Financial Management 1 (FM101)

Transcription

1 Financial Management 1 (FM101) The copyright of all IMM Graduate School of Marketing material is held by the IMM GSM. No publications may be reproduced without prior written permission from the IMM GSM. November 2010 IMM GSM Page 1 of 141 FM101

2 Table of contents Section A 1. Word of welcome 2. How to use this guide 3. The overall purpose of the subject 4. Pre-knowledge 5. The relationship with other subjects 6. The NQF level and number of credits 7. Prescribed textbook and resources required 8. Curriculum 9. Specific learning outcomes 10. Critical Cross-field Outcomes 11. Assessment details 12. Time-line Section B Study Unit 1: Basic accounting concepts and the accounting equation 1. The nature and roles of accounting and finance 2. Users of accounting information 3. Forms of business ownership 4. Financial and management accounting 5. Financial accounting concepts and terminology 6. The accounting equation Study Unit 2: Basic accounting concepts and financial statements 1. Basic accounting 2. Company financial statements IMM GSM Page 2 of 141 FM101

3 Study Unit 3: Determine the selling price of merchandise 1. Value added tax (VAT) 2. Determining selling prices Study Unit 4: Cost classification and terminology 1. Introduction 2. Cost classification in relation to the product or period 3. Cost classification in relation to volume of production 4. Cost classification for control or evaluation 5. Cost classification for decision making Study Unit 5: Materials 1. Classification of materials 2. Stock control 3. Stock valuation methods Study Unit 6: Labour, overheads costing 1. Classification of labour 2. Overheads 3. Job costing (absorption costing) 4. Marginal costing Study Unit 7: Budgetary control and sales variance 1. Operational budgets 2. Flexible budgets 3. Cash budgets 4. Sales variances Bibliography 141 IMM GSM Page 3 of 141 FM101

4 Section A 1. Word of welcome Welcome to financial management, a central part of the management function in the firm. Financial management addresses accounting and finance concepts relevant to all marketers, regardless of the extent of their involvement in the direct financial affairs of the firm. Decisions to invest in products or markets or to sell particular products depend to a great extent on the quality of information provided by the accounting and finance function. In this learner guide you will find a structured and integrated schedule of learning material, tutorial notes, time-lines, self-assessment questions and one assignment. In order to assist you in planning and managing your studies, the learner guide has been structured according to: an organisational component (Section A), and a learning component (Section B). The purpose of the organisational component is, amongst other things, to orientate you towards financial management and to inform you about administrative issues, whilst the purpose of the learning component is to structure the syllabus in terms of manageable study units. The learning component will explain what topics are covered, in how much depth, where to find relevant information pertaining to the subject and ultimately help you to study the subject as realistically and practically as possible. To ensure you get the maximum benefit from the study time you have available it is recommended that you work through the learning guide. This will help you identify the time you will need to complete the programme and by doing this you will be able to draw up a detailed and workable study schedule. Everyone connected with marketing should be a little streetwise about accounting and finance because financial decisions influence every aspect of IMM GSM Page 4 of 141 FM101

5 business operations. Financial management is a fascinating and enjoyable subject and it provides frameworks and techniques you will be able to apply in your day-to-day marketing work. Good luck and enjoy your studying. 2. How to use this guide We aim to make you a confident user of financial and management accounting techniques. The most effective way to achieve this will be to ensure that you understand and enjoy the module. The learner guide is especially designed for a student who studies at a distance. The guide will provide an overview of the total curriculum and will indicate the learning outcomes, which are essentially the core of this guide. It will provide you with each major topic that has to be covered, along with the learning outcomes for each topic, which are systematically explained. The guide will also indicate how the learning material must be prepared for examination. The learner guide should be studied in conjunction with the textbook and does not replace the textbook. At the end of each study unit you will find some typical examples of examination questions which should be used for self-evaluation. The following icons appear in all of the learning guides of the IMM Graduate School of Marketing: IMM GSM Page 5 of 141 FM101

6 indicates learning outcomes. indicates the sections in the prescribed textbook that you need to study. indicates the self-evaluation questions. 3. The overall purpose of the subject The fundamental aim of this course is to equip you with a thorough understanding of important financial concepts. These concepts are important and are applied to and integrated with other areas of learning within the marketing field of study. The overall course objectives for Financial Management 1 are to develop financial literacy on a theoretical and practical level, by explaining accounting concepts and terminology, determining selling price of merchandise, classifying costs into various categories, demonstrating knowledge of concepts related to materials management, demonstrating knowledge of concepts related to labour, overheads and job costing, and demonstrating an understanding of budgets and budgetary control. IMM GSM Page 6 of 141 FM101

7 4. Pre-knowledge It is essential that you are competent in mathematics at NQF level four. If you are not confident in your mathematical abilities at this level, it is strongly recommended that you improve or refresh your basic mathematical knowledge and skills. There are a number of firms offering short skills programmes in mathematical literacy. You should know or be able to do the following: Know the order of mathematical operations Work with formulas Calculate ratios Calculate percentages Construct, read and interpret graphs and charts. We will provide you with brief explanations in your learner guide where it is deemed necessary. It is, however, not possible to create a comprehensive mathematical guide within this text. You can also refer to the following book related to business calculations: Zidel, D Basic Business Calculations. Johannesburg: Penguin Books. An ability to use spreadsheets, such as MS Excel, to do financial calculations and create charts and graphs is an added advantage. 5. The relationship with other subjects Financial Management I should not be seen as an entity on its own, but in the context of the diploma/degree as a whole, since a number of concepts are also dealt with in other courses. IMM GSM Page 7 of 141 FM101

8 This course covers fundamental financial concepts that you are required to know on a theoretical and practical level. The terminology and other topics included are integrated with other IMM subjects, which in turn, help you to identify and recognise your prior learning. Finance as a topic can be boring if you don t understand the concepts. It can be, however, an interesting topic or course when being studied in the marketing context because marketing strategy affects the financial performance of the firm by generating sales and incurring costs. 6. The NQF level and number of credits This module forms a compulsory module for the Diploma in Marketing Management and BBA degree in Marketing Management. In terms of the new National Qualifications Framework (NQF) it is designed as a 20-credit module offered on NQF level 5. The IMM Graduate School of Marketing regards Financial Management I as a first year subject. 7. Prescribed textbook and resources required The prescribed textbook for this module is: Cloete, M., and Marimuthu, F. Accountants. Pretoria: Van Schaik Basic Accounting for Non- The textbook is written in a clear and systematic manner. Always start your studies by consulting the learner guide and then study the relevant sections in the prescribed textbook. It is unlikely that you will pass this module if you have only consulted the learner guide without studying the content of the textbook. The following textbooks are also recommended: IMM GSM Page 8 of 141 FM101

9 Marx, J., de Swart, C., Beaumont Smith, M., and Erasmus, P Financial Management in Southern Africa. 3 rd edn. Cape Town: Pearson. Pizzey, A Finance and Accounting for Non-Specialist Students. Harlow: Prentice-Hall. Niemand, A., Meyer, L., Botes, V.L., and Van Vuuren, S.J Fundamentals of Cost and Management Accounting. Revised 5 th edn. Durban: LexisNexis. We would also like to encourage you to make a habit of reading business and financially orientated literature, magazines and newspapers such as: 1. Business Day 2. Business Report 3. Engineering News 4. Financial Mail 5. FinWeek You can also subscribe to various newsletters published online by financial institutions or financially orientated magazines and portals such as: Financial Mail at Finance Week at The IMM Marketing Information Centre specialises in the provision of information for your project and work related needs. They have over 1500 marketing related books, prescribed and recommended IMM textbooks, a range of over 30 marketing and business related journals. IMM GSM Page 9 of 141 FM101

10 Calculators You will need a basic calculator that is typically used at schools and universities, similar to the one displayed in the picture. It can perform a variety of functions, including fraction calculations, percentage calculations, scientific calculations and statistical calculations. This type of calculator is adequate for the basic business calculations that you will have to perform during this course. 8. Curriculum This section addresses the overall content of the module. The Financial Management I curriculum is divided into seven study units. The seven study units with the corresponding chapters in the prescribed textbook (Cloete & Marimuthu 2008) are as follows: Unit Description Relevant Chapters 1 Accounting concepts and terminology Chapters 1 to 4 2 Financial statements Chapter 5 3 Determine selling price of merchandise Chapters 4, 7 4 Cost classification Chapter 8 5 Material and stock management Chapter 9 6 Labour, overhead and job costing, marginal costing Chapters 10, 13 7 Budgets and budgetary control Chapters 11, 12 IMM GSM Page 10 of 141 FM101

