 000
= R440 000 U
Sales volume variance = (AV – BV) × Standard profit
= (220 000 – 240 000) × (R25 –
R18,11)
= R137 800 (U)
Senayshia’s Beautiful Baskets

Standard cost operating statement
R R
Budgeted net profit 1 653
600
Add: Sales volume variances 137 800
U
Standard profit (flexed budget 1 515
profit) 800
Add/(less): Favourable/adverse 505 498
variance U
Sales price variance 440 000
(U)
Material price 31 306
(F)
Material usage 20 746
(U)
Labour rate 19 492
(F)
Labour efficiency 13 860
(F)
Variable overhead rate 9 746 (U)
Variable overhead efficiency 6 776 (F)
Fixed overhead expenditure 20 360
(F)
Fixed overhead volume 126 800
(U)
Actual profit 1 010 302
TUTORIAL EXERCISES
Exercise 1
Multiple-choice questions
1.1 Standard costs include the quantity and price of inputs

for each unit of product. These inputs include
a. delivery costs
b. marketing costs
c. accounting costs
d. overhead costs
1.2 Variances indicate

a. the cause of the variance
b. who is responsible for the variance
c. that actual performance is not going according to plan
d. when the variance should be investigated
1.3 Price variances focus on the difference between

a. actual price and standard price for actual quantity
allowed for units actually produced
b. actual price and standard price for standard quantity
allowed for units actually produced
c. actual price and standard price for actual quantity
allowed for estimated activity
1.4 The materials price variance is calculated as

a. (Actual price – Standard price) × Actual quantity
b. (Actual price – Standard price) × Standard quantity
c. (Actual quantity – Standard quantity) × Actual price
d. (Actual quantity – Standard quantity) × Standard price
1.5 Efficiency variances focus on the difference between

a. actual quantity used and standard quantity allowed for
estimated activity
b. actual quantity used and standard quantity allowed for
units actually produced
c. quantity allowed for estimated production and
standard quantity allowed for units actually produced
1.6 The labour efficiency variance is calculated as

a. (Actual direct labour hours used – Standard direct
labour hours that should have been used) × Actual
direct labour hours used
b. (Actual hourly wage rate – Standard hourly wage rate)
× Standard direct labour hours that should have been
used
c. (Actual direct labour hours used – Standard direct
labour hours that should have been used) × Actual
hourly wage rate
d. (Actual direct labour hours used – Standard direct
labour hours that should have been used) × Standard
hourly wage rate
Exercise 2
Max Company has developed the following standards for one
of its products:
Direct materials 15 kg @ R16 per pound

Direct labour 4 hours @ R24 per hour
Variable overheads 4 hours @ R14 per hour
The following activities occurred during the month of October

20x1:
Materials purchased 10 000 kg costing R170 000

Materials used 7 200 kg
Units produced 500 units
Direct labour 2 300 hours at R23,60 per hour
Actual variable overheads R30 000
The company records materials price variances at the time of

purchase.
2.1 The variable standard cost per unit would be

a. R392
b. R336
c. R296
d. R152
2.2 The materials price variance would be

a. R50 000 favourable
b. R50 000 unfavourable
c. R10 000 unfavourable
d. R10 000 favourable
2.3 The materials usage variance would be

a. R40 000 unfavourable
b. R40 000 favourable
2.4 The labour rate variance would be

a. R920 unfavourable
b. R920 favourable
c. R800 unfavourable
d. R800 favourable
2.5 The labour efficiency variance would be

a. R7 200 unfavourable
b. R7 200 favourable
Exercise 3
Grunter Ltd sells two types of product: Ras and Som. The
following information for April 20x1 is available:
Budgeted information
Product Unit Standard selling Standard cost
sales price per unit price per unit
Ras 15 R4,80 R2,25
000
Som 75 R2,10 R1,11
000
Actual information
Product Unit Total sales Total cost
sales
Ras 18 85 500 R40 680
000
Som 82 173 840 R94 300
000
Required
3.1 Sales price variance
3.2 Sales quantity variance
Exercise 4
Alpha Beta Ltd manufactures two types of product: A and B.
The following actual and budgeted information is available for
December 20x1:
Product A Product B
Budgeted information
Standardised selling R5,00 R8,00
price
Standardised cost R3,35 R5,70
price
Sales 8 000 units 4 000 units
Actual information
Sales R39 000 (7 500 R27 750 (3 900
units) units)
Required
Where necessary round off final answer to two decimal
places.
Exercise 5
Relay Ltd manufactures two products: M and N. The following
is relevant to the two products:
Product Product
M N
Budgeted sales units 1 200 800
Budgeted manufacturing cost per R20 R10
unit
Standard sales price per unit R40 R20
Actual sales units 1 100 720
Sales value R39 600 R15 840
Required
Calculate the following for each variance and in total:
Exercise 6
The following is a budgeted contribution format income
statement for FISRICK Industries:
Sales R360 000,00

Less: Variable cost R246 000,00
Direct materials A (@ R10 per kg) R120 000,00
Direct materials B (@ R4 per litre) R36 000,00
Direct labour (@ R16 per hour) R72 000,00
Variable factory overheads (@ R4 per hour) R18 000,00
Contribution margin R114 000,00
Less: Fixed costs R80 000,00
Net income R34 000,00
1. The company manufactures and sells a single product.
The budgeted units produced and sold (on which the
statement was based) was 6 000 units.
2. The standard usage per unit is as follows:
Direct materials A 8 kg
Direct materials B 6 litres
Direct labour 3 hours
Variable overheads 3 hours
3. Actual results for the period were as follows:
Units produced and 6 300 units

sold
Material A 25 000 kg at a total cost of R124
500
Material B 20 160 litres at a total cost of R41
328
Direct labour 9 600 hours at R17 per hour
Variable overheads R21 600
Required
Calculate the following variances and state possible causes
for the variances:
6.1 The standard variable cost per unit
6.2 Material price variance for material B
6.3 Material usage variance for material B
6.4 Direct labour rate and efficiency variances
6.5 Variable overhead expenditure and efficiency variances
Exercise 7
Bratz Ltd is a company specialising in custom-made evening
dresses. They cater to each individual customer’s needs by
tailor-making a dress according to the specifications they
receive.
A standard cost card for one of its products, Kelso Nite Out, is
given below:
R
Selling price 250,00
Production costs:
Direct materials: 12 metres per Kelso Nite Out 18,00
Direct labour: 4 hours per Kelso Nite Out 24,00
Overheads 100,00
Gross profit 108,00
The budgeted production for the month of June 20x1 is 1 000

units.
Actual results for the production and sale of the Kelso Nite
Out were as follows:
Sales – 1 200 units at R240,00 each

Production was 1 300 units
Direct materials – 6 000 metres at a cost of R22 400
Direct labour – 5 000 hours at R6,00 per hour
Variable overheads – R75 500
Fixed overheads per unit are R85,00.
The actual profit for June 20x1 was R119 700
Required
Calculate the following variances:
7.1 Material price
7.2 Material usage
7.3 Total material variance
7.4 Labour rate
7.5 Labour efficiency
7.6 Total labour variance
7.7 Variable overheads efficiency
7.8 Variable overheads spending
Exercise 8
Deshayne Ltd produces and sells high-quality rubber for
vehicles. An extract from the company’s most recent income
statement is given below:
Sales R400 000

Less: Variable costs
Direct materials (R98 800)
Direct labour (R78 800)
Variable factory overheads (R14 400)
Contribution margin R208 000
The company uses a standard costing system for planning
and control purposes. The standard cost and usage per unit
are:
Direct materials 6,4 metres R76,80

Direct labour 2,8 labour hours R56,80
Variable overheads 1,4 machine hours R11,20
R144,00
As indicated above, the variable overheads cost is applied to

products on the basis of machine hours. The company has
produced and sold 5 000 units at R160,00 per unit.
Actual information
Direct materials of 15 200 metres at R197 600
Direct labour cost of R157 600 at R19,70 per hour
Variable overheads cost of R28 800 at R7,20 per hour
Required
Determine the following variances:
8.1 Direct material price variance
8.2 Direct material usage variance
8.3 Direct labour rate variance
8.4 Direct labour efficiency variance
8.5 Variable overheads spending variance
8.6 Variable overheads efficiency variance
Exercise 9
SC Ltd produces a single product of which the standard cost
of one unit for June 20x1 was as follows:
Direct material (4,8 kg @ R6 per kg) R28,80

Direct labour (6 hrs @ R9 per hour) R54,00
Overheads (R4 per labour hour) R24,00
R106,80
The standard selling price of one unit was R150 and budgeted
sales were 1 800 units. All overheads are fixed in nature.
The actual results were as follows:
1 950 units were made and sold for a total of R302 250.
Direct materials used were 10 000 kg at a total cost of R58
000.
Direct labour was 12 500 hours at a cost of R115 000.
Actual fixed overheads were R48 200.
Required
9.1 Calculate the following variances:
a. Material price variance
b. Material usage variance
c. Labour rate variance
d. Labour efficiency variance
e. Fixed overheads expenditure
f. Fixed overheads volume
9.2 Calculate the expected profit and prepare a variance
report for management, reconciling the standard profit
expected with the actual profit.
Exercise 10
The following standard costs were developed for one of the
products of HFSC Manufacturers:
Standard cost card per unit
Direct materials 4 metres @ R14 per R56,00
metre
Direct labour 8 hours @ R10 per hour R80,00
Variable overheads 8 hours @ R8 per hour R64,00
Fixed overheads 8 hours @ R12 per hour R96,00
Total standard cost per R296,00
unit
The following information is available regarding the company’s

operations for the period:
Units produced 11 000

Materials purchased 52 000 metres at R13,70 per metre
Materials used 40 000 metres
Direct labour 84 000 hours costing R840 000
Overheads incurred:
Variable R756 000
Fixed R1 000 000
Budgeted fixed overheads for the period is R960 000, and the
standard fixed overhead rate is based on an expected
capacity of 80 000 direct labour hours.
Required
10.1 Calculate the materials price variance.
10.2 Calculate the materials usage variance.
10.3 Calculate the labour rate variance.
10.4 Calculate the labour efficiency variance.
10.5 Calculate the variable overheads spending variance.
10.6 Calculate the variable overheads efficiency variance.
10.7 Calculate the fixed overheads spending variance.
10.8 Calculate the fixed overheads volume variance.
15 Short-term decision making
Outcomes
distinguish between marginal and absorption costing

draft an income statement using the marginal costing
format
apply marginal costing to short-term decisions.
Chapter outline
15.1 Introduction
absorption costing
15.2.3 Choice of products where a limiting factor exists
15.1 Introduction
In Chapter 4 you were introduced to the traditional/absorption

costing method of drawing up an income statement. In this
chapter we will focus on marginal costing and contrast the
differences between the two methods. Other terms used for
marginal costing are variable costing or direct costing.

The objective of product costing is to determine the total
manufacturing cost per unit. This can be determined as
follows: total manufacturing cost incurred for the period
divided by the total number of units produced for the period.
When the unit cost is known, calculating the cost of units that
are still in stock and the cost of units sold is straightforward. It
is determining what should be included in the unit cost that
becomes difficult. According to the absorption costing
method, both fixed and variable costs are included in the unit
cost. The marginal costing method, on the other hand, includes
only the variable cost in the unit cost of a product.
Marginal costing: Cost Absorption costing: Cost per

per unit unit
Direct materials Direct materials
Add: Direct labour Add: Direct labour
Marginal costing: Cost Absorption costing: Cost per
per unit unit
Add: Variable Add: Manufacturing overheads
manufacturing overheads (fixed + variable)
= Cost per unit = Cost per unit

absorption costing
The following example will be used to illustrate the difference
in the structure of the income statement under the two costing
methods.
Starlite Ltd manufactures a product, Sparkles. The

following information has been provided for March 20x9:
Units manufactured and sold 10 000

Selling price per unit R50
Variable manufacturing cost R25 per unit
Fixed manufacturing cost R100 000
Variable selling and administrative cost R5 per unit sold
Fixed selling and administrative cost R35 000
Required
Draft an income statement for March 20x9 according to the
1. absorption costing method

2. marginal costing method.
Solution
1. Income statement: absorption costing
Note: Under absorption costing, costs are grouped

according to whether they are product or period.
2. Income statement: marginal costing
Note: Under marginal costing, costs are grouped

according to whether they are fixed or variable.
Both methods result in a net profit of R65 000. This is

because the number of units manufactured and sold is the
same; there is no opening or closing stock on hand. In this
book, we will only look at questions where the units
manufactured and sold are the same.
The main feature of marginal costing is the separation of
costs into fixed and variable costs and the calculation of
contribution.
Fixed costs
These are costs that remain constant in total, regardless of
the change in the level of activity.
Variable/marginal costs
These are costs that vary in total, in direct proportion to the
changes in the level of activity.
Marginal costing is important for short-term decision

making
It is assumed that in the short term only variable costs alter
or change, while fixed costs remain the same. Therefore, it
is only the variable costs which are relevant for short-term
decision making.
Short-term decisions are decisions that seek to make the best

use of existing facilities. These decisions include
special order decisions

dropping a product or department
key factor/limiting factor decisions
make-versus-buy decisions.
Note: The most important thing to remember when making

decisions using marginal costing is that there must be a
positive contribution for something to be acceptable. Both
financial and non-financial information must be considered
before a final decision is taken.

This kind of decision is required when a firm has spare
capacity and is offered a special order, below normal prices,
which will take up the unused capacity. The decision is based
on whether or not the special order will provide a contribution
towards the fixed costs.
Sweets Ltd manufactures chocolates which it sells for R50

per box. Current output is 20 000 boxes per period, which
represents 80% of capacity. It has the opportunity to use
the surplus capacity by selling its product at R30 per box to
a supermarket chain who will sell it as an “own label”
product.
Total costs for the last period were R700 000, of which
R200 000 were fixed. (Note that fixed costs will remain
unchanged.) This represents a total cost of R35 per box.
Current profits are R300 000.
Should the supermarket order be accepted even though
the selling price is below the total cost?
Steps for making special order decisions

Determine the following: Is production capacity available?
Will fixed costs remain unchanged? Will current selling
prices not be affected by the acceptance of the special
order? If your answer is “yes” to all these questions, then
proceed to the next step.
1. Calculate the surplus capacity.