11 9. Specific learning outcomes The aim of this course is to emphasise the need for financial literacy on the part of the marketing specialists. This will be by developing your ability to interpret financial reports, to apply basic financial techniques to marketing operations and to understand the essential indicators of the firm s financial position. Study Unit Description Learning Outcomes 1 Explain accounting concepts and terminology 2 Reading financial statements Define the purpose and users of accounting. Classify items as assets, liabilities or owner s equity. Show the effect of various transactions on the basic accounting equation. Describe the accounting cycle. Explain what year-end adjustments are and its impact on the financial statements. Interpret an income statement and balance sheet. 3 Determine selling price of merchandise Calculate cost of sales. Explain VAT concepts and calculate VAT. Calculate mark-ups on cost price and selling price. Calculate selling price (inclusive and exclusive of VAT). 4 Classify costs into various categories Classify cost in relation to product or period. Classify behaviour of cost in relation to volume of production. Classify cost for control or evaluation. Classify relevant and non-relevant costs for decision making. IMM GSM Page 11 of 141 FM101

12 5 Demonstrate knowledge of concepts related to materials management 6 Demonstrate knowledge of concepts related to labour overheads and job costing 7 Demonstrate an understanding of budgets and budgetary control Distinguish between direct and indirect materials. Describe stock control concepts, calculate stock levels and EOQ. Describe stock valuation methods and calculate the value of closing inventories using FIFO and the weighted average method. Distinguish between direct and indirect labour. Identify overhead costs. Calculate the cost of a product or a job. Distinguish between marginal and absorption costing. Describe components of an operational budget. Draft operational, flexible and cash budgets. Calculate and interpret sales variances. 10. Critical cross-field outcomes The critical cross-field outcomes, also known as transferable skills as identified by the South African Qualifications Authority (SAQA), are essential for your development as a student within the education and training system, regardless of the specific area of learning. It is these outcomes that are deemed critical for your development in the capacity of life-long learning. IMM GSM Page 12 of 141 FM101

13 The critical cross-field outcomes adopted by SAQA are as follows: (1) Identify and solve problems in which responses display that responsible decisions using critical and creative thinking have been made. (2) Work effectively with others as a member of a team, group, organisation, and community. (3) Organise and manage oneself and one s activities responsibly and effectively. (4) Collect, analyse, organise and critically evaluate information. (5) Communicate effectively using visual, mathematical and/or language skills in the modes of oral and/or written presentation. (6) Use science and technology effectively and critically, showing responsibility towards the environment and health of others. (7) Demonstrate an understanding of the world as a set of related systems by realising that problem solving contexts do not exist in isolation. (8) Reflecting on and exploring a variety of strategies to learn more effectively. (9) Participating as responsible citizens in the life of local, national and global communities. (10) Being culturally and aesthetically sensitive across a range of social contexts. (11) Exploring education and career opportunities. (12) Developing entrepreneurial opportunities. IMM GSM Page 13 of 141 FM101

14 The transferable skills identified in this course are as follows: Taught Practised Assessed Problem solving X X X Working in teams Self-management X X X Information gathering/research skills X X X Communication skills X X X Analytical skills X X X Learning strategies X X X Responsible citizenship Cultural sensitivity X Career development X X Entrepreneurship 11. Assessment details There are two assessments involved in terms of the Financial Management 1 module: Assignment: The assignment contributes 20% to the overall mark for the module. Assignments will focus on selected chapters, and need to be typed. Please ensure that you adhere to the general rules of the IMM Graduate School of Marketing pertaining to the style and format of assignments. You will be issued with a separate instruction in this regard. Examination: The exam incorporates all content covered in the workbook and constitutes 80% of the final mark for the Financial Management 1 module. The duration of the examination is three hours and the paper will count 100 marks. The examination paper will consist of multiple IMM GSM Page 14 of 141 FM101

15 choice and short question type answers, but the majority of the questions will require an ability to perform calculations as set out in the practice questions in this guide. Examination results are usually released within six weeks of sitting the examination. The final mark, consisting of an assignment mark and an examination mark, is released in the form of a final percentage (mark out of 100). The grading system is as follows: Percentage Scale Description 75% or more Pass with Distinction 50% - 74% Pass 0% - 49% Fail A timetable of the assessment programme for the semester, including dates for the assignment to be submitted during the course of the year, is available in the Calendar of Events for that year. Please refer to the current issue of the IMM GSM Prospectus. This document and the Student Yearbook provide details of the IMM GSM assessment policy. 12. Time-line With distance education, it is very important that you track your progress against the time-line. The following time-line can be used as a starting point to set up your personal time-line. Week Topic/study theme 1 Introduction to accounting, concepts and terminology 2 Accounting equation and accounting cycle 3 Accounting for stock, year-end adjustments 4 Year-end adjustments IMM GSM Page 15 of 141 FM101

16 5 Company financial statements 6 VAT, mark-up 7 Cost classification 8 Material and stock management 9 Stock valuation 10 Labour, overhead, job costing 11 Marginal costing 12 Budgets and budgetary control 13 Budgetary control and sales variances IMM GSM Page 16 of 141 FM101

17 SECTION B Why do I need to know about finance and accounting? There is not a chief executive or financial director these days who will deny the vital importance of establishing and strengthening the bond between the brand and its users. The problem arises in the language used by marketing people to communicate the value of those relationships at management forums It is the way marketing people try to communicate the complex ideas about the sensitive work they do in creating bonds between brands and their users. This is the language used to motivate an increase in marketing investment. I have frequently been told that if we could only prepare analyses and schedules that support a request for a budget increase in the same way the factory manager motivates money for a new piece of machinery; we would have a smoother ride. But we persist in trying to communicate in soft terms that confuse more than explain, and which marginalises marketing rather than raising the standing of its practitioners to where they belong, which is at the very front line of income generation. The gatekeepers of the shareholders purse strings want to hear how the new branding programme will affect the bottom line and what return it will achieve rather than be told about the consumer psychology behind the campaign. And they want to hear it stated in financial terms not the obtuse coded vernacular of the world of branding. Source: The effectiveness of marketing operations can be measured through the application of various financial analysis activities. None of these analytical activities can be performed if a person does not have a basic understanding of accounting and finance fundamentals. IMM GSM Page 17 of 141 FM101

18 Most of these financial analyses fall into one of four financial activities as explained below: The financial situation analysis determines how well marketing activities are doing. It involves the study of trends, comparative analyses, and assessment of present financial strengths and limitations of the product, brand or business unit. Financial information is used to evaluate alternatives as whether to introduce new products, move into new markets, eliminate a product, expand the sales force or change the distribution channel. Financial planning involves the projection of sales, cost forecasts and budgets, once it has been decided to implement a specific marketing action. Financial control is about comparing actual results to planned results, with the objective of keeping an unfavourable results gap as narrow as possible. IMM GSM Page 18 of 141 FM101

19 Study Unit 1: Basic accounting concepts and the accounting equation This study unit covers the introduction to accounting, discusses financial accounting concepts and terminology, and explains the accounting equation. Mastering the accounting equation is critical in understanding this study unit and creates the foundation of the remainder of this subject and for future studies in financial management. Specific Learning Outcomes After studying this unit, you should be able to: Define the purpose of accounting. Identify the main users of accounting information. Classify items as assets, liabilities or owner s equity. Show the effect of various transactions on the basic accounting equation.. 1. The nature and roles of accounting and finance IMM GSM Page 19 of 141 FM101

20 Reading reference Study Cloete & Marimuthu 2008: Chapter 1 Definition of accounting. Financial management addresses accounting and finance concepts relevant to all marketers, regardless of the extent of their involvement in the financial information and decisions in the business. Decisions to invest in products or markets or to sell particular products all depend on the basis of information provided by the accounting and finance function. The main purpose of accounting is to provide users with financial information that will assist them in making informed decisions. Accounting is a system comprising the following elements: Gathering financial information that has an effect on a specific business. Analysing how the financial information will affect the business. Recording the financial information through proper accounting processes. Reporting all financial information for a given period of time so that it can be read and understood. Interpreting the summarised information to allow users to make informed decisions about the business. You should now be able to master outcome 1. IMM GSM Page 20 of 141 FM101

21 2. Users of accounting information Reading reference Study Cloete & Marimuthu 2008: Chapter 1 Users of accounting information, and how useful is accounting information. 2.1 Identifying users of financial information Financial decisions are influenced by several factors such as the realities of the external environment, past strategies, management value systems, goals of the executive management team and internal power relationships. Stakeholders have expectations or demands, which can influence decisions depending on the power of the stakeholder or groups of stakeholders. We can define a stakeholder as an individual or group that can influence the firm s objectives or are affected by decisions made by the firm. Stakeholders can be classified or grouped into two groups, namely internal and external users of financial information: Internal External Owners Managers Employees and their representatives. Customers Competitors Lenders Government Suppliers Investment analysts. IMM GSM Page 21 of 141 FM101