2. Calculate the variable cost per unit.
3. Draft a marginal costing income statement for the
special order only.
If the contribution is positive, accept the order.

If the contribution is negative, reject the order.
4. Calculate the profit after the special order has been

accepted.
Note: Only calculate the profit if it is stipulated in the

question.
Solution
The key point is that the price of R30 offered by the
supermarket should be compared with the marginal costs
of production, not with the total cost.
Step 1: Calculate the surplus capacity

What quantity would the supermarket order amount to?
80% = 20 000 boxes
100% = 25 000 boxes (100 ÷ 80) × 20 000
20% = 5 000 boxes (20 ÷ 80) × 20 000
Therefore the supermarket order would amount to 5 000
boxes, which is 20% of the total capacity.
Step 2: Calculate the variable cost per unit
Total variable costs

*Variable cost per unit =
Total number of boxes produced
R500000
=
20000 boxes
= R25 per box
Step 3: Draft the marginal costing income statement

for the special order
The supermarket order would produce the following extra
contribution:
Sales (5 000 × R30) R150 000

Less: Marginal costs (5 000 × *R25) 125 000
Contribution 25 000
If the contribution is positive, accept the order.

If the contribution is negative, reject the order.
The supermarket order generates a positive contribution,

which means a further R25 000 towards payment of fixed
costs. Therefore, the acceptance of the supermarket order
should increase the overall profits.
Step 4: Calculate the profit after the special order has

been accepted
question.
Sales (5 000 × R30) + (20 000 × R50) R1 150
000
Less: Marginal costs (5 000 × *R25) + 625 000
500 000
Contribution 525 000
Less: Fixed costs 200 000
Net income 325 000
Before a final decision can be made, the following non-

financial factors should be considered:
Will the acceptance of one order at a lower price lead

other customers to demand lower prices as well?
Is this particular order the most profitable way of using
the spare capacity?
Will the supermarket order lock up capacity which could
be used for future full-price business?
Is it absolutely certain that fixed costs will not alter?
Will sales of the product in the supermarket’s “own label”
form reduce the main branded sales?

If a business has a range of products or departments, one of
which is thought to be unprofitable, it may consider dropping
the loss-making product or department.
A pharmaceutical company is considering whether to drop
product Bar from its line, because accounting statements
show that this product is being sold at a loss.
The question of profitability of product Bar was raised by
the following operating statement:
Product Product Product Total
Ace Bar Lase
R R R R
Sales 100 000 15 000 25 000 140
000
Total costs 120
85 000 17 000 18 500
500
Net profit 19
15 000 (2 000) 6 500
(loss) 500
The total costs can be separated into fixed and variable

costs after some examination of the costs:

Ace Bar Lase
R R R R
Variable costs
Direct materials 15 000 2 000 3 000 20
000
Direct labour 30 000 4 000 5 000 39
000
Indirect 15 000 3 000 4 000 22
manufacturing 000
costs
Selling and 6 000 800 1 000 7
administration 800
Fixed costs
Indirect 20
manufacturing 000
costs
Selling and 11
administration 700
Required
Based on the above information, should product Bar be
dropped? What other factors should be considered?
Steps for dropping a product or department
1. Draft a marginal costing income statement if the

information is not given in this format. Show fixed costs
in total and not per product.
2. Look at the contribution of each product.
If the contribution is positive, do not drop the

department or product, as it contributes towards the
payment of fixed costs.
If the contribution is negative, drop the department or
product.
3. Indicate your decision at this point, giving reasons.

4. To support your decision, draft a marginal costing
income statement that excludes the loss-making
product or department.
Solution
Arrange the original statement in marginal costing format:

Ace Bar Lase
R R R R
Sales 100 000 15 000 25 000 140
000
– Variable 66 000 9 800 13 000 88
costs 800
Direct materials 15 000 2 000 3 000 20
000
Direct labour 30 000 4 000 5 000 39
000
Indirect 15 000 3 000 4 000 22
manufacturing 000
costs
Selling and 6 000 800 1 000 7
administration 800
Contribution 34 000 5 200 12 000 51
margin 200
– Fixed costs 31
700
Indirect 20
manufacturing 000
costs
Selling and 11
administration 700
Net income 19
500
This presentation does, of course, give the same overall
profit but, in addition, the contribution of each product is
shown. It will be seen that product Bar provides a
contribution of R5 200 towards the payment of fixed costs,
which means that this product is worth keeping.
Marginal costing income statement excluding the loss-

making product
Product Product Total

Ace Lase
R R R
Sales 100 000 25 000 125
000
– Variable costs 66 000 13 000 79
000
Direct materials 15 000 3 000 18
000
Direct labour 30 000 5 000 35
000
Indirect 15 000 4 000 19
manufacturing costs 000
Selling and 6 000 1 000 7 000
administration
Contribution margin 34 000 12 000 46
000
– Fixed costs 31
700
Indirect 20
manufacturing costs 000
Selling and 11
administration 700
Net income 14
300
Or calculation can be shown as follows:
Profit without product

Bar
Contribution: Product Ace 34 000
Contribution: Product Lase 12 000
46 000
Profit 14 300
If product Bar is dropped, the profit will decrease by R5

200 (R19 500 – R14 300) as shown above.
What impact will dropping the product have on the long-

term profitability of the business?
What impact will dropping the product have on employee
assurance regarding their employment?
What impact will dropping the product have on customer
opinions?
15.2.3 Choice of products where a limiting factor

exists
This decision looks at when a business has the option of
producing various products and there is a single binding
constraint. Binding constraints include a restriction on the
following: labour hours, machine hours, raw material, etc.
These binding constraints prevent the business from achieving
their sales demand and consequently the business must
determine the optimal production mix that will maximise
profits.
A company is able to produce four products and is

planning its production mix for the next period. Estimated
cost, sales and production data are as follows:
Product A B C D
Selling price per unit R60 R90 R120 R108
Less: Marginal costs
Labour (at R6 per hour) 18 12 42 30
Material (at R3 per litre) 18 54 30 36
Contribution per unit R24 R24 R48 R42
Resources per unit
Labour (hours) 3 2 7 5
Material (litres) 6 18 10 12
Maximum demand (units) 5 000 5 000 5 000 5 000
Required
Based on the above information, what is the most
profitable production mix under the two following
independent assumptions?
1. If labour hours are limited to 50 000 in a period
2. If material is limited to 110 000 litres in a period
Where necessary round off calculations to two decimal

places.
Steps for a limiting factor decision
1. Calculate the contribution per product.

2. Calculate the contribution per limiting factor for each
product.
3. Rank the products, according to which product has the
highest contribution per limiting factor.
4. Determine the most profitable production mix, that is,
which product will not be fully supplied.
5. Calculate the profit generated from the products
produced.

question.
Solution
It will be seen that all the products show a contribution so
that there is a case for their production. However, because
constraints exist, the products must be ranked in order of
contribution per unit of the limiting factor so that overall
contribution can be maximised.
1. If labour hours are limited to 50 000 in a period:
Product A B C D
Contribution per unit R24R24 R48 R42
÷ Labour hours per unit 3 2 7 5
= Contribution per labour hour R8R12R6,86R8,40
(per limiting factor)
Ranking 3rd 1st 4th 2nd
To make all the products to the demand limits, we

would need:
(5 000 × 3) + (5 000 × 2) + (5 000 × 7) + (5 000 × 5)
= 85 000 labour hours
As there is a limit of 50 000 labour hours in the period,
the products should be ranked in order of
attractiveness judged by contribution per labour hour;
that is, B, D, A and C.
Best production plan when labour hours are restricted:
Produce5 000 units B using 10 000 labour hours

5 000 units D using 25 000 labour hours
5 000 units A using 15 000 labour hours
and no units of C
which uses a total of 50 000 labour hours
available.
2. If material is limited to 110 000 litres in a period:
Product A B C D
Contribution per unit R24 R24 R48 R42
÷ number of litres of material 6 18 10 12
Contribution per litres of material R4 R1,33 R4,80 R3,50
Ranking 2nd 4th 1st 3rd
To make all products to the demand limits, we would
need:
(50 000×6) + (5 000×18) + (5 000×10) + (5 000×12)
= 30 000 + 90 000 + 50 000 + 60 000
= 230 000 litres
Ranking of products by contribution per litres of
material is C, A, D and B.
Best production plan when material is restricted:
Produce 5 000 units of C using 50 000 litres of

material
5 000 units of A using 30 000 litres of
material
which equals 80 000 litres of material
2 500 units of D using 30 000 litres
material (30 000 ÷ 12 = 2 500) and
no units of B which uses a total of 110
000 litres of material
Note: The optimum production mix is a short-term

solution to maximising profits. The company should
consider the long-term solution to the binding
constraint. The long-term solution would include
sourcing additional labour and raw material suppliers.

In this decision the business must choose either to produce a
product or component in-house or buy it from an external
supplier. There are two alternatives available:
Alternative 1: Where the production of the product or
component does not impact on existing production
Alternative 2: Where the production of the product or

component impacts on existing production
Alternative 1
Ethie Ltd currently produces 10 000 units of component
PRC435 in-house. The cost per unit of component
PRC435 is:
Rand
Direct materials 5,00
Direct labour 2,50
Variable manufacturing overheads 3,50
Fixed manufacturing overheads 7,00
Total cost 18,00
This component can be purchased from an external

supplier at a cost of R15,50 per unit. The company has
unused capacity and can produce the component in-
house.
Alternative 2
Ethie Ltd does not have spare capacity and currently
component PRC435 is not being produced in-house.
Production of this component would displace the existing
production of product WTY1 by 1 000 units. The variable
cost to manufacture product WTY1 is R100 and this
product sells for R150 per unit.
Under each alternative, determine if the company should
produce the component in-house or purchase it from an
external supplier.
Steps involved in the make-versus-buy decision
1. Compare the cost to buy the component with the

variable cost to manufacture the component.
2. If the production of the component displaces/replaces
existing production, then add the lost contribution to the
variable cost of manufacturing the component in-
house.
3. Choose the option that has the lowest costs.
Solution
Alternative 1
Buying-in price R 15,50

Less: Variable manufacturing R 11,00 (R5 + R2,50 +
cost R3,50)
Savings per component R 4,50
The decision is to manufacture the components in-house

rather than buying them from an external supplier. This
results in a saving of R4,50 per component and an
increase in profits of R45 000 (R4,50 × 10 000). The
variable cost to manufacture is cheaper than the buying-in
price and the company has surplus production capacity.
The fixed costs are irrelevant to this decision, since they
will be incurred whether or not the component is produced
in-house.
Alternative 2
Buying-in price R 155 000 (R15,50 × 10 000)

Less: Variable manufacturing R 110 000 (R11,00 × 10 000)
cost
Lost contribution R 50 000 (R150 – R100) × 1
000
Savings from buying in R 5 000
The decision is to purchase the component from an

outside supplier instead of manufacturing it in-house, as
this will result in a saving of R5 000.
How reliable is the supplier?

Will the supplier maintain the quality of the components?
Will the supplier increase the price of the component in
the near future?
TUTORIAL EXERCISES
Exercise 1
For each of the questions that follow, select the most
appropriate answer.
1.1 Under absorption costing, the cost per unit includes
a. direct materials + direct labour + fixed
manufacturing overheads
b. direct material + direct labour + fixed and variable
c. direct materials + direct labour + variable
1.2 A constrained resource

a. prevents an organisation from meeting its sales
demand or production level
b. is a limiting factor
c. includes items such as machine hours, labour
hours, floor space, etc.
d. all of the above are applicable
1.3 Non-financial indicators

a. must be considered before any decision is taken
b. are qualitative factors which include issues such
as employee morale, customer satisfaction and
long-term profitability
c. cannot be quantified in monetary terms
d. all of the above
1.4 A company produces special bath soaps for

individuals who suffer from eczema. These soaps
retail at R8,50 per bar. Currently the company is
operating at 80% capacity, which is equivalent to 25
000 bars of soap. The variable manufacturing cost
per bar of soap is R2,50. The company has an
opportunity to utilise its surplus capacity in the form
of a special order, but this special order would be at
a reduced selling price of R5,50 per bar of soap.
This special order would result in
a. a positive contribution of R18 750
b. a positive contribution of R15 870
c. a negative contribution of R18 750
d. a negative contribution of R15 870
1.5 AB Ltd has two departments, department A and

department B. The following information pertains to
the two departments:
Department Department Total

A (R) B (R) (R)
Sales 200 000 250 000 450
000
Less: Variable 100 000 150 000 250
costs 000
Contribution 100 000 100 000 200
000
Less: Fixed 60 000 150 000 210
costs 000
Net profit or 40 000 (50 000) 10
loss 000
If the company drops the loss-making product, the net

profit will
a. decrease by R100 000
b. decrease by R50 000
c. decrease by R150 000
Questions 1.6 and 1.7 are based on the following
information:
The MDC Company produces three products with the
following costs and selling prices:
Products
A B C
Selling price per unit R15 R20 R20
Variable cost per unit R8 R10 R12
Contribution margin per R7 R10 R8
unit
Direct labour hours per 1 hr 1,5 2 hrs
unit hrs
Machine hours per unit 3,5 2 hrs 2,5
hrs hrs
1.6 If MDC Company has a limit of 10 000 direct labour

hours but no limit on units produced or machine
hours, then the three products should be produced in
the order:
a. A, B and C
b. B, C and A
c. C, A and B
d. A, C and B
1.7 If MDC Company has a limit of 15 000 machine

hours, but no limit on units produced or direct labour
hours, then the three products should be produced
in the order:
a. A, B and C
b. B, C and A
c. A, C and B
d. C, A and B
1.8 A company produces three components: X1, X2 and

X3. The cost per unit for each component is as
follows:
X1 X2 X3
(R) (R) (R)
Variable manufacturing 10,00 32,00 20,00
costs
Fixed manufacturing 8,00 33,20 15,00

costs
Total cost 18,00 65,20 35,00
An external supplier can supply these components at

the following prices:
X1 R16,00
X2 R28,00
X3 R22,00
Which components should the company purchase

from the external supplier?
a. X1 and X3
b. X2 and X3
c. Only X2
d. Only X1
Exercise 2
In a period 20 000 litres of Sparko were produced and
sold. Costs, revenues and sales were as follows:
Sales (20 000 litres) R900 000

Production costs
Variable R350 000
Fixed R220 000
General overheads
(selling and admin) fixed R180 000
Required
Produce separate income statements using, firstly, the
format which we have been using in the past (total costing
approach), and secondly, the marginal costing format.
Exercise 3
Splashee Ltd manufactures and markets floaters which
they sell for R20 per pack. Current output is 40 000 packs
per month, which represents 80% of capacity. They have
the opportunity to utilise their surplus capacity by selling
their product at R13 per pack to a sports chain store who
will sell it as their brand product.
Total costs for the last month were R560 000, of which
R160 000 were fixed costs. This represented a total cost of
R14 per pack.
Required
Should Splashee Ltd accept the sports store order?
Provide detailed calculations in support of your answer.
Exercise 4
A cinema chain based in Durban owns three cinemas in
the suburbs of Pinetown, Ballito and Amanzimtoti. It has
prepared budgets for the next year based on a ticket price
of R8,00:
Pinetown Ballito Amanzimtoti Total

R R R R
Budgeted 3 200 000 2 400 1 600 000 7
ticket 000 200
receipts 000
Costs 2 600 000 2 100 1 800 000 6
000 500
000
Film hire 1 000 000 800 780 000 2
000 580
000
Wages 600 000 500 320 000 1
and 000 420
salaries 000
Overheads 1 000 000 800 700 000 2
000 500
000
Net 600 000 300 (200 000) 700
profit/loss 000 000
The overhead costs are 40% variable and 60% fixed. The
management is concerned about the Amanzimtoti cinema
and the fact that it is showing a budgeted loss, and is
considering closing the cinema and selling the site to a
property developer.
Required
4.1 Draft a marginal costing income statement, showing
the contribution and the profit for each cinema.
4.2 On the grounds of profitability, do you think that the
Amanzimtoti cinema should be closed? Give a
reasoned explanation for your decision.
Exercise 5
A company is considering dropping products Lex and Trex
from its line because accounting statements show that
these products are being sold at a loss. The sales of the
remaining products cannot be increased because the
market is already saturated. The following operating
statement considered typical of a year’s operations raises
the question of the profitability:
ABC Ltd
Income statement for the year ended 30 June 20x1
Product Product Product Product

Nexis Lex (R) Bantex Trex (R)
(R) (R)
Sales 100 000 115 000 25 000 30 000
Less: 60 000 108 000 10 500 36 000
Variable
costs
Marginal 40 000 7 000 14 500 (6 000)
income/loss
Less: Fixed 25 000 9 000 8 000 6 000
costs*
Net profit or 15 000 (2 000) 6 500 (12 000)
loss
*Fixed costs are committed costs that will not decrease if
production is reduced.
Required
Advise management whether the loss-making products
should be dropped. Provide detailed workings to support
your decision.
Exercise 6
ABC Ltd produces three products. Information relating to
these products is provided below:
Product Product Product

A B C
Selling price per R140 R130 R150
product
Direct materials R65 R40 R60
Direct labour:
Production: R12 per R48 R36 R24
hour
Assembly: R3 per R6 R18 R21
hour
Resources per unit
Labour hours:
Production 4 hours 3 hours 2 hours
Assembly 2 hours 6 hours 7 hours
Maximum sales 20 000 26 000 18 000
demand in units
The labour hours in the assembly department are not
limited.
Required
6.1 Calculate the most profitable production mix if the
labour hours in the production department are limited
to 180 000 in a period.
6.2 Which products will not be fully supplied?
6.3 Calculate the profit for the year assuming that fixed
costs amount to R700 000.
Exercise 7
Nadburgh Ltd manufactures three products of which the
average costs of production are as follows:
X Y Z
Direct materials R57R36R54
Direct labour:
Production department at R6 per hourR24R36R12
Assembly department at R3 per hour R 9 R12 R 6
Maximum potential sales for next year are:
X 12 000 units at R134 each

Y 20 000 units at R120 each
Z 16 000 units at R104 each
Production hours are restricted to 164 000, so the sales

demand cannot be met. Assembly hours are not limited.
Required
7.1 Calculate and state the order in which product
demand should be satisfied.
7.2 State which products would not be fully supplied.
7.3 Calculate the anticipated profit for next year,
assuming fixed costs are R644 000.
Exercise 8
ABC Ltd makes and sells portable television sets. Each
television sells for R200. The following cost data per
television is based on a full capacity of 12 000 televisions
produced each period:
Direct materials R75

Direct labour R55
Factory overheads R48
(75% variable; 25% fixed)
ABC Ltd is currently selling 7 200 televisions through

regular distributors each period. A special order has been
received for the sale of 2 500 televisions at a selling price
of R170 each to an overseas customer. The only selling
costs that would be incurred on this order would be R10
per television for shipping.
Required
8.1 Should the special order be accepted and why?
Provide detailed calculations in support of your
answer.
8.2 List two factors that should be considered before
accepting a special order.
Exercise 9
Hayfer Products are concerned that, despite all attempts,
they are unable to turn a loss into a profit. After much
consideration, they decide to discontinue unprofitable lines.
The following statement of profitability of three products,
drawn upon a total cost approach, has been presented to
management:

A (R) B (R) C (R) (R)
Sales 16 000 14 000 8 000 38
000
Direct 5 000 3 500 3 500 12
wages 000
Direct 6 000 3 000 3 700 12
materials 700
Factory 2 200 2 200 2 200 6 600
overheads
Selling 3 200 2 500 2 000 7 700
expenses
Total cost 16 400 11 200 11 400 39
000
Profit/(loss) (400) 2 800 (3 400) (1
000)
One of the managers has stated that of the total factory

overheads, R3 000 is fixed and the variable amounts for
products A, B and C are R1 500, R1 050 and R1 050
respectively. He also states that the selling expenses are a
mixed cost consisting of R2 000 fixed costs, and the
variable costs of R2 400, R2 100 and R1 200 for products
A, B and C respectively. He has suggested that a decision
be taken on a marginal costing basis.
Required
9.1 Redraft the above profit statement using a marginal
costing format.
9.2 Recommend a product policy to management; that is,
which product(s) they should continue producing and
which one(s) should be discontinued. Give a brief
explanation.
9.3 Based on your recommendation in 9.2, calculate the
projected profit or loss.
Exercise 10
Superb Ltd currently produces three products as well as
the two subcomponents that are required to manufacture
these products. Due to the increase in the demand for their
products, production capacity has become constrained.
Superb Ltd is trying to source a supplier that can produce
the subcomponents. The cost per unit for subcomponent
TRY1 and TRY2 is as follows:
TRY1 TRY2
R R
Direct materials 5,00 3,50
Direct labour 10,00 8,00
Variable manufacturing overheads 7,50 7,75
Fixed manufacturing overheads 7,50 3,75
Total cost 30,00 22,00
The buying-in prices of subcomponents TRY1 and TRY2

are R25 and R18 respectively. Which subcomponents, if
any, should Superb Ltd purchase from the external
supplier? What other non-financial factors should be
considered before a final decision is made?
16 Cost-volume-profit (CVP) analysis
Outcomes
At the end of this chapter students should be able to:
describe cost-volume-profit analysis

calculate breakeven point
use cost-volume-profit analysis to estimate profits
calculate and evaluate the effect of changes in selling prices, volume and
costs.
Chapter outline
16.1 Introduction
16.1.1 Fixed costs
16.3 CVP according to the contribution margin approach
16.3.3 Sales required to achieve expected (target) profit or return
16.1 Introduction
Cost-volume-profit (CVP) analysis is a decision-making tool that helps

management determine the effects that changes in costs, price, quantity and mix
will have on future profits. Managers commonly use CVP analysis as a tool to
answer questions such as the following:
How much can sales drop before the company will incur losses?
How will a change in costs, price or volume affect profits?
How many units must be sold to achieve a planned profit?
What profit will a certain sales volume yield?
At what volume of production are costs and income equal?
In Chapter 15 you were introduced to the marginal income statement where fixed
costs and variable costs are shown separately. Management requires cost
information in a format that promotes their planning, control and decision-
making tasks. These tasks can best be performed when information on the fixed
and variable cost components are available.
16.1.1 Fixed costs

Fixed costs are costs that do not change in total with different production levels,
for example rent on premises.

Variable costs are costs that change in total with different production levels, but
remain constant on a per-unit basis; that is, the variable cost per unit will remain
constant irrespective of the changes in the production levels, for example raw
materials.

Marginal costing layout of an income statement
R
Sales (10 000 units × R5) 50 000
Less: Variable costs (10 000 units × R2) 20 000
Contribution margin/marginal income 30 000
Net profit 10 000
Note 1: When using the marginal costing layout, total costs have been divided
into fixed and variable costs.
Note 2: Sales – Variable costs = Contribution
(This is the contribution towards paying fixed costs and making a profit.)
A business will only begin making a profit once all expenses have been covered.
This means that variable expenses (that is, cost price of the goods) must be
covered by the selling price of the goods. Any profits on the sale of goods must
then contribute towards the payment of the fixed costs. Once these fixed costs
have been covered, it can be said that the business has broken even and so can
begin making a profit.
The following are a few basic assumptions that CVP analysis is based on:
The selling price will remain constant, irrespective of the level of activity.
All costs can be divided into fixed and variable components.
Fixed costs will remain constant, irrespective of the volume; variable costs
will change in direct proportion to the volume.
16.3 CVP according to the contribution margin
approach
CVP analysis will be illustrated by means of the following example:
Budgeted income statement of Toys Ltd, a manufacturer of product Doll
Total Cost per unit %

Sales (10 000 units) R400 000 R40 100
Less: Variable costs (10 000 units) R300 000 R30 75
Contribution margin/marginal income R100 000 R10 25
Less: Fixed costs R40 000
Net profit R60 000
The contribution margin is the amount remaining after variable costs have been
deducted from sales revenue. It is first used to cover fixed costs and then
contributes to the profit for the period. If the contribution margin is not sufficient
to cover fixed costs, then there will be a loss.
The contribution margin can also be shown on a unit basis, which is calculated as
follows:
Contribution margin per unit = Selling price – Variable cost per unit
= R40 – R30
= R10
The contribution margin expressed as a percentage is known as the contribution

margin ratio, which is the difference between the sales and the variable cost,
expressed as a percentage of sales. Unit amounts or total amounts can be used in
the calculation of this ratio.
Contribution margin = (Sales – Variable costs) ÷ Sales × 100

ratio
= (R400 000 – R300 000) ÷ R400 000 × 100
= 25%
or
= (SP per unit – VC per unit) ÷ SP per unit ×
100
= (R40 – R30) ÷ R40 × 100
= 25%
A higher contribution margin ratio means that the contribution increases rapidly
as the sales levels increase. Once the breakeven point has been passed, profits
will accumulate more rapidly than a product with a lower contribution margin
ratio.

At the breakeven point, total revenue equals total costs and profit is equal to
zero. At this point, contribution is equal to fixed costs.
Figure 16.1 Illustration of breakeven point using a breakeven graph
BREAKEVEN QUANTITY
Breakeven quantity is the number of units that must be sold so as to recover all
fixed costs; that is, the point at which no profit or loss is incurred.
Breakeven quantity = Fixed costs ÷ Contribution margin per unit

= R40 000 ÷ R10
= 4 000 units
Breakeven value is the equivalent of breakeven quantity expressed in rands; that

is, the sales revenue necessary to recover all costs.
Breakeven value = Breakeven quantity × Selling price

= 4 000 units × R40
= R160 000
or
Breakeven value = Fixed costs ÷ Contribution margin ratio
= R40 000 ÷ 25%
= R160 000
The breakeven value can also be used to calculate the breakeven quantity:
Breakeven quantity = Breakeven value ÷ Selling price

= R160 000 ÷ R40
= 4 000 units

The margin of safety represents the amount by which the sales exceed the
breakeven sales. It is an indication of the amount by which sales can drop before
any losses are sustained. It can be calculated and expressed in units, rand value
or as a percentage.
MARGIN OF SAFETY EXPRESSED AS A VALUE

= Total sales – Breakeven sales
= R400 000 – R160 000
= R240 000
or
= Profit ÷ Contribution margin ratio
= 60 000 ÷ 25%
= R240 000
MARGIN OF SAFETY EXPRESSED IN UNITS

= Total sales (units) – Breakeven sales (units)
= 10 000 units – 4 000 units

= 6 000 units
MARGIN OF SAFETY RATIO (EXPRESSED AS A PERCENTAGE)

Total sales – Breakeven sales
= × 100
Total sales value
R240 000
= × 100
R400 000
= 60%
or
Total sales (units) – Breakeven sales (units)

= × 100
Total sales units
6 000
= × 100
10 000
= 60%
This indicates that sales can decrease by 60% before the company will incur a
loss.
16.3.3 Sales required to achieve expected (target) profit or return

Using CVP techniques, the sales value or volume that will produce a certain net
profit can also be determined. Using the illustrative example, suppose that an
expected profit of R30 000 is anticipated from the sales of product Doll.
The calculation will be as follows:

Fixed costs + Target prof it
Sales volume (units) =
Contribution margin per unit
R40 000+R30 000

=
R10
= 7 000 units
Sales value 1 = Sales volume × Selling price per unit
= 7 000 units × R40 per unit
= R280 000
or
Fixed costs + Target prof it