22 2.2 The needs of users of financial information Financial information should possess a number of qualities in order to fulfil the needs of the users thereof. It should be relevant, reliable, provide means to do comparisons with the past or across different businesses and it should be clear so that users can understand it. In addition to these qualities, financial information should also achieve a threshold of materiality or significance, meaning that it should only be included within reports if it does not clutter them up or interfere with the user s ability to interpret financial results. The timely flow of information helps managers to compare actual performance to planned performance. Accounting information helps owners of the business to assess if the managers of the business are also pursuing the goal of wealth maximisation. The reasons for using accounting information by different users are set out in the table below: User Use Owners Managers Employees Customers Competitors Lenders Government Suppliers Investment analysts Determine profitability and financial viability. Ensure business operates efficiently and solve problem areas highlighted. Determine if employer is able to provide stable employment and remuneration. Determine if business can provide products over long period of time. Competitor intelligence, to maintain competitive edge. Determine if business can repay loans and interest. Determine how much taxes and levies should be paid. Determine if business can pay for goods purchased on credit. Determine if business would be good investment, and to assess risk and return of an investment in business. You should now be in a position to master outcome 2. IMM GSM Page 22 of 141 FM101

23 3. Forms of business ownership Reading reference Please read Cloete & Marimuthu 2008: Chapter 1 Basic business forms in South Africa. No learning outcome is set for this section but regard the reading as important background information. An understanding of the different forms of business ownership is necessary as the nature of ownership will in the first instance have an impact on the treatment of owners claims, and secondly, the reporting and treatment of financial information in the financial statements. 3.1 Forms of business ownership in South Africa In South Africa you may find that businesses are operated as a: Sole proprietary Partnership Close Corporation Name followed by CC Private company with limited liability Name followed by (Pty) Ltd Public company with limited liability Name followed by Ltd Important note: The Companies Act was signed by the President on the 08th April 2009 and gazetted in the Gazette No (Notice 421). The Act comes into operation on a date still to be fixed by the President by proclamation in the Gazette. This Act affects Close Corporations, Private companies and Public companies as mentioned above. IMM GSM Page 23 of 141 FM101

24 The new Companies Act has identified two types of companies to be incorporated under the new act. A company can either be a profit company or a non-profit company. A profit company is defined as a company incorporated for the purpose of financial gain for its shareholders. A non-profit company is incorporated for public benefit and the income and property are not distributable to its incorporators. A non-profit company may be regarded as a successor to the previous Section 21 companies in the current act. Profit companies can be: 1) a state-owned company (SOC); 2) a private company (Proprietary Limited) if it is not state-owned and the Memorandum on Incorporation prohibits it from offering its securities to the public and restricts the transferability of its securities; 3) a personal liability company (Incorporated) if it meets the criteria for a private company and the Memorandum of Incorporation states that it is a personal liability company; 4) a public company (Limited) in any other case. One of the effects of the new Companies Act of 2008 is the phasing out of close corporations. No new close corporations may be formed once that Act comes into operation. Existing close corporations can elect to continue to exist until deregistered, dissolved or converted into a private company governed under the new Companies Act. It will be possible for businesses to continue to run their operations out of an existing close corporation if they so wish. Another effect is that a private company will still be prohibited from offering its shares to the public and the transferability of its shares will be restricted but, it will no longer be subject to a limitation of 50 shareholders. IMM GSM Page 24 of 141 FM101

25 3.2 Distinguishing between forms of ownership A sole proprietary dissolves upon the death or retirement of the proprietor. A partnership must be dissolved upon the death or retirement of one of the partners and a new partnership agreement has to be drawn up. We will further distinguish between the forms of ownership on the basis of liability for debts and capital formation. Business Form Sole proprietary Partnership Close Corporation Private company Public company Liability Owner bears unlimited liability for debts may lose personal assets. Partners jointly and severally liable for debt of business may lose personal assets. Members liability limited to amount of money invested in business may under certain circumstances lose limited liability. Shareholders liability limited to amount of capital invested in shares. Shareholders liability limited to amount of capital invested in shares. Capital Owner provides own capital or borrows from financial institution. Partners provide own capital or borrow from financial institution. Members provide own capital or borrow from financial institution. Capital is raised by issuing shares to owners (not public) or borrowing from financial institution. Capital is raised by issuing shares to shareholders, or borrowing from public through debentures or borrowing from financial institutions. IMM GSM Page 25 of 141 FM101

26 3.3 Accounting and legal requirements We will summarise the differences in accounting requirements between different forms of business ownership in South Africa. Business Legal Financial Taxation Form statements Sole proprietary Partnership Close Corporation Private company Public company Very little legal requirements. Very little legal formalities. Partnership Agreement. Founding Statement. Certificate of Incorporation. Association Agreement to regulate relationship between members. Memorandum of Association and Articles of Association. Certificate of Incorporation. Memorandum of Association and Articles of Association. Certificate of Incorporation. Prospectus. Minimum subscription fulfilled. Certificate to Commence Business. Not regulated. Not regulated. Financial statements prepared but not required to be audited. Financial statements prepared but not required to be audited or lodged with Registrar of companies. Financial statements audited and lodged with Registrar of companies. Owner pays tax in personal capacity, not as business. Partners pay tax in personal capacity, not as business. CC pays tax on profits of business at preferential rates available to CC below certain turnover. Company pays tax on its profits. Company pays tax on its profits. IMM GSM Page 26 of 141 FM101

27 Transferring of ownership of shares in public companies (if they are members and their shares are listed on the JSE) takes place at the JSE Securities Exchange South Africa ( the JSE ). The JSE was formally established on 8 November 1887 as a market-place for the shares of South Africa s many mining and financial companies. 3.4 Types of business activity Please read Cloete & Marimuthu 2008: Chapter 1 Types of business activity. No outcome is set for this section but regard the reading as important background information. We can classify business types by various types of activities, including service businesses, manufacturers, wholesalers and retailers. Service businesses These businesses provide services for which they charge fees. Typical examples include attorneys, accountants, architects and information, communication and technology (ICT) companies. Manufacturers Manufacturers buy raw materials that they then transform into finished products which are sold to wholesalers and retailers. Wholesalers The term middleman is often associated with wholesalers, because they buy in bulk from manufacturers and then supply the goods in smaller quantities to retailers, or the public. IMM GSM Page 27 of 141 FM101

28 Retailers Retailers buy goods from the wholesalers or manufacturers and sell the goods to the general public. It is also stated that retailers can be viewed as service providers for reasons listed below: Bring goods within reach of the consumer Allow the consumer to buy on credit Pay attention to the need of their consumers Sell goods in small quantities Make consumers aware of new products on the market Offer convenience shopping. The format of financial statements will vary by the type of business. For instance, service businesses may have a category Fees Collected instead of Sales. One also needs to consider Work-In-Progress as part of inventory in a manufacturing environment, and that you will not find in a service business. IMM GSM Page 28 of 141 FM101

29 4. Financial and management accounting Reading reference Study Cloete & Marimuthu 2008: Chapter 1 The accounting field. Accounting accumulates data for reporting to external and internal users (with different objectives). Management accounting seeks to meet the need of the business managers in the firm and financial accounting seeks to meet the needs of all the other users. The major differences between the two types of accounting can be found in: Nature of the reports produced Level of detail provided in the reports Regulatory requirements related to the format and timing of accounting reports Interval at which reports are prepared Time horizon historical or forward looking Range and quality of information. You should now be able to master outcome 2. IMM GSM Page 29 of 141 FM101

30 Self-assessment exercise Now do Exercise 1 and Exercise 2 in Cloete & Marimuthu 2008: Chapter 1. Solutions Exercise 1 1. c 2. a 3. e 4. b 5. d Exercise d 2.2 b 2.3 d 2.4 d 2.5 c 2.6 c 2.7 c IMM GSM Page 30 of 141 FM101

31 5. Financial accounting concepts and terminology Study reference Study Cloete & Marimuthu 2008: Chapter 2. Wealth of a business is measured through the measurement: Assets Liabilities = Owner s equity It is important to define the terms that will be used throughout this subject and in subsequent studies in financial management. Term Definition Assets Resources controlled by an entity resulting from past events out of which future economic benefits will flow. OR In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset. Simply stated, assets represent ownership of value that can be converted into cash (although cash itself is also considered an asset). Non-current assets An item of value with a lifespan of more than one year. Property, plant and equipment Financial assets (e.g. investments) Intangible assets (e.g. patents, trade marks). Current assets An item of value with a lifespan of less than one year. Cash Debtors Stock. Liabilities Present obligations resulting from past events, the settlement of which leads to decreases in economic benefits. IMM GSM Page 31 of 141 FM101