Sales value =
Contribution margin ratio
R40 000+R30 000

=
0,25
= R280 000
Proof
Total
Sales (7 000 units × R40) R280 000
Less: Variable costs (7 000 units × R30) R210 000
Contribution margin R70 000
Less: Fixed costs R40 000
Target profit R30 000
Note: The above two formulae used to calculate sales volume and value are
adjustments to the breakeven quantity and breakeven value formulae. That is,
if sales volume is required, then the breakeven quantity formula is adjusted by
adding target profit to fixed costs and, similarly, if the sales value is required,
then the breakeven value formula is adjusted by adding target profit to fixed
costs.
This technique reveals the effect management decisions are likely to have on the
future profit structure. It enables management to predict the results of decisions.
An analysis of the breakeven point enables management to take effective steps
and to influence the variable factors in a purposeful manner.
We will now examine the effect of changes in price, costs or volume on profits,
contribution and the breakeven point.
These figures will be used to discuss the different factors, which change in the
following illustrative examples:
Sales units 20 000

Sales price per unit R15
Variable costs per unit R9
Contribution margin per unit R6
Contribution margin ratio 40%
Total fixed costs for the period R60 000
Breakeven value (BEV) R150 000
Breakeven quantity (BEQ) 10 000 units

Changes in the selling price alter the contribution ratio, change the breakeven
point and affect profit.
Assume an increase of 10% in the selling price to achieve a target profit of

R30 000.
Required
1. Contribution margin ratio

2. Breakeven point in units and rand
3. Number of units that must be sold to achieve the target profit

Solution
Current After price increase
Selling price per unit R15,00 R16,50
Variable costs R9,00 R9,00
Contribution margin R6,00 R7,50
Contribution ratio 40% 45%
BEQ = Fixed costs ÷ Contribution per = R60 000 ÷ = R60 000 ÷

unit R6 R7,50
= 10 000 units = 8 000 units
BEV = BEQ × SP = 10 000 × 15 = 8 000 × 16,50
= R150 000 = R132 000
Number of units to achieve the target profit

Fixed costs + Target prof it R60 000+R30 000 R60 000+R30 000
= = =
Contribution margin per unit R6 R7,50
= 15 000 units = 12 000 units
If the selling price is increased and other costs remain constant, the
contribution margin is higher and the fixed costs can be recovered faster, thus
the breakeven point drops. Profits beyond the breakeven point are higher and
losses below the breakeven point are lower.
If the selling price is decreased and other costs remain constant, the
contribution margin is lower and the rate of fixed cost recovery is slower, thus
the breakeven point climbs upwards. Profits beyond the breakeven point are
lower and losses below the breakeven point are higher.

Like changes in the selling price, increases and decreases in the variable cost
alter the contribution ratio, change the breakeven point and affect profits.
Assume an increase of 20% in variable cost due to increases in the material

prices. The company needs to achieve a target profit of R30 000.
Required
Round off the nearest whole number.
Solution

BEQ = Fixed costs ÷ Contribution per = R60 000 ÷ = R60 000 ÷

unit R6 R4,20
= 10 000 units = 14 286 units
BEV = Fixed costs ÷ Contribution ratio = 60 000 ÷ = 60 000 ÷ 0,28
0,40
= R150 000 = R214 286
= = =
Contribution margin per unit R6 R4,20
= 15 000 units = 21 429 units
An increase in variable costs has the same effect as a decrease in the selling
price; the contribution margin is lower and the rate of fixed cost recovery is
slower, thus the breakeven point climbs higher. Profits after the breakeven
point are lower; losses before the breakeven point are higher.
A decrease in variable costs has the same effect as an increase in the selling
price; the contribution margin is higher and the rate of fixed cost recovery is
accelerated, thus the breakeven point drops. Profits beyond the breakeven
point are higher; losses below the breakeven point are lower.

Increases and decreases in the fixed cost do not alter the contribution margin
ratio, but they do change the breakeven point.
Assume an increase of R10 000 in fixed costs.
Required

Solution

BEQ = Fixed costs ÷ Contribution per unit = R60 000 ÷ R6 = R70 000 ÷ R6
= 10 000 units = 11 667 units
BEV = Fixed costs ÷ Contribution ratio = 60 000 ÷ 0,40 = 70 000 ÷ 0,40
= R150 000 = R175 000

= = =
Contribution margin per unit R6 R6
= 15 000 units = 16 667 units
If fixed costs are increased, the breakeven point climbs higher. Profits after
the breakeven point are lower by the amount of the increase; losses before
the breakeven point are greater by the amount of the increase.
A decrease in fixed costs causes the breakeven point to drop. Profits beyond
the breakeven point are greater by the amount of the decrease; losses below
the breakeven point are smaller by the amount of the decrease.
Fixed costs
=
(Selling price p/u – Variable cost p/u)
or
Breakeven units = Breakeven rands ÷ Selling price

Firstly, you need to calculate the contribution margin ratio:
CONTRIBUTION MARGIN RATIO
Sales – Variable costs

= × 100
Sales
BREAKEVEN POINT IN RANDS
Fixed costs
=
or
Breakeven rands = Breakeven units × Selling price

Add the required/target profit to the fixed costs in either of the breakeven
formulae:
Fixed costs + Required prof it
Sales in units tomake target prof it =
(Selling price p/u – Variable cost p/u)
Fixed costs + Required prof it

Sales in rands to make target prof it =
MARGIN OF SAFETY AS A PERCENTAGE

Budgeted sales – Breakeven sales
= × 100
Budgeted sales
MARGIN OF SAFETY IN RANDS

= Budgeted sales – Breakeven sales
or
= Profit ÷ Contribution margin ratio
MARGIN OF SAFETY IN UNITS

= Budgeted sales in units – Breakeven sales in units
This shows how close the business is operating to its breakeven point. In other
words, is the business only just breaking even or does it have some breathing
space?
TUTORIAL EXERCISES
Exercise 1
For each of the multiple-choice questions that follow, select the most
appropriate answer.
Questions 1.1–1.5 are based on the following information:
XYZ Ltd manufactures and sells a single product. The costs and revenue for
this product are presented below:
Total Per unit

Sales (15 000 units) R750 000 R50
Less: Variable expenses R360 000 R24
Contribution margin R390 000 R26
Less: Fixed expenses R169 000
Net profit R221 000
1.1 What is the company’s contribution margin ratio?

a. 52%
b. 25%
c. 35%
d. 53%
1.2 What is the company’s breakeven point in units?

a. 5 600 units
b. 6 500 units
c. 2 500 units
d. 5 200 units
1.3 What is the company’s breakeven point in rand?

a. R523 000
b. R235 000
c. R325 000
d. R253 000
1.4 In order to earn a target profit of R104 000, how many units would the
company have to sell?
a. 10 000 units
b. 10 200 units
c. 10 800 units
d. 10 500 units
1.5 What is the company’s margin of safety as a percentage? (Round off to

the nearest whole number.)
a. 57%
b. 75%
c. 67%
d. 76%
Exercise 2
The following information relates to Ethie Traders, which produces and sells a
single product. The selling price per unit is R15, total fixed costs are R60 000,
and the contribution margin ratio is 40%. You are required to determine the
level of sales in units and rand that it must attain in order to cover its fixed and
variable costs.
Exercise 3
A company sells 21 000 units of a particular product per annum. The unit
selling price is R20. Budgeted variable manufacturing costs are R11 per unit
and budgeted fixed factory overheads are R35 000 per annum.
Budgeted variable selling expenses are R3 per unit and budgeted fixed selling
expenses are R25 000 per annum.
Required
3.1 Calculate the net profit using the marginal costing format if the company
sold 21 000 units.
3.2 Calculate the breakeven point in units and in rand.
3.3 Calculate how many units the company would have to sell in order to
generate a target profit of R120 000 and calculate the rand sales that
the company would have to generate to earn the same target profit.
3.4 Calculate the margin of safety as a percentage if 21 000 units were sold.
(Round off to the nearest whole number.)
Exercise 4
Sunshine Stores had sales of R4 500 000 for 20x1. Fixed expenses totalled
R1 200 000 and the net profit totalled R1 500 000.
Required
4.1 Present the above information in the marginal costing format.
4.2 Calculate the contribution margin ratio.
4.3 Calculate the breakeven point in rands.
4.4 Calculate the margin of safety ratio. (Round off to the nearest whole
number.)
Exercise 5
Fast Ltd budgets March sales at R265 000. The variable expenses are
expected to be 56% of sales and profit is expected to be R31 768.
Required
5.1 Calculate the breakeven point for March in rands.
5.2 Calculate the March sales if the company makes a profit of R10 560 (all
the cost relationships were the same as budgeted).
Exercise 6
The present market for golf balls is estimated at 80 000 balls per month and
market research indicates that with a selling price of R3 per golf ball, a market
penetration of one third to a half can be achieved within 12 months. Your
company has devised a process which will produce golf balls with a fixed cost
of R97 500 per month and a variable cost of R1,50 per ball.
Required
6.1 Calculate the contribution margin (CM) ratio.
6.2 Calculate the breakeven point in units and in rands.
6.3 Calculate the number of golf balls that must be sold in order to earn a
target profit of R52 500.
6.4 Calculate the margin of safety as a percentage. (Round off to the nearest
whole number.)
6.5 Further market research reveals that at a selling price of R2,80 the
company could reach sales of 135 000 balls.
a. Calculate the profit to be made, if the company sells 135 000 golf
balls per month. (Draft a marginal costing income statement.)
b. Calculate the new breakeven point in units.
c. Should the company reduce the selling price? Give a reason for your
answer.
Exercise 7
Electron Ltd manufactures and sells a telephone answering machine. The
company’s income statement for the most recent year is given below:
Total (R) Per unit (R) Percentage

Sales (20 000 units) 1 200 000 60 100
Less: Variable expenses 900 000 45 ?
Contribution margin 300 000 15 ?
Less: Fixed expenses 240 000
Net income 60 000
Management is anxious to improve the company’s profit performance and has

asked for several items of information.
Required
7.1 Calculate the company’s contribution margin ratio.
7.2 Calculate the company’s breakeven point in units and in rands.
7.3 Assume that next year management wants the company to earn a
minimum profit of R90 000. How many units will have to be sold to meet
this target profit figure?
7.4 Calculate the company’s margin of safety as a percentage.
7.5 Assume that sales increase by R400 000 next year. If cost relationships
remain unchanged, what would the company’s new net income be?
(Draft a marginal costing statement to support your answer.)
17 Time value of money
Outcomes
understand the concepts of cash flow and the time value of

money
calculate interest
calculate the time value of money.
Chapter outline
17.1 Introduction
17.2 Cash flow and other time value of money concepts
17.3 Interest
17.3.3 Nominal rate
17.4 Formulae used in time value of money
17.1 Introduction
The time value of money implies that a particular sum of

money in your hand today is worth more than the same sum at
some future date. For example, given the choice between
receiving R1 000 today or R1 000 a year from now, you
should take the money today. In this chapter, we will explain
the basic concepts related to the time value of money and
illustrate selected calculations using basic mathematical
principles, expressed as formulae. The time value of money is
important, because the majority of business decisions boils
down to a trade-off between spending or borrowing money
today and receiving or paying back money in the future.
Financial managers use the time value of money principle as a
tool to determine how much money an organisation must earn
in the future to justify today’s expenditures on investments.
17.2 Cash flow and other time value of
money concepts
Cash flow is any receipt (cash inflow) or payment (cash

outflow) of money that occurs at a specific point in time. Cash
flows form the basis of time value of money calculations and
are either single cash flows, annuities or unequal cash flows.
Single cash flows This is a once-off cash inflow or outflow.

Annuity This is a stream of equal receipts or
payments at equal intervals of time.
Ordinary annuity This is an annuity where the payments
take place at the end of each period at
the same time that interest is calculated.
Perpetuity This is an annuity where the payments
continue forever.
Annuity due This is an annuity where the payments
are due at the beginning of each period.
Compounding This refers to the calculation of interest
on a principal amount and then adding
that interest to the principal amount in
the subsequent period. The investment
grows in each subsequent period by the
amount of interest it would earn over the
period. Compounding calculates the
future value of a sum invested today for
a number of years.
The cost of capital This is the rate of interest used by the
organisation when determining time
value of money. Alternative terms used
are discount rate and required rate of
return.
Discounting This is the reverse of compounding. It
considers the future value and
establishes its equivalent value today
(present value). It involves removing the
interest that is embedded in the future
value.
Future value (FV) The future value is the amount that an
investment will be worth at a future date
if invested at a particular simple or
compound interest rate.
Present value This is the value of the future value in
(PV) today’s terms determined by the
application of the discount rate.
17.3 Interest
Interest is the price paid for money borrowed or received for

money invested. If you borrowed a sum of money from the
bank for a certain period of time, you will have to pay the
bank for the use of the money. The percentage agreed on
between the borrower and lender is the interest rate. In this
section we will discuss the following two types of interest rate
that apply in the time value of money calculations: simple
interest and compound interest.

Simple interest is the interest calculated on the amount of
money originally borrowed (or invested), referred to as the
principal (P). Simple interest means accruing the same amount
of interest each year based on the same principal amount.
Interest is not earned on accrued interest. It can be calculated
using the following formula:
I=P×i×n
Where:
I = interest
P = principal
i = interest rate
n = time
Mr Sipho invests R6 000 at 10% simple interest for four

years. How much will he receive at the end of the four
years?
Solution
The value of the investment after four years will be:
Principal amount R6 000

Add: The interest accrued for the three years (R6 R2 400
000 × 10% × 4 years)
Future value R8 400

When we borrow or invest money at a compound interest rate,
the interest due at the end of each year is added to the amount
of the original loan or investment. The following year’s
interest is then calculated on the new balance, consisting of
the principal and the interest portion that was added. It
therefore refers to interest that is earned on interest.
Money invested at compound interest increases quicker in

value, which is why compound interest is preferred over
simple interest. For example, repayments on loans from banks
and housing bonds are usually based on compound interest.
Mr Sanders invests R6 000. Interest is at 10% per year

compounded annually. How much will he receive at the
end of four years?
Solution
The value of the investment after four years, including
capital and interest, will be:
Year Interest calculation Interest Balance

1 R6 000 × 0,10 R600 R6 600
2 R6 600 × 0,10 R660 R7 260
3 R7 260 × 0,10 R726 R7 986
4 R7 986 × 0,10 R799 R8 785
The future value of the investment has grown to R8 785

using compound interest. You will have noticed how the
annual interest earned increases, therefore compound
interest is when interest is payable on both capital and
accumulated interest. It assumes reinvestment of the
interest receivable at the end of the year, at the same
interest rate.
Other interest rates that we apply in time value of money
calculations are nominal and effective interest rates, where
the compounding takes place more than once per year.
17.3.3 Nominal rate

This is known as the quoted rate in cases where interest is
calculated more than once a year. The adjustment of
compounding is not taken into account. For example, if the
bank quotes you a rate of 10% compounded monthly, the
nominal rate is 10% even though the true interest will be much
more, since there is compounding.
If the effective rate is known, then the nominal rate can be

calculated as follows:
1
Nominal rate = n [(1 + i) n

− 1]
Where:
i= the effective interest rate

n = the number of compounding periods per annum
The effective interest rate of a loan is 15% per annum.

Interest is compounded every quarter. Calculate the
nominal rate.
Solution
1
4
Nominal rate = 4 [(1 + 0,15) − 1]
0.25
= 4 [(1,15) − 1]
= 0,1422
= 14,22%
Therefore, the nominal rate (quoted rate) is 14,22%.

This is the rate of interest actually earned in one year after
taking into account the adjustment of compounding. For
example, if the bank quotes you a rate of 10% compounded
monthly, the effective rate will be much more, since there is
compounding. It can be calculated using the following
formula:
n
I
Ef f ective rate = (1 + ) − 1
n
Where:
I = the nominal interest rate (quoted rate)
n = the number of compounding periods per annum
I
= the periodic rate (rate per period)
n
The nominal interest rate on a loan is 15% per annum

compounded semi-annually. Calculate the effective interest
rate of the loan.
Solution
I n
Ef f ective rate = (1 + ) − 1
n
2
0,15
= (1 + ) − 1
2
= 0,1556
= 15,56%
Therefore the actual interest paid on the loan is 15,56%.
17.4 Formulae used in time value of

money
Financial managers use the time value of money principles to

justify expenditures on new investments. It is therefore
important to have an understanding of the various ways that
the future and present values may be calculated, i.e.
mathematical formulae, factor tables (at the end of the
chapter) and financial calculators. The latter method is beyond
the scope of this textbook and will not be discussed.

The mathematical formula used for calculating the present
value of a single cash flow is:
1
PV = FV [ ]
n
1 + i
Where:
PV = present value
FV = future value
i = interest rate
n = number of periods
Table A, at the end of the chapter, presents the present value

factors of a single cash flow. The 1 ÷ (1 + i)n in the
mathematical formula can be replaced by the applicable factor
from the table, instead of calculating it mathematically.
In three years from now, you want to buy a vehicle to the

value of R150 000. What is the amount that you must
invest now at 10% compound interest per annum in order
to reach your goal of R150 000 at the end of the three-year
period?
Solution
The present value of a single cash flow can be calculated
using the mathematical approach as follows:
1
PV = FV [ n ]
1+i
1
= 150 000 [ 3
]
1+0,10
= 150 000 × 0,751
= R112 650
Using the table approach, the factor can be found in Table

A using a discount rate of 10% and three years as the
number of periods:
PV = FV × PVIF10%;3
= R150 000 × 0,751
= R112 650

The mathematical formula used for calculating the present
value of an ordinary annuity (annuity received at the end of
the period) is:
1
PV = PMT [1 − n
]
(1+i)
i
Where:
PMT = annuity amount (payment)
Table B, at the end of the chapter, presents the present value

factors of cash flows invested at the end of each period. The
equation in the square brackets in the mathematical formula
can be replaced by the applicable factor from the table, instead
of calculating it mathematically.
An amount of R5 000 is to be invested annually at the end

of each year for five years at 10% compound interest per
annum. Determine the present value of this annuity.
Solution
Using the mathematical approach, the present value can
be calculated as follows:
1
PV = PMT [1 − (1+i)
n ]
i
1
= 5 000 [1 − 5
]
(1+0,10)
0,10
= R5 000 × 3,791
= R18 955

B using a discount rate of 10% and five years as the
number of periods:
PV = FV × PVIFA10%;5
= R5 000 × 3,791
= R18 955
An amount of R6 000 is to be invested annually at the

beginning of each year for three years at 10% compound
interest per annum. Determine what the present value of
this annuity will be at the beginning of the first year.
Solution
= R6 000 × [1,7355 + 1]
= R6 000 × 2,7355
= R16 413
Using the table approach:
This is an annuity due (received/paid at the beginning of

the period): Table B shows the PV factors of annuities
received/paid at the end of the year for n years. The factor
must be adjusted from Table B. Use the Table B factor of
the previous period (n – 1) and add 1 000.
PV = Annuity × Present value of R1 per period factor
(Table B)
= R6 000 × 2,736*
= R16 416
*Table B at 10% for two years = 1,736 + 1,000 = 2,736
The present value of the annuity due is R16 413 (rounded
to the nearest rand). The slight difference of R3 is because
of the rounding of the factors in Table B to three decimals.

A perpetuity means that the cash flow will be received or paid
periodically at certain time intervals into infinity, since there is
no termination date.
The formula used for calculating the present value of a

perpetuity (PVP) is:
Annual return (received or paid)

PVp =
Interest rate or required return
ILLUSTRATIVE EXAMPLE Present value of a

perpetuity
Miss Cami sought advice from her financial advisor, as she

wants to establish a trust fund by investing an amount of
money at 15% compounded annually. She wants to
receive R30 000 per year indefinitely from the trust fund.
What is the present value of the amount that she will have
to invest now?
Solution
Annual return (received or paid)

PVp =
Interest rate or required return
30 000
=
0,15
= 200 000
The mathematical formula used for calculating the future
value of a single cash flow is:
FV = PV(1 + i)n
Table C, at the end of the chapter, presents the future value

factors of a single cash flow. The (1 + i)n in the mathematical
formula can be replaced by the applicable factor from the
table, instead of calculating it mathematically.
If you invest R10 000 now at 20% compound interest over

a four-year period, what amount will you receive at the end
of the three years?
Solution
Using the mathematical approach, the future value of a
single flow can be calculated as follows:
n
FV = PV × (1 + i)
4
= R10 000 × (1 + 0,20)
= R10 000 × 2,074
= R20 740
We can replace (1 + i)n with the applicable FV factor from

Table C, instead of calculating it mathematically. Using the
table approach, the factor can be found in Table C using a
discount rate of 20% and four years as the number of
periods:
FV = PV × FVIF20%;4
= R10 000 × 2,074
= R20 740

The mathematical formula used for calculating the future
value of an ordinary annuity (annuity received at the end of
the period) is:
n
(1 + i) − 1
FV = PMT [ ]
i
Table D, at the end of the chapter, presents the future value

factors of cash flows invested at the end of each period. The
equation in the square brackets in the mathematical formula
can be replaced by the applicable factor from the table, instead
of calculating it mathematically.
A person would like to invest R5 000 at the end of each

year at an annual interest rate of 14%. What is the value of
the investment after four years?
Solution
Using the mathematical approach, the future value can be
n
(1+i) −1
FV = PMT [ ]
i
4
(1+0,14) −1
= 5 000 [ ]
0,14
= 5 000 × 4,921
= R24 605
We can replace [ (1+i) −1
i
] with the applicable FV factor from
Table D, instead of calculating it mathematically. Using the
table approach, the factor can be found in Table D using a
discount rate of 14% and four years as the number of
periods:
FV = PV × FVIFA14%;4
= R5 000 × 4,921
= R24 605
Mr Hayne intends to establish a savings account for his

daughters’ university education when they enter high
school. He will make payments of R5 000 each into this
account at the beginning of each year and will earn
compound interest of 8% per annum on his investment.
You are required to calculate the future value of the annuity
due after five years when his daughters will have finished
high school.
Solution
Using the mathematical approach, the future value can be
n+1
(1+i) −1
FV = PMT [ − 1]
i
5+1
(1+0,08) −1
= 5 000 [ − 1]
0,08
= 5 000 × (7,3359– 1)
= 5 000 × 6,3359
= R31680
This formula differs from the FV formula for an ordinary

annuity only in that –1 is subtracted (to recognise the first
payment that is paid now) and 1 is added to the number of
periods (n+1), since the first payment was made at the
beginning of the year and was already accounted for when
1 was subtracted.
D using a discount rate of 8% and five years as the
number of periods. Thereafter the factor must be multiplied
by (1 + i) to arrive at the factor at the beginning of the
period. Alternatively, using Table C, add the factors for
periods one to five at a discount rate of 8%.
FV = PMT × FVIFA8%;5 × 1,08
= R5 000 × (5,8666 × 1,08)
= R5 000 × 6,3359
= R31 680
Your client wants to obtain a loan to finance a new vehicle.

His bank offers him a loan to the value of R120 000 at 16%
interest per annum, repayable in equal annual instalments
over six years, including capital and interest. Your client
has asked you to calculate the amount of the instalment
that he will have to pay each year.
Solution
Present value
Annuity =
Present value of R1 per period f actor @ i; n
Present value
Annuity =
Present value of R1 per period f actor @16%; 6 years
12 000
=
3,685
= R32 564

A loan amortisation schedule will show you how much your
loan reduces by every period, over the full period of the loan.
You can determine how much of your instalment goes towards
interest and how much towards reducing the capital (actual
loan amount).
Using the previous example, where the instalment for a
16% loan of R120 000 for a period of six years was
calculated as R32 564, the amortisation schedule will be
shown as follows:
Year Opening Interest Instalment Closing

balance R R balance
R R
1 120 000 19 200 32 564 106 636
2 106 636 17 32 564 91 133,76
061,76
3 91 133,76 14 32 564 73 151,16
581,40
4 73 151,16 11 32 564 52 291,35
704,19
5 52 291,35 8 32 564 28 093,97
366,62
6 28 093,97 4 32 564 (25,01)*
495,04
Difference
due to
rounding.
TUTORIAL EXERCISES
Exercise 1
Match the following concepts to the correct definitions:
1.1 the present A It is the amount that an

value investment will be worth at a
concept future date if invested at a
particular simple or compound
interest rate.
1.2 the future B It is the current value of future
value cash flows, determined by
concept application of a discount rate.
1.3 compound C It is the process used to
interest determine the present value of
an investment.
1.4 simple D It is the interest on the principal
interest investment for the entire term.
1.5 the E It is the calculation of interest
concept of and the addition of that interest
discounting to the principal for investment
in the following period.
1.6 unequal F It is a non-repetitive cash inflow
cash flows or outflow.
1.7 a single G It is an annuity where the
cash flow payments continue indefinitely.
1.8 an ordinary H It is the unequal cash flows that
annuity occur repetitively at the end of
each payment interval.
1.9 a I It is an annuity where the
perpetuity payments fall due at the
beginning of each period.
1.10 an annuity J It is an annuity where the
due payments take place at the end
of each payment interval.
Exercise 2
Identify whether the following statements are true or false:
2.1 The ordinary annuity is an annuity for which the cash
flow occurs at the beginning of each period.
2.2 Time value of money is based on the belief that a rand
that will be received at some future date is worth
more than a rand today.
2.3 Annuity due is an amount that occurs at the beginning
of each period.
2.4 Starting to invest early for retirement reduces the
benefits of compound interest.
2.5 If a bank compounds savings accounts quarterly, the
nominal rate will exceed the effective annual rate.
2.6 The present value of a future sum decreases as either
the discount rate or the number of periods per year
increases; other factors remain constant.
2.7 As a result of compounding, the effective annual rate
on a bank deposit (or a loan) is always equal to or
greater than the nominal rate on the deposit (or
loan).
2.8 When a loan is amortised, a relatively high
percentage of the payment goes to reducing the
outstanding principal in the early years, and the
principal repayment’s percentage declines in the
loan’s later years.
2.9 Interest earned on a given deposit that has become
part of the principal at the end of a specified period is
called compound interest.
2.10 The nominal and effective rates are equivalent for
annual compounding.
Exercise 3
Using the tables, determine the factors for the following:
3.1 The future value of R1 after five periods at 16% per
period.
3.2 The present value of R1 after 10 periods at 14% per
period.
3.3 The future value of R1 per period after eight periods
at 10% per period.
3.4 The present value of R1 per period after 14 periods at
15% per period.
Exercise 4
This question consists of six independent subquestions.
Answers must be calculated correctly to four decimals and
one-tenth of a percent. Show all your workings.
4.1 Determine the present value of an annuity of R40 000
received at the end of each period for 10 periods, at
a discount rate of 8% per period.
4.2 Determine the present value of an annuity of R40 000,
received at the beginning of each period for 10
periods, at a discount rate of 8% per period.
4.3 Determine the future value of an amount of R30 000,
invested at the end of each period for 10 periods, at
an interest rate of 8% per period.
4.4 Determine the future value of an amount of R30 000,
invested at the beginning of each period for 10
periods, at an interest rate of 8% per period.
4.5 Determine the effective interest rate for a savings
account which bears interest at a nominal rate of 6%
per annum, compounded monthly.
4.6 Determine the nominal interest rate for a loan which
bears interest at an effective rate of 6% per annum, if
interest is compounded half-yearly.
Exercise 5
5.1 Senayshia borrowed R4 000 for five years at a 6%
simple interest rate. How much interest is that?
5.2 Camishka borrowed R3 500 for three years at a 7,5%
simple interest rate. How much interest is that?
5.3 Thashin borrowed R5 000 for three years and had to
pay R1 350 simple interest at the end of that time.
What rate of interest did he pay?
5.4 Shavik borrowed R7 000 at a simple interest rate of
3% per year. After a certain number of years he had
paid R840 in interest altogether. Indicate the number
of years.
5.5 Kayush borrowed R2 000 for two years at a 5%
compound interest rate. How much interest is that?
5.6 Shriyana borrowed R1 000 for three years at a 5%
compound interest rate. How much did she owe after
three years?
Exercise 6
You want to invest money in order to pay your university
fees. Two options are available:
6.1 Use a special savings account that pays 1% interest
compounded monthly.
6.2 Use a premium savings account with a 12% quoted
nominal interest rate per annum, compounded
quarterly.
Which option will you choose?
Exercise 7
Listed below are multiple-choice questions. Choose the
most appropriate option for each statement.
7.1 An amount of R5 000 is invested now at a rate of 8%

per annum. What will be the value of the investment
after five years, if simple interest is added once at
the end of the period?
a. R5 400
b. R7 000
c. R6 600
d. R4 600
7.2 If a single amount of R12 000 is invested at 8% per

annum with interest compounded quarterly, the
amount to which the principal will have grown by the
end of year three is approximately
a. R15 117
b. R14 880
c. R15 218
d. R15 880
7.3 What is the present value of R2 000 payable in two

years’ time, if the interest rate is 8% per annum,
compounded annually?
a. R1 747
b. R1 714
c. R2 280
d. R2 140
7.4 The future value of an ordinary annuity of R1 000

each year for 10 years, deposited at 3%, is
a. R11 800
b. R1 344
c. R10 000
d. R11 464
7.5 The future value of a R2 000 annuity due deposited at