32 Non-current liabilities Current liabilities Owner s equity OR In financial accounting, a liability is defined as an obligation of a firm arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future. Obligations of the business which are payable over a period of more than one year. Long-term loan Bond from bank over property. Obligations of the business which are payable within one year. Bank overdraft Creditors. Owner s interest in the business and comprises capital contribution less drawings, plus net profit, where: Income Expenses Income expenses = Net profit Receipts by a business for normal operations. Sales Fees earned Rent received Interest received. Amounts spent by a business during normal operations (excluding capital expenses) Rent paid Interest paid Advertising Salaries. We will return to a more comprehensive discussion of these terms later in this unit. IMM GSM Page 32 of 141 FM101

33 Self-assessment exercise Complete Exercise 1 and Exercise 2 in Cloete & Marimuthu 2008: Chapter 2. You will now be able to master outcome 3 IMM GSM Page 33 of 141 FM101

34 Solutions Exercise 1 NCA CA NCL CL OE I E a) Capital X b) Delivery vehicle X c) Weekly wages X d) Sales X e) Trading stock X f) Mortgage loan X g) Telephone account X h) Debtors (accounts receivable) X i) Computer X j) Interest received X k) Creditor (accounts payable) X l) Interest paid X m) Property X n) Discount allowed X o) Discount received X p) Depreciation X q) Stationery used X r) Stationery unused (stationery on hand) s) Bank overdraft X t) Drawings X u) Photostat machine X v) Shop fittings X X IMM GSM Page 34 of 141 FM101

35 Exercise 2 a) The monthly rental paid for the shops b) A loan raised from Bee Bank X c) Amounts owed to Megacity by customers d) Petty cash on hand. X 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 k) Cash at the bank X ASSET LIABILITY INCOME EXPENSE X X X X X X X IMM GSM Page 35 of 141 FM101

36 6. The accounting equation Study reference Study Cloete & Marimuthu 2008: Chapter 3 The basic accounting equation. 6.1 Basic accounting equation The three main elements of accounting fit together as follows: Assets = Owner s equity + Liabilities The right hand side of this equation represents all the money that is available to the business in the long term from the owners and the outside providers of funds to purchase assets (the left hand side of the equation). This equation is the Basic Accounting Equation. (BAE) Important! Please work through illustrative examples 1, 2 and 3 in the textbook. Self-assessment exercise Now do Exercise 1 and Exercise 2 in Cloete & Marimuthu Chapter 3 You should now be in a position to master outcome 4 IMM GSM Page 36 of 141 FM101

37 Solutions Exercise R R = R (Cash plus + motor vehicle) 1.2 R (Borrowings) 1.3 R (Owner investment) 1.4 Assets = Owner s equity + Liabilities R = R R Exercise Liabilities = R ( ) 2.2 Assets = R ( ) 2.3 Owner s equity = R ( ) 2.4 Liabilities = R ( ) 2.5 Assets = R ( ) 2.6 Owner s equity = R ( ). Hint: To solve make use of the BAE in each instance. IMM GSM Page 37 of 141 FM101

38 6.2 Effect of transactions on the basic accounting equation Study reference Study Cloete & Marimuthu 2008: Chapter 3 The effect of transactions on the basic accounting equation. This section is to strengthen your understanding of the BAE and is part of learning outcome 3. Every financial transaction, however simple or complex, affects the basic accounting equation. Important! Please ensure that you now work through the examples in the textbook of transactions affecting the BAE: Transactions that affect assets and equities only o Capital contributions o Loans o Purchase of assets for cash o Buying assets on credit o Payments to creditors o Withdrawals by the owner Transactions that give rise to income and expenditure o Income (cash) o Income (credit) o Expenditure (cash) o Expenditure (credit) Transactions involving payments by debtors. It should be noted that the accounting equation neither answers the question as to how much profit the business has generated nor the question about the financial position of the business. The accounting equation must therefore be adapted into an income statement (indicating profits made) and a balance sheet (statement of financial position). IMM GSM Page 38 of 141 FM101

39 Self-assesment exercise Now do Exercises 5, 6 and 7 in Cloete & Marimuthu 2008: Chapter 3. IMM GSM Page 39 of 141 FM101

40 Solutions Exercise 5 DATE ASSETS = OWNERS EQUITY + LIABILITIES Vehicles Equipment Debtors Bank Capital/ Income/ drawings expense Loan Creditors Exercise 6 OWNERS DATE ASSETS = LIABILITIES EQUITY + Capital/ Income/ Vehicles Equipment Debtors Bank Loan Creditors drawings expense IMM GSM Page 40 of 141 FM101

41 Exercise 7 DATE ASSETS = OWNER S EQUITY + LIABILITIES ACCOUNT DEBIT ACCOUNT CREDIT Bank Loan Loss on theft of asset Equipment Bank Loss on theft of asset Buildings Bank Drawings Bank Debtors Sales Wages Bank IMM GSM Page 41 of 141 FM101

42 Study Unit 2: Basic accounting concepts and financial statements This study unit addresses basic accounting matters such as the conceptual framework of basic accounting, the accounting cycle, year-end adjustments and an introduction to company financial statements. Mastering the year-end adjustments and an understanding of the components of the respective financial statements is critical to read financial statements. Specific learning outcomes After you have studied this module you should be able to: Describe the accounting cycle. Explain what year-end adjustments are and its impact on the financial statements. Interpret an income statement and balance sheet. IMM GSM Page 42 of 141 FM101

43 1. Basic accounting Study reference Please read Cloete & Marimuthu 2008: Chapter 4, Section 4.1 Conceptual framework. 1.1 Accounting conceptual framework Qualitative characteristics are the attributes that make the information provided in financial statements useful to users. The four (4) qualitative characteristics are understandability, relevance, reliability and comparability. Understandability An essential quality of the information provided in financial statements is that it is easily understood by all users. For this purpose, users are assumed to have a reasonable knowledge of business, economic activities, accounting, and a willingness to study the information with reasonable diligence. Relevance Information must be relevant and useful to the decision-making needs of users. Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting their past evaluation. Reliability Information must be reliable. Information has the quality of reliability when it is free from material error and bias and can be depended upon by the users to represent faithfully that which it either purports to represent or could reasonably be expected to represent. IMM GSM Page 43 of 141 FM101

44 Comparability Users must be able to compare the financial statements of a firm through time, in order to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different firms in order to evaluate their relative financial position, performance and changes in their financial position. Hence the measurement and display of the financial effect on like transactions and other events must be carried out in a consistent way throughout a firm and over time for that firm and in a consistent way for different firms. Accounting statements rest on four important principles which are so important that a note to the accounts must warn users if this is not the case. These principles are: The going concern it is assumed that a business is going to continue its operations in the future. The matching principal cost and revenue are matched to reflect the same time period, i.e., cost of materials or stock purchased will only be reflected against revenue generated by such materials or stock. Any materials or stock purchased and not yet used will be carried as a shortterm asset in the balance sheet. This principal is also known as the accruals principal. Prudence (conservatism) until a deal has been concluded and completed, profit cannot be counted and the lower asset value or profit alternatives will be reflected in the financial statements. Consistency once a method has been chosen by the accountant to treat accounting entries, it is essential that the same method is applied in future years. This will ensure that statements can be compared over time. IMM GSM Page 44 of 141 FM101

45 1.2 The accounting cycle Study reference Study Cloete & Marimuthu 2008: Chapter 4, Section 4.2 The accounting cycle. The accounting cycle is the series of steps that take place in order for financial statements to be accurately and uniformly produced at the end of an accounting period which is typically the length of one month, quarter of a year, or a whole year. Below is a list of the steps you would take to complete the accounting cycle, listed in the order that you would perform them, and with a brief summary of each step. 1. A transaction occurs between the business and some other entity. This transaction could be the revenue from the sale of a product or a payment to another business for services. 2. A source document is required to substantiate the transaction. 3. Analyse the transaction and how it relates to the accounting balance sheet. For example, determine which accounts are affected by the transaction and how they are affected. Record the transaction to a journal such as a sales journal. Journals are kept in chronological order and may be updated continuously, daily, or however often it is necessary. 4. Record the transaction to the general ledger. Take all of your entries and categorise them by the account. 5. Perform a trial balance. Debits and credits need to be equal at the end of an accounting cycle, so calculate the entries to ensure they match. 6. Prepare adjustments. Just because entries are recognised, does not mean the work has been performed. Revenue can only be recognised when the work has been completed, so adjust the entries accordingly. The adjustment can also be the result of accounting policies, such as provision for bad debts or depreciation on assets. IMM GSM Page 45 of 141 FM101

46 7. Perform trial balance with adjustments. Take the adjustments from Step 6 and prepare a trial balance. If the debits and credits do not match, then you need to adjust them to make sure they do match. 8. Perform closing entries using a general journal. Close the accounts in preparation of the next accounting cycle. Revenues and expenses need to be closed out, which means they need to have zero balances. Balances are moved to the next cycle. 9. Prepare a final trial balance after all closing entries have been made (summary of the closing entries in the general ledger). 10. Prepare financial statements. From the adjusted trial balance, these corrected balances are used to prepare the financial statements. 11. Analyse and interpret information contained in the financial statements. While the actual terminology, timeline, and other factors of the accounting cycle vary, the above steps represent the general steps included universally in the accounting cycle. In realistic scenarios, a streamlined process, aided by computer programs and other devices, allows an accountant to combine some of these steps and complete the process in less time and with less effort. For example, often, a computer program allows steps one and two to be combined and allows the steps to accurately appear on the journal or general ledger almost instantaneously. Also, calculations performed by a computer or calculator work to eliminate human errors. Self-assessment exercise Now do Exercise 1 in Cloete & Marimuthu 2008: Chapter 4. After you have studied this section you should be able to master learning outcome 1. IMM GSM Page 46 of 141 FM101

47 Solution Exercise 1 Shiloh Clothing Income statement for the year ended 28 February 20x2 Sales Less: Cost of sales Gross profit for the year Add: Other income Dividends received Rent income Gross income for the year Less: Operating expenses Advertising Bank charges Interest paid Electricity and water Licence Wages Stationery and postage Telephone Net profit for the year IMM GSM Page 47 of 141 FM101

48 Shiloh Clothing Balance sheet as at 28 February 20x2 Non-current assets Premises Vehicles Equipment Notes Cost price Accumulated depreciation Book value Investment Shares: JSE Current assets Stock Accounts receivable Bank Cash float TOTAL ASSETS Equity & liabilities Owner s equity Non-current liabilities Loan: PBS (17% p.a.) Mortgage bond (15% p.a.) Current liabilities Accounts payable TOTAL EQUITY & LIABILITIES Notes: 1) Statement of changes in equity Capital R Add: Net profit R Less: Drawings R R IMM GSM Page 48 of 141 FM101

49 1.3 Year-end adjustments Study reference Study Cloete & Marimuthu 2008: Chapter 4, Section 4.4 Year-end adjustments, depreciation. A number of adjustments can be made at year end, including: Depreciation Provision for doubtful debts Prepaid expenses Accrued expenses Accrued income Income received in advance/prepaid income Depreciation The benefits that a firm obtains from an asset extend over several years. The life of production machinery may extend over many years, whereas a companyowned motor car used by a salesman probably has a much shorter useful life. By accepting that the life of a fixed asset is limited, the accounts of a firm need to recognise the benefits of the fixed asset as it is consumed over several years. This consumption of a fixed asset is referred to as depreciation. A portion of the benefits of the fixed asset will be used up or consumed in each accounting period of its life in order to generate revenue. To calculate profit for a period, it is necessary to match expenses with the revenues they help earn. In determining the expenses for a period, it is therefore important to include an amount to represent the consumption of fixed assets during that period (that is, depreciation). IMM GSM Page 49 of 141 FM101

50 The Receiver of Revenue (SARS) controls the rate at which depreciation may be claimed in South Africa because it affects the profits, and consequently, the amount of tax payable. The rate of depreciation for different types of assets is published as schedules to Practice Notes. Special accelerated depreciation rates may also be available as incentive to develop industries or regions. The basics that underline depreciation are: 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 balance sheet, that is, at book value. Important! Please ensure that you now work through the depreciation examples in the textbook. Self-assessment exercise Now do Exercise 3 in Cloete & Marimuthu 2008: Chapter 4. IMM GSM Page 50 of 141 FM101

51 Solution Exercise 3 TKZ Stores journal entry as at 30 June Vehicles Depreciation Accumulated depreciation on vehicles Debit Credit Workings R x 20% = TKZ Stores journal entry as at 30 June Furniture and fittings Depreciation Accumulated depreciation on furniture and fittings Debit Credit Workings (R ) x 15% = TKZ Stores income statement as at 30 June Less: Operating expenses Depreciation ( ) R TKZ Stores balance sheet as at 30 June Non-current assets Cost Accumulated depreciation Book value Vehicles Furniture and fittings ( ) ( ) IMM GSM Page 51 of 141 FM101

52 1.3.2 Provision for doubtful debts Study reference Study Cloete & Marimuthu 2008: Chapter 4 Year-end adjustments, provision for doubtful debts. When sales are allowed on credit, the possibility exists that some of the debtors will not pay their outstanding debt. It is prudent that some provision for doubtful debt is created in order to give a more accurate report on the expected amount of outstanding debt, including a provision for doubtful debt. The amount provided for doubtful debt is estimated as a percentage of the total amount of debt outstanding and is based on past experience and the economic climate. The following situations could arise that relate to the provision of bad debt: Scenario Debit Credit Write off a bad debt when a provision for bad debt does not exist Create provision for doubtful debt Increase provision for doubtful debt Decrease provision for doubtful debt Write off a bad debt when provision for bad debt exists Bad debt acc. (expense) increase Bad debt acc. (expense) increase Bad debt acc. (expense) increase Provision for doubtful debt acc. (negative asset) decrease Provision for doubtful debt acc. (negative asset) decrease Debtors control acc. (current asset) decrease Provision for doubtful debt acc. (negative asset) increase Provision for doubtful debt acc. (negative asset) increase Bad debt acc. (expense) decrease Debtors control acc. (current asset) decrease IMM GSM Page 52 of 141 FM101

53 Important! Please ensure that you now work through the provision for doubtful debt examples in the textbook. Self-assessment exercise Now do Exercise 4 in Cloete & Marimuthu 2008: Chapter 4. IMM GSM Page 53 of 141 FM101

54 Solution Exercise 4 ZZ Traders journal entry as at 28 February bad debts Bad debts Debtors control Write off bad debt Debit 640 Credit 640 Bad debts Provision for doubtful debts Debit 728 Credit 728 Adjust provision for doubtful debts to 5% of outstanding debtors Outstanding debtors balance R = R Provision for doubtful debts should be ( x 5%) = R2 878 Currently the provision for doubtful debts is = R2 150 Therefore the provision must be increased by R728 in order to equal R ZZ Traders income statement as at 28 February Less: Operating Expenses Bad Debts Expense ( ) R ZZ Traders balance sheet as at 28 February Current assets Debtors ( ) R Less: Provision for doubtful debts R2 878 IMM GSM Page 54 of 141 FM101

55 1.3.3 Prepaid expenses Study reference Study Cloete & Marimuthu 2008: Chapter 4 Year-end adjustments, prepaid expenses. Prepaid expenses refer to payments made in one accounting period but are only due in the following accounting period. The matching principle requires that the amounts due in the following accounting period should be excluded from the expense for the current accounting period. Important! Please ensure that you now work through the prepaid expenses examples in the textbook. Accrued expenses Study Cloete & Marimuthu 2008: Chapter 4 Year-end adjustments, accrued expenses. Accrued expenses refer to payments due in the current accounting period but not yet paid. The matching principle requires that the amounts due in the current accounting period should be written off against income in the current accounting period. Important! Please ensure that you now work through the prepaid expenses examples in the textbook. IMM GSM Page 55 of 141 FM101

56 1.3.4 Accrued income Study reference Study Cloete & Marimuthu 2008: Chapter 4 Year-end adjustments, accrued income. Accrued income refers to income earned in the current accounting period but not yet received. The matching principle requires that the income earned in the current year should be recorded in full in the current accounting period. Important! Please ensure that you now work through the prepaid expenses examples in the textbook Income received in advance Study Cloete & Marimuthu 2008: Chapter 4 Year-end adjustments, income received in advance. Income received in advance refers to income earned in the current accounting period but not yet received. The matching principle requires that the income received in the current accounting period but only earned in the following accounting period should be recorded in the following accounting period. Important! Please ensure that you now work through the prepaid expenses examples in the textbook. You should have mastered learning outcome 2 if you have studied the section and have attempted the exercises. IMM GSM Page 56 of 141 FM101

57 Self-assessment exercise Now do Exercises 5, 6, 7and 8 in Cloete & Marimuthu 2008: Chapter 4. Solution Exercise 5 Purchases I/S Cost of sales Loan: ABC Bank B/S Current liab. Prepaid income B/S Current liability Depreciation (year) I/S Expense Debtors B/S Current asset Refreshments I/S Expense Wages I/S Expense Equipment B/S Current asset Rent paid I/S Expense Accumulated depreciation Interest received I/S Income Drawings Unused stationery Accrued income B/S Non-current asset B/S Owner s equity B/S Current asset Prepaid expenses B/S Current asset B/S Current asset Accrued expense B/S Current liability IMM GSM Page 57 of 141 FM101