8%, compounded annually for each of the next 10
years, is
a. R28 974
b. R31 292
c. R14 494
d. R13 420
7.6 The present value of an ordinary annuity of R3 500

each year for five years at a discount rate of 12% is
a. R1 985
b. R12 618
c. R6 168
d. R3 920
Exercise 8
Calculate the following time value of money problems and
show all workings, including formulae used:
8.1 The present value of R100 received at the end of year
one, R200 received at the end of year two, and R300
received at the end of year three, assuming an
opportunity cost of 13%.
8.2 The future value of R200 received today and
deposited at 8% for three years.
8.3 The present value of R200 to be received 10 years
from today, assuming an opportunity cost of 10%.
8.4 If the present value interest factor for i percent and n
periods is 0,270, the future value interest factor for
the same i and n is …?
8.5 A generous benefactor to the local ballet plans to
make a once-off endowment which would provide the
ballet with R150 000 per year into perpetuity. The
rate of interest is expected to be 5% for all future
time periods. How large must the endowment be?
8.6 What is the future value of a R10 000 annuity due
deposited at 12% compounded annually for each of
the next five years?
8.7 Calculate the future value of an ordinary annuity of R2
000 each year for 10 years, deposited at 12%.
8.8 Calculate the future value of R10 000 received today
and deposited for six years in an account that pays
interest of 12%, compounded quarterly.
Exercise 9
To expand its operations, Sencam International has
applied to Capitec Bank for a three-year R3 500 000 loan.
Required
Calculate the instalment. Prepare a loan amortisation table
assuming 10% interest rate.
Exercise 10
10.1 Your dad has borrowed R12 000 at a rate of 10% from
a finance company and must repay it in four equal
instalments at the end of each of the next four years. How
large would his payments be?
10.2 You have borrowed R14 000 from the bank at a rate of
10% and must repay it in five equal instalments at
the end of each of the next five years. How much
interest would you have to pay in the first year?
10.3 You plan to borrow R35 000 at a 7,5% annual interest
rate. The terms require you to amortise the loan with
seven equal end-of-year payments. How much
interest would you be paying in year two?
The four basic factor tables included at the end of this

chapter are as follows:
Table A: Present value of R1 AFTER n years (cash

flow occurs at END of period)
Table B: Present value of R1 per annum received
FOR n years (cash flow occurs at END of period)
Table C: Future value of R1 AFTER n years (cash
flow occurs at BEGINNING of period)
Table D: Future value of R1 per annum received
FOR n years (cash flow occur at END of period)
Table A Present value of R1 received/paid after n
years
Formula: 1
(1+i)
n
Table B Present value of R1 per annum
received/paid at the end of the year for n years
Formula: [1 − 1
(1+i)
n ]
i
Table C Future value of R1 received now, after n
years
Formula: (1 + 1)n
Table D Future value of R1 per annum received for n
years at the end of each year
n
Formula:
(1+i) −1
Click here to download PDF versions of Tables A, B, C and D

18 Capital budgeting
Outcomes
At the end of this chapter, students should be able to
describe the capital budgeting process

explain the purpose of investment appraisal
identify a project’s relevant cash flows
analyse an investment project’s costs, benefits and risks
calculate a project’s payback period, net present value,
internal rate of return
evaluate investment projects.
Chapter outline
18.1 Introduction
18.3 Categories of capital budgeting projects
18.4 Why do organisations use investment appraisal?
18.5 Relevant and irrelevant cash flows in investment
appraisal
18.1 Introduction
Organisations need to make important decisions regarding

which long-term projects (fixed assets such as property, plant
and equipment) they should undertake that will generate
returns, and which they should reject. To arrive at such
decisions, organisations use the capital budgeting process.
A profit-making organisation will have to provide appropriate

returns to those who have invested their money in it. To
achieve that, the organisation will have to identify projects that
are suitable and that can provide the organisation itself with
such appropriate returns.
The capital budgeting process involves maximisation of

shareholder wealth. Therefore, in striving to maximise the
wealth of shareholders, an organisation must bear in mind the
needs of stakeholders other than shareholders, such as
suppliers, employees, and the general public.
Capital decisions are very costly, and therefore mistakes will

involve very high costs if they are to be reversed. It is very
important to plan well for capital investments. This will
involve a lot of people both inside and outside the
organisation, and hence this contributes to the complexity of
the process.
The capital investment process has six stages, including the

following:
STAGE 1: SCREENING STAGE

Organisations must screen the various types of capital
investment projects that are necessary in order to achieve its
objectives. It is the responsibility of management to identify
various capital investment projects available to invest in, based
on the organisation’s strategies.
STAGE 2: SEARCH STAGE

At this stage, organisations need to obtain more information
regarding the alternative investment projects that are available.
This will enable them to make more informed decisions when
investing in specific projects. Some of the alternatives that
were identified at the screening stage will be rejected early on
at the search stage, once additional information has been
received. Other alternatives will be evaluated more thoroughly
at stage 3, the information acquisition stage.
STAGE 3: INFORMATION ACQUISITION STAGE

When deciding on alternatives, an organisation needs to
consider the predicted revenues, costs, and the impact of
investing in each of these alternatives. Both the qualitative
financial factors and the quantitative factors are very
important. The responsibility of identifying these factors lies
with the management accountant.
STAGE 4: AUTHORISATION STAGE

The most suitable projects that meet the organisation’s
objectives and the benefits of which exceed the costs will be
selected for investment. The cost-benefit analysis is usually the
responsibility of the management accountant who prepares a
formal analysis of all projects, including their financial
outcomes. This is then used by managers to determine the best
project(s).
STAGE 5: FINANCING STAGE

The organisation now needs to obtain funds for the project(s)
that it has chosen to invest in. There are different sources of
funds that could be used, namely retained earnings (these are
internal sources of funds that the organisation has built up
through the years when profits were made), and funds from the
capital markets (equity and debt). It is the responsibility of the
treasury department to arrange funding for the organisation.
STAGE 6: IMPLEMENTATION STAGE

The chosen project(s) will be implemented. Constant
monitoring of how the performance of the project(s) is
progressing, is vital at this stage. The information generated
during the monitoring exercise is fed into the post-completion
audit, which will be dealt with later in this chapter.
18.3 Categories of capital budgeting
projects
Capital projects are for the long term – normally with a life of
at least one year. Organisations normally classify capital
budgeting projects into the following categories:
1. Expansion projects. Organisations engage in projects in

order to increase the size of their businesses, for example
when acquiring other businesses to enter new markets, or
even to increase their market share in existing business
operations.
2. Replacement projects. When fixed assets are used on a
frequent basis, they age as a result of wear and tear,
causing the asset to break down increasingly and
consequently affecting the general productivity of the
organisation. The organisation is then forced to replace the
asset with a new, more efficient asset.
3. Regulatory projects. In some instances certain projects
have to be undertaken by organisations because they are
required by law to do so. This may be necessary to
improve safety at work or to preserve the environment. In
such cases, the organisation is obliged to execute the
project, even though it will not generate much (or any)
revenue.
4. New projects. These are projects that the organisation has
never undertaken before. They expose the organisation to
even greater uncertainties compared to other categories of
projects. Decisions relating to new projects also involve
more time and human resources.
The projects can be classified as independent projects that

have unrelated cash flows or mutually exclusive projects that
compete against one other. If projects are independent, they
can all be selected, provided they meet the organisation’s
expectations. However, when projects are mutually exclusive,
then acceptance of one project implies rejection of the other.
18.4 Why do organisations use

investment appraisal?
Organisations use assets to convert inputs into outputs that

they provide to customers. Since resources are generally not
limitless, the organisation needs to maximise the benefit it gets
from the resources it uses. An organisation has to deal with
two decisions in order to address its capital budgeting
alternatives:
1. It has to make a decision regarding the assets to be

acquired.
2. It must decide how much the organisation is willing to
spend to acquire those assets.
The acquisition decision will come as a result of weighing the

benefits to be gained against the costs that will be incurred.
The management of an organisation must conduct an
investment appraisal in order to make sure that whatever
decisions are taken, are consistent with the overall objectives
of the organisation. Generally, it will be important to look at all
the available alternatives so as to compare and choose the one
from which the organisation will derive the most benefit.
Hence, the primary purpose of investment appraisal is
concerned with maximising the wealth of shareholders.
A simple real-world assumption is that, if an organisation

maximises the benefits it generates by using resources, it will
translate into the maximisation of the benefits that investors
would get. This is a simplification of the real world, since
more factors will need to be considered that will impact on the
capital budgeting process.
18.5 Relevant and irrelevant cash flows in

investment appraisal
The relevant financial inputs for decision-making are future

cash flows that will differ between the various alternatives
being considered. Therefore only relevant cash flows should be
considered, i.e. incremental or differential cash flows. The
following cash flows are discussed in terms of their relevance
or irrelevance:
Additional costs of fixed assets. The total cost of fixed

assets includes any transportation and installation costs, as
these are substantial costs incurred by organisations when
fixed assets are acquired. These charges are therefore added
to the price of the assets when the project’s cost is being
determined.
Depreciation. This is a non-cash charge even though
depreciation shelters income from taxation. This has an
impact on cash flow, although depreciation itself is not a
cash flow. Depreciation is added to net operating profit after
tax (NOPAT) when estimating a project’s cash flow or the
wear-and-tear allowance stipulated by the tax authorities’
must be part of the tax calculation in order to arrive at the
operating cash flow. The only investment appraisal method
to include depreciation is the accounting rate of return.
Incremental cash flows. These are additional cash flows
that represent the change in the organisation’s total cash
flow that occurs as a direct result of accepting the project.
Interest expenses. These are expenses that are not included
in a project’s cash flow since the cost of debt is already
embedded in the cost of capital (minimum required rate of
return), which is the rate used to discount the project’s cash
flows. Subtracting interest from the cash flows will amount
to double counting interest costs.
Opportunity cost. This is the value the organisation will
lose as a result of taking the next best alternative. This
includes, for example, the cash flow forfeited when an asset
is retained. These costs are relevant and should be included
in investment decisions.
Sunk cost. This is a cost that has already been incurred, or
an organisation has signed a contract (committed itself)
regarding the cost. It is a past cost that cannot be reversed.
Such costs are irrelevant when it comes to investment
appraisal and have to be excluded from such an exercise.
Working capital. This type of capital is used to finance
additional inventories that are required to support a new
operation. Towards the end of a project’s life, inventories
will be used, but not replaced, and receivables will be
collected and not replaced. As these changes occur, the
organisation will receive cash inflows, which will allow the
investment in working capital to be returned at the end of
the project’s life. Working capital is an amount invested at
the beginning of the investment period, where it is reflected
as an outflow, and released at the end of the investment
period, where it is reflected as an outflow. This is as a result
of the working capital being no longer required, and the cash
that was tied up in it is made available. It is not an annual
cash flow. In some cases, however, additional investment in
working capital is needed on an annual basis. This
additional investment in working capital will also be
included as a cash flow, and be recouped at the end of the
project. Working capital does not qualify for tax relief and is
excluded from capital allowance calculations.
The following appraisal methods are used to decide whether or

not capital projects should be accepted for inclusion in the
capital budget and also for ranking the projects:
Payback
Accounting rate of return
Net present value (NPV)
Profitability index (PI)
Internal rate of return (IRR)
The payback and the accounting rate of return methods do not

take into account the time value of money, whereas the net
present value, profitability index and internal rate of return
methods are referred to as discounted cash flow methods,
because they also consider the time value of money.

The payback period is the length of time that it takes for an
investment project to recoup the funds invested in the project.
This method is based on cash flows. It provides a measure of
liquidity and risk, that is, the sooner the investor can recover
the initial investment, the sooner he can invest it elsewhere and
lower the risk of this particular investment.
Organisations normally set the required payback period as a

standard that has to be adhered to, and if the payback period of
an investment project is shorter than this standard period, the
project will be accepted. When faced with mutually exclusive
projects (projects that compete with each other), the project
with the shortest payback period would be selected.
It is advisable not to use the payback method on its own to
evaluate capital projects, as it is only a measure of payback,
but not of profitability.
Where the cash flows are constant, the payback can be

Initial investment
Payback =
Annual net cash inf low
A payback period may not always be exactly in a full year. To

calculate the payback in years and months, multiply the
decimal fraction of a year by 12 to convert the decimal to
months.
ILLUSTRATIVE EXAMPLE 18.1
Zeus Ltd invested R2 million in a project that is expected to

generate net cash inflows of R500 000 for the next five
years.
Calculate the payback period for the project.
Solution
R2 000 000
Payback =
R500 000
= 4 years
Where cash flows are uneven, the payback is calculated by

working out the cumulative cash flow over the life of a
project.