58 Exercise 6 Angel Traders Income statement for period ended 30 June 20x0 Gross profit Add: Other income Rent received ( / 11mnths = 1 200pm x mnths Commission received ( ) Less: Expenses Stationery ( ) 600 Water and lights ( ) Bad debts ( ) 860 Depreciation on machinery R R xxx Angel Traders Balance sheet at 30 June 20x0 ASSETS R R Non-current assets Note Current assets Debtors ( ) Stationery on hand 100 Accrued income (rent income) Owners equity & liabilities Liabilities Accrued expense (water and lights) 320 Prepaid income (commission received) Note 1 Cost Machinery R Accumulated depreciation R ( ) Carrying value R IMM GSM Page 58 of 141 FM101

59 Exercise 7 Hot Chicks Income statement for the year ended 28 February 20x3 Sales Less: Sales returns Net sales Less: Cost of sales Opening stock Add: Purchases Less: Purchases returns Add: Carriage on purchases Goods available for sale Less: Closing stock Gross profit Add: Other income Rent received Discount received Gross income for the year Less: Operating expenses Carriage on sales Rates and taxes Salaries and wages Telephone Stationery Repairs Insurance Bad debts ( ) Depreciation ( ) (2 984) (42 029) Net profit for the year IMM GSM Page 59 of 141 FM101

60 Exercise 8 Pretty Princess Delivery Services Income statement for year ended 31 December 20x1 Income: Fees received Less: Expenses Spares used Insurance expense Salaries Municipal costs Rental paid Depreciation on office equipment Depreciation on delivery Interest payable 750 Net income R R IMM GSM Page 60 of 141 FM101

61 Pretty Princess Delivery Services Balance sheet at 31 December 20x1 ASSETS R R Non-current assets Note Current assets Stock of spares ( ) Debtors Expenses prepaid (insurance) ( ) Bank Total assets OWNER S EQUITY AND LIABILITIES OWNER S EQUITY Note Liabilities Current liabilities Creditors Accrued expense (interest) Note 1 Cost Accumulated depreciation Carrying value R R R Office equipment Delivery vehicles Note 2 Statement of changes in equity Capital Add: Net profit Less: Drawings (3 000) IMM GSM Page 61 of 141 FM101

62 2. Company financial statements Study reference Study Cloete & Marimuthu 2008: Chapter 5, Sections 5.1 and 5.2 GAAP and company terminology. 2.1 Generally Accepted Accounting Principles (GAAP) International Accounting Standards (IAS) are set by the International Accounting Standards Board (IASB) which is the main body of The International Accounting Standards Committee (IASC), located in London, England. The IASB is an independent accounting standard-setting body, consisting of 14 members from nine countries, including the United States. When the IASB sets a brand new accounting standard, a number of countries tend to adopt the standard, or at least interpret it, and fit it into their individual country s accounting standards. These standards, as set by each particular country s accounting standards board, will in turn influence what becomes Generally Accepted Accounting Principles for each particular country. The acronym GAAP stands for Generally Accepted Accounting Principles. The IASC does not set GAAP, nor does it have any legal authority over GAAP. The IASC can be thought of as merely a very influential group of people who love making up accounting rules. However, a lot of people actually do listen to what the IASC and IASB have to say on matters of accounting. The best way to think of GAAP is as a set of rules that accountants follow. Each country has its own GAAP, but on the whole, there aren t many differences between countries interpretations might vary from country to country, but everyone tends to agree that a company can t simply make up billions of dollars IMM GSM Page 62 of 141 FM101

63 worth of revenue and put it on its books. Every country, in turn, influences the other countries that follow GAAP. GAAP are imposed on companies so that investors have a minimum level of consistency in the financial statements they use when analysing companies for investment purposes. GAAP cover such things as revenue recognition, balance sheet item classification and outstanding share measurements. Companies are expected to follow GAAP rules when reporting their financial data via financial statements. That said, keep in mind that GAAP is only a set of standards. There is plenty of room within GAAP for unscrupulous accountants to distort figures. So, even when a company uses GAAP, you still need to scrutinise its financial statements. By law all companies have to use GAAP when preparing financial statements. For reporting periods beginning on or after 1 January 2005, South African statements of GAAP are fully aligned with International Financial Reporting Standards (IFRS). 2.2 Company terminology 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. Four types of profit companies can be identified according to the Companies Act, 2008: 1) a state-owned company (SOC); 2) a private company (Proprietary Limited) if it is not state-owned and the Memorandum on Incorporation prohibits it from offering its securities to the public and restricts the transferability of its securities; IMM GSM Page 63 of 141 FM101

64 3) a personal liability company (Incorporated) if it meets the criteria for a private company and the Memorandum of Incorporation states that it is a personal liability company; 4) a public company (Limited) in any other case. Of these companies, it is only the public company that can sell shares to the general public Share capital A public company can issue shares, which is known as share capital. Currently, if companies have par value shares, it means that the fixed value and amount of issued shares is indicated in the memorandum of association. In the case of companies with no par value shares, the memorandum of association only indicates the amount of issued shares as these shares do not have a fixed value. A major change introduced by the new Companies Act (Act No.71 of 2008), is that a share will no longer have a fixed or nominal value ( par value shares ), but will be fixed in number only ( no par value shares ). Authorised share capital Authorised share capital is the total number of shares a company is authorised to issue according to its Memorandum of Incorporation (previously memorandum of association) and approved by the Commission (previously the Registrar of Companies). A company s Memorandum of Incorporation must set out the classes of shares, and the number of shares of each class, that the company is authorised to issue. Issued share capital Companies do not issue all their shares they retain some of their shares as a reserve. The portion issued is called the issued share capital. Any unissued IMM GSM Page 64 of 141 FM101

65 shares can be issued later by the directors, subject to the rules set out in the Memorandum of Incorporation. Share premium Previously if a share was sold at a premium, then the issue price will be the par value plus an additional premium. So if a 1 cent nominal value share is issued at R2.01, then the par value was 1 cent and the premium was R2.00 per share. The company issuing the shares will receive R2.01 for each share issued. Under the new Companies Act, 2008 shares will no longer have a par value and the distinction between the par value and the share premium will fall away. Types of shares Shareholders of a company receive a share of the profits in the form of dividends. Dividends are dependent on the type of share they have purchased as well as the company s dividend policy. A company s Memorandum of Incorporation must set out the classes of shares, and with respect to each class of shares a distinguishing designation for that class; and the preferences, rights, limitations and other terms associated with that class Reserves Reserves are profits retained in the business and can take various forms. Non-distributable reserves These reserves are non-trading profits that cannot be distributed to shareholders and can for example arise from items such as revaluations of assets and some foreign exchange movements. Distributable reserves Distributable reserves are trading profits that have not been paid out by the company and may be distributed to shareholders at a later stage. IMM GSM Page 65 of 141 FM101

66 General reserves Profits that have been retained by the company in order to purchase assets are set aside under general reserves Profits, taxation, reserves and dividends Companies are liable to pay tax as separate legal entities. Company tax is payable on profit made during the course of business. Once taxation has been calculated and provided for payment to the Receiver of Revenue, the remainder of the profits can be divided between reserves, dividends and retained earnings. Important! Please ensure that you now work through Example 1 dealing with: Provisional tax payments Tax assessments Interim dividends Final dividends Distribution of net profit earned. Also work through Example 2 dealing with the preparation of financial statements. Self-assessment exercise Now do Exercise 1 in Cloete & Marimuthu 2008: Chapter 5. You should have mastered learning outcome 3 after you have studied the text and have attempted the exercise. IMM GSM Page 66 of 141 FM101

67 Solution Exercise 1 JT Limited Income statement for the year ended 28 February 20x1 Net income before taxation Less: Taxation Net income after taxation Transfer to general reserve Less: Preference dividends Less: Ordinary dividends Retained income for the year Add: Retained income at beginning of year (45 000) (6 000) (6 000) (24 000) Retained income at end of year IMM GSM Page 67 of 141 FM101

68 JT Limited Balance sheet as at 28 February 20x1 ASSETS Non-current assets Cost Accumulated depreciation Book value Land & buildings Motor vehicles Equipment Investment Current assets Stock Debtors TOTAL ASSETS EQUITY & LIABILITIES Shareholders equity Issued share capital Ordinary share capital Preference share capital General reserve (12 + 6) Retained income Non current liabilities Long-term loan Current liabilities Creditors Bank overdraft Receiver of Revenue (45-18) Shareholders for dividends (24 + 6) TOTAL EQUITY & LIABILITIES Note to the balance sheet Authorised share capital ordinary shares at R1 each % preference shares at R1 each IMM GSM Page 68 of 141 FM101

69 2.3 Annual financial statements of public companies This section together with the next section is intended to give you a complete picture of annual financial statements of public companies. Please consider this section as important reading material as it indicates the level of complexity that accountants and users of financial statements sometimes have to deal with. Financial statements of public companies have to be prepared according to specific guidelines as determined by the Companies Act 71 of 2008, which stipulates that annual financial statements are to be produced in the strict and complicated international financial reporting standards (IFRS) and the international auditing standards (IAS). IFRS financial statements consist of: A balance sheet Income statement Either a statement of changes in equity (SOCE) or a statement of recognised income or expense (SORIE) A cash flow statement Notes, including a summary of the significant accounting policies. Furthermore, annual financial statements of a public company must also include: An auditor s report A report by the directors with respect to the state of affairs, the business and profit or loss of the company, or of the group of companies, if the company is part of a group The remuneration, and benefits received by each director, or individual holding any prescribed office in the company. The International Accounting Standards Board (IASB) issued an accounting statement announcing changes to the titles of financial statements as they will be used in International Financial Reporting Standards (IFRS): IMM GSM Page 69 of 141 FM101

70 Balance sheet will become statement of financial position Income statement will become statement of comprehensive income Cash flow statement will become statement of cash flows. Entities are not required to use the new titles in their financial statements. The CFA Institute is a global association of investment professionals comprising the world s largest association of investment professionals. With over 100,000 members, and regional societies around the world, they are dedicated to developing and promoting the highest educational, ethical, and professional standards in the investment industry. The CFA Institute s Centre for Financial Market Integrity has developed a comprehensive manual for practitioners interested in guidelines to assisting in achieving best practice in Excellence in Corporate Reporting: A COMPREHENSIVE BUSINESS REPORTING MODEL: Financial Reporting for Investors According to the publication mentioned above, financial statements should be reported from the perspective of the shareholder who bears the ultimate risk, and with the shareholder s best interests held paramount. Accordingly, they state that financial statements should be fully transparent and report the fair values of all assets, liabilities, exchanges, and transactions that could potentially impact the investor and that all assets and liabilities should be included in the balance sheet, with no hidden assets, hidden debt, or hidden obligations. Source: The following model financial statements were published by Deloitte and are available from IMM GSM Page 70 of 141 FM101

71 2.3.1 Model income statement International GAAP Holdings Limited Consolidated statement of comprehensive income for the year ended 31 December 2009 Notes Year ended 31/12/09 Year ended 31/12/08 CU 000 CU 000 Continuing operations Revenue 5 140, ,840 Cost of sales (87,897) (91,840) Gross profit 53,021 60,000 Investment revenue 7 3,608 2,351 Other gains and losses ,005 Distribution expenses (5,087) (4,600) Marketing expenses (3,305) (2,254) Occupancy expenses (2,128) (2,201) Administration expenses (11,001) (15,124) Finance costs 9 (4,418) (6,023) Other expenses (2,801) (2,612) Share of profits of associates 20 1,186 1,589 Gain recognised on disposal of interest in former associate Profit before tax 30,303 32,131 Income tax expense 10 (11,564) (11,799) Profit for the year from continuing operations 13 18,739 20,332 Discontinued operations Profit for the year from discontinued operations 11 8,310 9,995 PROFIT FOR THE YEAR 27,049 30,327 Other comprehensive income Exchange differences on translating foreign operations (39) 85 Net value gain on available-for-sale financial assets Net value gain on cash flow hedges Gain on revaluation of properties - 1,150 Share of other comprehensive income of associates - - Other comprehensive income for the year, net of tax 66 1,312 TOTAL COMPREHENSIVE INCOME FOR THE YEAR 27,115 31,639 Profit attributable to: Owners of the Company 23,049 27,564 Non-controlling interests 4,000 2,763 Total comprehensive income attributable to: 27,049 30,327 Owners of the Company 23,115 28,876 Non-controlling interests 4,000 2,763 27,115 31,639 continued... IMM GSM Page 71 of 141 FM101

72 International GAAP Holdings Limited Consolidated statement of comprehensive income for the year ended 31 December 2009 continued Notes Earnings per share 14 From continuing and discontinued operations Year ended 31/12/09 CU 000 Year ended 31/12/08 CU 000 Basic (cents per share) Diluted (cents per share) From continuing operations Basic (cents per share) Diluted (cents per share) IMM GSM Page 72 of 141 FM101

73 2.3.2 Model balance sheet International GAAP Holdings Limited Consolidated statement of financial position at 31 December 2009 Assets Notes 31/12/09 31/12/08 01/01/08 CU 000 CU 000 CU 000 Non-current assets Property, plant and equipment , , ,058 Investment property 16 1, Goodwill 17 20,285 24,060 23,920 Other intangible assets 18 9,739 11,325 12,523 Investments in associates 20 7,402 7,270 5,706 Deferred tax assets Finance lease receivables Other financial assets 22 10,771 9,655 7,850 Other assets Total non-current assets 160, , ,966 Current assets Inventories 24 31,213 28,982 29,688 Trade and other receivables 25 19,735 16,292 14,002 Finance lease receivables Other financial assets 22 8,757 6,949 5,528 Current tax assets Other assets Cash and bank balances 23,446 19,778 9,082 83,474 72,249 58,563 Assets classified as held for sale 12 22, Total current assets 105,810 72,249 58,563 Total assets 266, , ,529 continued... IMM GSM Page 73 of 141 FM101

74 International GAAP Holdings Limited Consolidated statement of financial position at 31 December 2009 continued Equity and liabilities Capital and reserves Notes 31/12/09 31/12/08 01/01/08 CU 000 CU 000 CU 000 Issued capital 28 32,439 48,672 48,672 Reserves 29 4,237 3,376 1,726 Retained earnings ,805 94,909 73, , , ,222 Amounts recognised directly in equity relating to assets classified as held for sale Equity attributable to owners of the Company 147, , ,222 Non-controlling interests 31 24,316 20,005 17,242 Total equity 171, , ,464 Non-current liabilities Borrowings 32 20,221 31,478 28,014 Other financial liabilities 34 15, Retirement benefit obligation Deferred tax liabilities 10 4,646 3,693 2,593 Provisions 35 2,294 2,231 4,102 Deferred revenue Other liabilities Total non-current liabilities 43,069 38,119 35,489 Current liabilities Trade and other payables 37 16,373 21,220 52,750 Borrowings 32 22,446 25,600 33,618 Other financial liabilities Current tax liabilities 10 5,270 5,868 4,910 Provisions 35 3,356 3,195 2,235 Deferred revenue Other liabilities ,006 56,048 93,576 Liabilities directly associated with assets classified as held for sale 12 3, Total current liabilities 51,690 56,048 93,576 Total liabilities 94,759 94, ,065 Total equity and liabilities 266, , ,529 IMM GSM Page 74 of 141 FM101

75 2.3.3 Model cash flow statement (direct method) International GAAP Holdings Limited Consolidated statement of cash flows for the year ended 31 December 2009 Notes Year ended 31/12/09 Year ended 31/12/08 CU 000 CU 000 Cash flows from operating activities Receipts from customers 211, ,487 Payments to suppliers and employees (165,666) (181,378) Cash generated from operations 45,366 33,109 Interest paid (4,493) (6,106) Income taxes paid (13,848) (13,340) Net cash generated by operating activities 27,025 13,663 Cash flows from investing activities Payments to acquire financial assets (3,163) (2,163) Proceeds on sale of financial assets 938 1,712 Interest received 2,315 1,313 Royalties and other investment income received 1, Dividends received from associates Other dividends received Amounts advanced to related parties (738) (4,311) Repayments by related parties 189 1,578 Payments for property, plant and equipment (22,932) (11,875) Proceeds from disposal of property, plant and equipment 11,462 21,245 Payments for investment property (10) (12) Proceeds from disposal of investment property - 58 Payments for intangible assets (6) (358) Net cash outflow on acquisition of subsidiaries 44 (477) - Net cash inflow on disposal of subsidiary 45 7,566 - Net cash inflow on disposal of associate Net cash (used in)/generated by investing activities (3,173) 8,250 Cash flows from financing activities Proceeds from issue of equity shares Proceeds from issue of convertible notes 4,950 - Payment for share issue costs (6) - Payment for buy-back of shares (17,011) - Payment for share buy-back costs (277) - Proceeds from issue of redeemable preference shares 15,000 - Proceeds from issue of perpetual notes 2,500 - Payment for debt issue costs (595) - Proceeds from borrowings 17,122 26,798 Repayment of borrowings (37,761) (23,209) Proceeds from government loans 2,610 - Proceeds on disposal of partial interest in a subsidiary Dividends paid on redeemable preference shares (613) - Dividends paid to owners of the Company (6,635) (6,479) Net cash used in financing activities (20,089) (2,890) Net increase in cash and cash equivalents 3,763 19,023 Cash and cash equivalents at the beginning of the year 19, Effects of exchange rate changes on the balance of cash held in foreign currencies (80) (184) Cash and cash equivalents at the end of the year 46 23,083 19, Reading financial statements IMM GSM Page 75 of 141 FM101