Bubbles Ltd wants to acquire a machine that will be used
for printing books to be published. The machine will be
used for five years and will cost R250 000. The expected
cash inflows from this project are given as follows:
Year Cash flows

R
1 100 000
2 75 000
3 65 000
4 40 000
5 30 000
The organisation has a standard payback period of three

years.
Required
Determine if this project will be accepted or rejected by
using the payback method.
Solution
YearCash Cumulative cash flows

flows
R R
0 –250 000 –250 000
1 100 000 –150 000
2 75 000 –75 000
3 65 000 –10 000
4 40 000 10 000 / 40 000 = 0.25
5 30 000
In the first year, the organisation recovers R100 000 of the

amount invested, and the remaining balance that still needs
to be recouped is R150 000. The original investment is
recovered between years 3 and 4. Only R10 000 needs to
be recovered from the R40 000 year 4 cash flow, hence
0,25 of a year is needed to recover that. The payback
period is 3,25 years (3 + 0.25) or 3 years and 3 months
(0,25 × 12 months = 3 months). This is slightly higher than
the standard payback period set by the organisation.
Therefore, the project will be rejected.
Advantages of the payback period
It is simple to calculate and easy to understand.

More emphasis is placed on earlier cash flows, as they
are likely to be more accurate than cash flows that come
in later years.
Disadvantages of the payback period

The disadvantages of the payback method are as follows:
The time value of money is ignored.

The cash flows that come after the payback period has
been met are ignored.

The accounting rate of return (ARR) is the only appraisal
method that uses accounting profits as opposed to cash flows.
This method estimates the rate of return from an investment
project without the use of either discounting or compounding.
It is also known as return on investment (ROI) or return on
capital employed (ROCE) and has variations in its formulae.
The most common formula is:
Average annual prof it 100

ARR = =
Average value of investment 1
If the ARR is greater than the organisation’s target return, then

the project should be accepted. When comparing mutually
exclusive projects, the project with the highest ARR should be
chosen.
Sencam Ltd is considering an investment in a capital

project that requires R150 000, where the required rate of
return is 12%. Straight-line depreciation will be charged on
the capital expenditure over the five-year life of this project.
The equipment will not have any residual value at the end
of its useful life. The cash flows expected over the life span
of the project are:
Year Cash flows

R
1 80 000
2 80 000
3 65 000
4 40 000
5 20 000
Required
Determine if this project will be accepted or rejected by
using the accounting rate of return.
Solution
The total cash inflows for the five years are:
R80 000 + R80 000 + R65 000 + R40 000 + R20 000 =
R285 000
Total profit = Total cash inflows – Depreciation

= R285 000 – R150 000
= R135 000
Average profit = R135 000/5 years = R27 000
Initial investment + Residual value

Average investment =
2
R150 000 + R0
=
2
= R75 000
R27 000 100

Hence ARR = ×
R75 000 1
= 36%
Since this method is based on profits rather than cash

flows, it is affected by accounting policies. These policies
can be different for each organisation, and as such it
makes this measure of accounting rate of return less useful
than methods that are based on cash flows.
Advantages of the accounting rate of return
It is simple to calculate and easy to understand.

The total useful life of the project is considered.
It is expressed in terms that managers of organisations
can relate to; that is profit and capital.
Disadvantages of the accounting rate of return
The time value of money is ignored.

Profits rather than cash flows are used in the calculation.

The net present value (NPV) represents the net benefit or net
loss in present value terms earned on the project. It is
calculated by discounting the future after tax cash flows, and
then subtracting the initial investment.
This is theoretically the best method of investment appraisal,

as it calculates the gain/loss due to the shareholders. An NPV
of zero implies that the project’s cash flows exactly cover the
capital invested and provides the required return on the capital.
If the NPV is positive, then the project is generating more cash
flows than required to service the debt and to provide the
required return to shareholders. It should therefore be
accepted. A negative NPV signifies that the project is not
generating sufficient cash flows to service the debt and to
provide the required return to shareholders, and should thus be
rejected. When faced with mutually exclusive projects, the
project with the highest NPV should be selected.
Caminaysh College is a private college that needs to install

a new electronic student registration system. They are
considering two mutually exclusive projects with equally
useful lives. System ITSS will meet all the college’s
requirements, and system COIL, which costs more to
implement, will have greater earnings potential because of
its features. The financial figures for each investment
project are set out in the following table:
System ITSS System COIL

Initial investment R 60 000 R 75 000
Project useful life 5 years 5 years
Project cash inflows
Year R R
1 11 000 17 000
2 20 000 22 500
3 22 000 25 000
4 21 000 24 500
5 20 000 25 000
The cost of capital is 15%.
Required
Calculate the net present value of these two projects and
recommend which project has to be undertaken based only
on financial figures.
Solution
System ITSS
Cash flows Discount factor @ 15% Present value

R R
–60 000 1.000 –60 000
11 000 0.870 9 570
20 000 0.756 15 120
22 000 0.658 14 476
21 000 0.572 12 012
20 000 0.497 9 940
NPV 1 118
System COIL
Cash flows Discount factor @ 15% Present value

R R
–75 000 1.000 –75 000
17 000 0.870 14 790
22 500 0.756 17 010
25 000 0.658 16 450
24 500 0.572 14 014
25 000 0.497 12 425
NPV –311
(Discount factors at 15% from present value table A)

The decision rule is that any project that generates a higher
positive net present value is acceptable. In this situation,
System ITSS is only acceptable since it has a higher
positive NPV. But System COIL has a negative NPV.
Therefore, based on financial factors only, System ITSS will
be preferable.
Advantages of a net present value method
The time value of money is taken into consideration.

All the cash flows for the project are used.
The absolute gain or loss due to the shareholders is
calculated.
The discount rate used for appraising the project can be
adjusted to reflect the level of inherent risk in different
projects.
It is based on cash flows and not profits. Using cash
flows is more appropriate for decision making.
Disadvantages of the net present value method
It is not well understood by non-financial managers.

The project that has a higher NPV does not always
represent the best investment project for the
organisation.
It is difficult to determine the cost of capital to be used for
discounting the cash flows.
It is not easy to understand NPV analysis figures
compared to percentage figures given by the accounting
rate of return and the internal rate of return.

The profitability index of a project is calculated by dividing
the present value of the cash flows of the project by its initial
investment. Use of the NPV rule becomes problematic if the
organisation does not have enough funds to invest in all the
projects with positive NPVs when capital is rationed. In such
cases, it becomes very important to rank projects according to
their profitability index, that is, according to their earning
power. The profitability index of a project is calculated as
follows:
PV of cash f lows of the project

Prof itability index (PI) =
Initial investment
The profitability index is related to the NPV approach. Every

time the NPV is positive, the PI is more than 1, and if the NPV
is negative, PI will be less than 1. The decision criterion is to
invest in the project if the profitability index (PI) is greater
than 1.
Using the information from Illustrative example 18.4,

calculate the profitability index for both projects.
Solution
Sum of the present value of the cash flows as per previous
example:
System System
ITSS COIL
R R
9 570 14 790
15 120 17 010
14 476 16 450
12 012 14 014
9 940 12 425
61 118 74 689
PI for System = R61
ITSS 118
R60
000
= 1,019
PI for System = R74

COIL 689
R75
000
= 0,996
In this case, System ITSS will be ranked first because of its

higher PI and also because it is > 1. The profitability index
is an indication of the value that the organisation will
receive in exchange for every rand invested in a capital
investment project.

The internal rate of return (IRR) requires that the actual rate of
return of the project be calculated. It is the discount rate at
which the NPV of a project will be zero, that is, it is the rate at
which the project breaks even. This means that at the IRR, the
total present value of the discounted cash inflows is equal to
the total present value of the cash outflows of the project. The
IRR is the exact rate of return that the project is expected to
achieve. If the IRR exceeds the cost of capital used to finance
the project, a surplus will remain after paying for the capital,
and this will be due to the shareholders, which increases
shareholder wealth.
Using linear interpolation, we can determine the IRR. Use one
low rate to achieve a positive NPV and one high rate to
achieve a negative NPV. Then use interpolation to calculate the
IRR that results in a nil NPV. Calculate the NPV at two
different rates, and then use the following formula to derive the
IRR:
c
IRR = a + [ × (b − a)]
c − d
Where
a = Lower discount rate
b = Higher discount rate
c = NPV at lower discount rate
d = NPV at higher discount rate
When inputting figures into formulae, do not convert

percentage to decimals; instead use whole numbers and add in
a percentage sign at the end.
Using information from Illustrative example 18.4, calculate

the IRR.
Solution
Firstly, we need to calculate two NPVs: one NPV must be
positive and the other must be negative. For illustrative
purposes, the two discount rates are given. These rates are
usually determined through trial and error.
SYSTEM ITSS
Cash Discount Present Discount Present

flows factor @ 15% value factor @ value
16%
R R R
–60 1.000 0.497 1.000 –60
000 000
11 0.870 9 570 0.862 9 482
000
20 0.756 15 120 0.743 14 860
000
22 0.658 14 476 0.641 14 102
000
21 0.572 12 012 0.552 11 592
000
20 0.497 9 940 0.476 9 520
000
NPV 1 118 NPV –444
SYSTEM COIL
Cash Discount Present Discount Present

flows factor @ 15% value factor @ value
14%
R R R
–75 1.000 –75 000 1.000 –75
000 000
17 0.870 14 790 0.877 14 909
000
22 0.756 17 010 0.769 17 303
500
25 0.658 16 450 0.675 16 875
000
24 0.572 14 014 0.592 14 504
500
25 0.497 12 425 0.519 12 975
000
NPV –311 NPV 1 566
SYSTEM ITSS
c
IRR = a + [ × (b − a)]
c − d
Where
a = 15%
b = 16%
c = R1 118
d = (R444)
1118
IRR = 15 + [ × (16 − 15)]
1118−(444)
= 15 + [0,72 × 1]
= 15,72%
SYSTEM COIL
c
IRR = a + [ × (b − a)]
c − d
Where
a = 14%
b = 15%
c = R1 566
d = (R311)
1566
IRR = 14 + [ × (15 − 14)]
1566−(311)
= 14 + [0,83 × 1]
= 14,83%
Normally, the organisation’s discount rate will be given in

most questions. By using this discount rate to calculate the
NPV, it will give us a guide as to whether the NPV is
positive or negative. If the NPV at this rate is positive, the
next NPV to calculate has to be negative, and we will have
to choose a much higher discount rate than the one we
have just used.
On the contrary, if the initial NPV turns out to be negative at
the organisation’s discount rate, then the next NPV to be
calculated has to be positive. We will need to use a
discount rate that is much lower than the one used initially.
The IRR for System ITSS (15,72%) is above the cost of
capital of 15% (as per Illustrative example 18.4); therefore it
should be accepted, whereas the IRR for System COIL
(14,83%) is below the cost of capital of 15%, and should
therefore be rejected.
Advantages of internal rate of return
It considers the time value of money.

Its simplicity makes the concept easy to understand.
All cash flows are taken into consideration.
Disadvantages of internal rate of return
IRR cannot accommodate changing interest rates.

IRR is a relative figure, whereas NPV is an absolute
figure. Therefore, IRR can give a different ranking from
the ranking proposed by NPV.
The IRR method assumes that project earnings for the
period of the investment will be reinvested at the IRR,
and this usually overestimates the returns from the
project.
If a project has irregular cash flows, that is, the project
generates negative cash flows in-between positive cash
inflows, the project can have more than one IRR.
Roshan Ltd is considering investing R400 000 in a new

plant that will increase sales by 10 000 units per annum.
Units sell for R30,00 each and have a variable cost of
R12,00 each. Cash fixed costs are expected to increase by
R60 000 as a direct result of the investment. The plant will
be depreciated to zero over its five-year useful life. It is
anticipated that Roshan Ltd will receive R20 000 on
scrapping of the plant at the end of its useful life. This
investment is expected to require R50 000 in working
capital. The company tax rate is 30% and the required
return is 10%.
Required
1. Calculate the operating and total cash flows over the life
of the investment.
2. Calculate the NPV for the project.
Solution
Operating cash flow: R

Sales (10 000 × R30) 300 000
Variable costs (10 000 × (120
R12) 000)
Contribution 180 000
Fixed costs (60 000)
Depreciation (R400 000 ÷ 5 (80
yrs) 000)
Profit before interest and tax 40 000
Tax (30%) (12
000)
Net profit after tax 28
000
Add: Depreciation 80
000
Operating cash flow 108
000
Net present value:
Year 0 Year 1– Year 5

4
R R R
Investment (400
000)
Working capital (50 000) 50 000
Operating cash flow 108 000 108
000
After tax salvage 14 000
value
Total cash flow (450 108 000 172
000) 000
PV factor at 10% 1.000 3.170* 0.621*
Present value (450 342 360 106
000) 812
Net present value (R828)
*Table B: 4 years and 10%; Table A: 5 years and 10%

The project has resulted in a negative net present value,
which signifies that the project is not generating sufficient
cash flows to service the debt and to provide the required
return to shareholders, and should therefore be rejected.
TUTORIAL EXERCISES
Exercise 1
Mahi Singh Ltd is considering an investment of R50 000.
The corporation expects to get after tax cash inflows of R16
000 per year for the first five years, and R7 500 for the last
three years of the project. Straight-line depreciation is
charged for the entire useful life of the project. The required
rate of return is 8% for this project.
Required
a. Payback period
b. Net present value
c. Internal rate of return
d. Accounting rate of return
Exercise 2
Riya Corp is reviewing an investment proposal. The initial
cost of the investment is R52 500. The estimated cash
flows and net profit for each year are presented in the
schedule below. All cash flows are assumed to take place
at the end of the year.
Year Net cash Net

flows profit
1 R20 000 R2 500
2 R17 500 R3 500
3 R15 000 R4 500
4 R12 500 R5 500
5 R10 000 R6 500
The cost of capital is 12%.
Required
a. Payback period
b. Accounting rate of return (base your calculation on the
initial cost of the investment)
c. Net present value
Exercise 3
North Coast Boards requires an investment of R1 000 000
in new machinery that has an expected life of five years
with annual cash flows of R240 000 received at the end of
each year.
Required
a. Compute payback period.

b. Compute the net present value using a 12% discount
rate.
c. Compute the internal rate of return.
d. Would you recommend this project to be accepted?
Provide reasons.
Exercise 4
Su (Pty) Ltd is considering a capital investment project that
requires an initial investment of R145 000 and has an
expected life of four years. Annual cash flows at the end of
each year are expected to be as follows:
Year Amount
1 R35 000
2 R45 000
3 R55 000
4 R50 000
Required
a. Compute payback assuming that the cash flows occur

evenly throughout the year.
b. Compute the net present value of the project using an
8% discount rate.
Exercise 5
Hayne Ltd has invested R10 000 in new machinery. This
machine is expected to generate a net cash flow saving in
operating cost after tax of R2 500 per annum for five years.
Depreciation has been calculated at R2 000 per annum, but
it has not been included in determining the cost saving, as
it does not constitute cash flow.
Required
a. Calculate the payback period for the project.

b. Calculate the ARR for the project.
Exercise 6
Marion Avenue Traders is considering the purchase of a
new machine that will cost R15 million and have a
productive life of five years. It is expected that at the end of
five years the machine could be sold for R1 million. The
company’s policy is to depreciate equipment straight line to
zero over its useful life, which is also acceptable for tax
purposes. The machine is expected to generate annual
profits before interest and taxes of R3 million. The tax rate
is 30%. Additional working capital of R2 million will be
required when the machine is first purchased and will
remain constant until the end of its life, when working
capital will be reduced to zero.
Marion Avenue Trader’s weighted average cost of capital is
15% and it requires projects to generate an internal rate of
return at least equal to cost of capital. If this requirement is
met, it also requires that projects must pay back their total
investment within three years.
Required
a. The net present value of the project
b. The internal rate of return of the project; interpolated
between 15% and 20%
c. Calculate the payback period of the project.
d. Provide recommendations on whether the project should
be accepted or not.
Exercise 7
Shakti Mothilal (Pty) Ltd is currently evaluating two
investment projects involving the purchase of machinery.
The following relative cash flow data is used:
Machine Machine
A B
R R
Initial investment 160 000 160 000
Income
1 30 000 30 000
2 40 000 30 000
3 50 000 30 000
4 60 000 30 000
5 70 000 30 000
250 000 150 000
Scrap value at end of economic R5 000 Nil
life
The firm’s cost of capital is 12%.

Ignore tax and work to the nearest rand.
Required
a. Calculate each project’s payback period for machine A
and B.
b. Calculate the rate of return on average investment for
machine B.
c. Calculate the net present value (NPV) for each project.
d. Summarise the preferences dictated by NPV measures
and indicate with motivation which project you would
recommend.
Index
A
accounting 1
nature of accounting 2
accounting concepts 44
consistency concept 44
going concern concept 44
matching concept 44
prudence concept 44
accounting cycle 44
adjustments 47
analysis and interpretation 50
closing entries 48
final trial balance 48
financial statements 48
journals 46
ledger accounts 46
notes to the financial statements 49
post-adjustment trial balance 48
pre-adjustment trial balance 47
source documents 46
statement of cash flow 49
statement of changes in equity 49
statement of financial position 49
statement of profit or loss and other comprehensive
income 49
transactions 45
accounting field 10
cost accounting 10
financial accounting 10
management accounting 10
accounting information 3
comparability 3
relevance 3
reliability 3
understandability 3
analysing financial statements 119
common size statements 119
comparative financial statements 119
indexed financial statements 119
ratio analysis 119
annuity 305
assets 16
current assets 17
non-current assets 17
assumptions of CVP analysis 291
average stock level (AveSL) 182
B
basic wages 197
gross wages 197
medical aid fund 198
net wages 198
pay as you earn (PAYE) 198
pension fund 198
unemployment insurance fund (UIF) 198
basic accounting equation (BAE) 22
assets 22
buying assets on credit 27
capital contributions 26
expenditure (cash) 30
income 29,30
liabilities 22
loans 26
owner’s equity 22
payments to creditors 28
purchase of assets for cash 27
withdrawals by owner 29
breakeven point 293
breakeven quantity 293
breakeven value 293
business activity 8
manufacturers 8
retailers 9
service businesses 8
wholesalers 9
business forms 3
close corporation (CC) 4
company 5
partnership 4
sole trader 3
C
capital budgeting process 328
authorisation stage 328
financing stage 328
implementation stage 329
information acquisition stage 328
screening stage 328
search stage 328
capital budgeting techniques 331
accounting rate of return 331
internal rate of return (IRR) 331
net present value (NPV) 331
payback 331
profitability index (PI) 331
carrying costs (holding costs) 180
cash budgets 246
categories of capital budgeting projects 329
expansion projects 329
independent projects 329
mutually exclusive projects 329
new projects 329
regulatory projects 329
replacement projects 329
classification of labour 196
direct labour 196
indirect labour 196
closing process 101
companies 109
Companies Act of 2008 109
profits, taxation, reserves and dividends 112
reserves 111
share capital 110
share premium 111
types of share 111
company 5
non-profit companies 5
private company 6
profit companies 5
public company 6
compounding 305
conceptual framework 43
comparability 44
relevance 43
reliability 44
understandability 43
contribution margin approach 292
contribution margin per unit 292
contribution margin ratio 292
control over cash 139
cost behaviour 164
cost classification 162
cost classification for control 167
controllable and non-controllable costs 167
cost classification for decision making 168
avoidable cost 169
differential/incremental cost 168
opportunity cost 168
relevant costs 168
cost concept 162
cost of capital 305
cost price of the job 223
cost-volume-profit (CVP) 290
CVP analysis in decision making 295
D
decisions using marginal costing 273
choice of products where a limiting factor exists 279
dropping a product or department 275
make versus buy 281
special order decisions 274
direct labour variances 258
efficiency variance 258
rate variance 258
total labour variance 258
direct materials variances 257
price variance 257
total direct materials variance 258
usage (quantity) variance 257
discounting 305
E
economic order quantity (EOQ) 181
employer’s contributions 199
F
first-in-first-out method (FIFO) 186
fixed costs 164, 273, 291
fixed manufacturing overheads variances 259
absorption costing system 259
expenditure variance 259
marginal costing system 259
volume variance 259
flexible budgets 241
future value (FV) 305
annuity due 313
ordinary annuity 312
single cash flow 311
I
incentive schemes 202
halsey bonus scheme 202
halsey-weir bonus scheme 202
rowan premium bonus scheme 203
taylor’s differential piecework system 203
interest 305
compound interest 306
effective rate 308
nominal rate 306
simple interest 306
irrelevant costs 169
sunk costs 170
J
job costing (absorption costing) 222
L
labour recovery rate 205
annual labour cost 205
productive hours 205
liabilities 17
current liabilities 17
non-current liabilities 17
loan amortisation 314
M
manufacturing costs (product costs) 162
direct labour 163
direct materials 163
indirect labour 163
indirect materials 163
manufacturing overheads 163
margin of safety 294
margin of safety expressed as a value 294
margin of safety expressed in units 294
margin of safety ratio 294
mark-ups 155
on cost price 156
on selling price 157
materials 177
accounting entries 178
direct materials 177
maximum stock level (MaxSL) 182
minimum stock level (MinSL) 182
N
non-manufacturing costs (period costs) 163
administrative expenses 163
marketing expenses 163
O
operational budgets 233, 235
direct labour budget 235
direct materials purchases budget 235
direct materials usage budget 235
inventory budget 235
manufacturing overheads budget 235
production budget 234
sales and administration expenditure budget 235
sales budget 234
ordering costs 181
overhead absorption rate (OAR) 222
overheads 221
actual overheads 224
applied overheads 224
budgeted overheads 224
indirect labour 221
other manufacturing overheads 222
owner’s equity 17
expenses 17
income 17
P
payroll accounting 207
salaries journal 207
wages journal 210
performance reports 242
periodic inventory system 183
periodic method of accounting for stock 50
perpetual inventory system 183
perpetual method of accounting for stock 50
present value (PV) 305
annuity due 310
perpetuity 311
single cash flow 308
R
rates and exemptions 153
exempt supplies 153
standard-rated supply 153
zero-rated supplies 153
ratio analysis 119
cross-sectional 119
efficiency ratios 119, 120
liquidity ratios 119, 120
profitability ratios 119, 121
solvency ratios 119, 121
time-series 119
reconciliation process 140
remuneration methods 197
hourly wages 197
piecework pay 197
salaries 197
reorder level (ROL) 181
repayment of loan 314
reserves 111
distributable reserves 112
non-distributable reserves 112
retailers 50
S
sales required to achieve target profit or return 295
sales variances 256
sales price variance 256
sales quantity variance 256
selling price of the job 224
actual overheads 224
applied overheads 224
budgeted overheads 224
semivariable, semifixed or mixed costs 165
separating a mixed cost 166
share capital 110
authorised share capital 110
issued share capital 111
standard costing system 253
standards 254
ideal standards 254
practical or currently attainable standards 254
setting standards 254
standard cost 254
stock control 180
average stock level (AveSL) 182
carrying costs (holding costs) 180
economic order quantity (EOQ) 181
lead time 181
maximum stock level (MaxSL) 182
minimum stock level (MinSL) 182
ordering costs 181
reorder level (ROL) 181
stock-out costs 181
stock valuation methods 183
first-in-first-out method (FIFO) 186
periodic inventory system 183
perpetual inventory system 183
weighted average method 187
T
time value of money 304
annuity 305
annuity due 305
compounding 305
cost of capital 305
discounting 305
future value (FV) 305
loan amortisation 314
perpetuity 305
present value (PV) 305
repayment of loan 314
single cash flows 305
types of share 111
ordinary shares 111
preference shares 111
U
users of accounting information 2
external users 2
internal users 2
V
value-added tax 152
variable costs 165, 291
variable manufacturing overheads variances 258
efficiency variance 259
spending (rate) variance 258
variable/marginal costs 273
variance analysis 255
favourable variance 255
unfavourable variance 255
VAT payable/refundable 154
VAT system 153
input tax 153
output tax 154
W
weighted average method 187
Y
year-end adjustments 91
accrued expenses 98
accrued income 99
allowance for credit losses 94
depreciation 92
prepaid expenses 97
This le was downloaded from Z-Library project
Your gateway to knowledge and culture. Accessible for everyone.
z-library.se singlelogin.re go-to-zlibrary.se single-login.ru
O cial Telegram channel
Z-Access
https://wikipedia.org/wiki/Z-Library
ffi
fi

Basic Accounting For Non-Accountants (Melanie

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Basic Accounting For Non-Accountants (Melanie

Uploaded by

Copyright:

Available Formats

BASIC ACCOUNTING

Melanie Cloete • Ferina Marimuthu

No part of this publication may be reproduced, stored in a

Please contact DALRO for information regarding copyright clearance

First edition 2008

ISBN 978 0 627 03626 2

Commissioning editor Claire Thornton

Every effort has been made to obtain copyright

Please note that reference to one gender includes

Website addresses and links were correct at time of

Melanie Cloete’s qualifications include a Higher Diploma in

Ferina Marimuthu is a lecturer in management accounting at

This book is a result of the combined efforts of the authors,

It sought to close a gap that had been identified in the market:

This book is intended primarily for non-accounting specialists

students doing a one-year introductory accounting course at

The accounting discipline is constantly changing and is both

We wish to thank Catherine Du Preez for contributing the

We dedicate this book to our loving husbands and children for

We trust that this book will be enjoyed and used by various

With best wishes for a stimulating and positive learning

Melanie Cloete and

CHAPTER 1 Introduction to accounting

CHAPTER 3 The accounting equation

CHAPTER 4 Basic financial statements

CHAPTER 5 Basic financial statements with year-end

CHAPTER 6 Company financial statements and their

CHAPTER 7 Bank reconciliation

CHAPTER 8 Value-added tax (VAT)

CHAPTER 9 Cost classification and terminology

CHAPTER 12 Overheads and job costing

CHAPTER 13 Budgetary control

CHAPTER 14 Standard costing and variance analysis

CHAPTER 15 Short-term decision making

CHAPTER 16 Cost-volume-profit (CVP) analysis

CHAPTER 17 Time value of money

CHAPTER 18 Capital budgeting

At the end of this chapter students should be able to

define the purpose of accounting

1.1 What is accounting?

1.1 What is accounting?

1.1.1 Definition of accounting

gathering – the bringing together of all financial information that

1.1.2 Nature of accounting

1.2 Users of accounting information

The users of accounting information can be divided into two groups,

Owners – use accounting information to determine whether their

Customers – use accounting information to determine whether the

1.3 How useful is accounting information?

The four main qualitative characteristics that influence the usefulness

Comparability – the information must be comparable to the

It is important to bear in mind that the benefit derived from providing

1.4 The basic business forms found in South

1.4.1 Sole trader

The business comprises one owner.

The owner is independent.

Expansion prospects are hampered by the limited access to capital.

This is a legal relationship that exists between two to 20 people

New partners bring in additional capital and introduce new ideas.

Partners are jointly and severally liable, meaning that if the

1.4.3 Close corporation (CC)

This is a legal entity unique to South Africa and was established in

Members enjoy limited liability. The liability of the members is