76 In this section we will describe the financial statements with reference to the model financial statements provided in the previous pages Income statement The income statement measures the operating performance during a given accounting period. It reflects the normal operating transactions, and includes losses or gains on the disposal of assets and other non-recurring and extraordinary events. Unlike the balance sheet, which shows the condition of a firm at a specific point in time, the income statement measures the income over a period. Revenue is measured at the fair value of the consideration received or receivable. Revenue is usually reduced for estimated customer returns, rebates and other similar allowances. Cost of Sales (C.O.S. for short) is the expense a company incurred in order to manufacture, create, or buy inventory. It includes the purchase price of the raw material as well as the expenses of turning it into a product. The table that follows shows the cost of sales calculations for a trading firm and a manufacturing firm, respectively. Trading Company Manufacturing Company Opening Stock Opening Stock Plus Purchases Plus Manufacturing Labour Plus Other Charges Plus Raw Material (customs duty, freight, railage) Plus Manufacturing Overhead Less Closing Stock Less Closing Stock Gross profit is the total revenue subtracted by the cost of generating that revenue. It tells you how much money a business would have made IMM GSM Page 76 of 141 FM101

77 if it didn t pay any other expenses such as salaries, general administration expenses and income taxes. Investment revenue comprises rental income earned through investment properties and interest received earned through assets such as bank deposits. Other gains and losses arise from items such as: Gain/(loss) on disposal of property, plant and equipment Gain/(loss) on disposal of available-for-sale investments Government grants received for staff retraining Net foreign exchange gains/(losses) Gain/(loss) arising on effective settlement of legal claims. Distribution expenses are costs to the business when sending its finished goods out to customers and may also include payroll costs (salaries, commissions, and travel expenses of executives, salespeople and employees), involved in sales. Marketing expenses advertising expenses a company incurs in selling the products or services. Occupancy expenses include rent, depreciation and amortisation, utilities, maintenance, insurance, rates and taxes, and other expenses of premises occupied by the business. Administration expenses consists of salaries paid to employees not directly involved in the selling of the product, research and development costs, and other miscellaneous charges that must be subtracted from the company s income. Finance cost relates to interest paid on bank overdrafts, loans and financial lease obligations. IMM GSM Page 77 of 141 FM101

78 Income tax represents the sum of the tax currently payable and deferred tax. The tax currently payable is based on taxable profit for the year. Taxable profit differs from profit as reported in the income statement because of items of income or expense that are taxable or deductible in other years and items that are never taxable or deductible Balance sheet Assets Assets are grouped into non-current assets and current assets. Non-current assets are assets intended for continuing use over a period longer than 12 months. Examples include: Property, plant and equipment Investments Goodwill Other intangible assets. Intangible assets cannot be seen or touched and include items such as goodwill, patents, brands and trade marks. Goodwill in financial statements arises when a company is purchased for more than the fair value of the identifiable assets of the company. The difference between the purchase price and the sum of the fair value of the net assets is by definition the value of the goodwill of the purchased company. Although goodwill is technically an intangible asset, goodwill and intangible assets are usually listed as separate items on a company s balance sheet. The International Financial Reporting Standards (IFRS) require that all costs, both tangible and intangible involved in the purchase of one company by another to be IMM GSM Page 78 of 141 FM101

79 reported. However, it is not easy to accurately value intangible assets such as brands. In an article in Business Day, Dr. Roger Sinclair, Professor of marketing at the Witwatersrand and MD of valuation firm BrandMetrics, wrote an article Measuring Value: when fair seems foul, on the difficulty of valuing brands where he referred to the Barclays-ABSA deal. Barclays Bank had to report the ABSA brand value in their balance sheet, but at a value which Dr. Sinclair regards to be a very unrealistic valuation. The ABSA brand was only valued at 172m or about R1,8bn as reported in Barclays Bank annual financial statements, when ABSA earned R4.5bn in the year of the takeover and had assets worth R80bn. He comments that The notion of brands as assets is very new to accountants and it will take some time for them to understand that they differ drastically from what they are used to. Current assets are those that form part of the circulating capital of a business. They are replaced frequently or converted into cash during the course of trading. The most common current assets are: Inventory (stock) Trade receivables (debtors or account receivables) Cash. The inventory of a manufacturer is composed of three groups: Raw materials to be used in the product Partially finished goods in process of manufacture Finished goods ready for shipment to customers. The generally accepted method of valuation of the inventory is cost or market, whichever is lower. This gives a conservative figure. Where this method is used, the value for balance sheet purpose will be cost, or perhaps less than cost if, as a result of deterioration, obsolescence, decline in prices, or other factors, less than cost can be realised on the inventory. Inventory valuation includes an allocation of production and other expenses as well as the cost of materials. IMM GSM Page 79 of 141 FM101

80 Trade receivables represent the amount due from customers but not yet collected. When goods due are shipped prior to collection, a receivable is recorded. Customers are usually given 30, 60, or 90 days in which to pay. Experience shows that some customers fail to pay their bills, either because of financial difficulties or some catastrophic event befalling their business. Therefore, in order to show the trade receivable item at a figure representing expected receipts, the total is after a provision for doubtful accounts. Cash represents notes and coins and money on deposit in the bank. Prepaid expenses may arise for a situation such as this: During the year, insurance premiums and advertising charges for the next year are paid. Those insurance premiums and advertising service are as yet unused at the balance sheet date, so there exists an unexpended item, which will be used up over the next 12 months. If the advance payments had not been made, the company would have more cash in the bank. So, payments made in advance from which the company has not yet received benefits, but for which it will receive benefits next year, are listed among current assets as prepaid expenses. Capital and reserves Issued capital and reserves Issued capital refers to the funds invested in the firm by the owners or shareholders. This section of the balance sheet also shows any reserves that have been retained in the firm. The reserves can be either classified as distributable or non-distributable reserves. Distributable reserves can be handed out to shareholders by way of dividend payments. Retained earnings When a firm generates a profit, management has one of two choices: they can either pay it out to shareholders as a cash dividend, or retain the earnings and reinvest them in the business. When the executives decide that earnings should be retained, they have to account for them IMM GSM Page 80 of 141 FM101

81 on the balance sheet under Shareholder Equity. This allows investors to see how much money has been put into the business over the years. Liabilities Liabilities are debts owed to other parties. Non-current liabilities are debts incurred by the firm that are not payable within the next 12 months such as secured or unsecured loans. Current liabilities are debt owed and payable within the next 12 months such as accrued expenses, creditors and bank overdrafts. An accrued expense is a debt that has been incurred or has accumulated over a period of time and must be paid but has not yet been paid. Contingent liabilities are debts that the firm may be faced with in future. Examples of contingent liabilities include legal disputes, guarantees or assets financed with residual values. These are revealed in the notes to the balance sheet The cash flow statement The cash flow statement forms part of the annual financial statements and tells us where the cash came from went to and what happened to the balance sheet for the period in question. Unlike the income statement that explains changes in one balance sheet item only, i.e. retained earnings, the cash flow statement explains the sources from which the firm acquired its funds and the uses to which they were put. The cash flow statement comprises four sections that can broadly be labelled as cash flows from operating activities, cash utilised in investing activities, cash flows from financing activities, and cash and cash equivalent summation. IMM GSM Page 81 of 141 FM101

82 The current income statement and balance sheet for the current and previous year is required for construction of the cash flow statement. Cash from operating activities Typically this section will reflect the income from normal trading activities such as the trading profit plus depreciation (remember that depreciation is not a cash expense). The net result of changes to working capital (current assets and current liabilities) is also reflected in this section of the cash flow statement. Finally other expenses such as dividend payments and taxation are subtracted to arrive at the net cash flow from operating activities. Cash utilised in investing activities This section will reflect expenditure such as the replacement of properties, fixtures, equipment and vehicles for the purpose of maintaining or expanding the current level of activities in the firm. It may also reflect the proceeds on disposal of properties, fixtures, equipment and vehicles. Cash flows from financing activities The firm is also funded by external sources. In this section changes to the external sources of funds are reflected. It may include items such as the redemption of preferential shares, buyback of shares, issuing of shares, increasing or decreasing interest-bearing debt. Cash and cash equivalent summation The final section of the cash flow statement shows the net increase or decrease in cash and cash equivalents for the current year. The cash and cash equivalents balance from the previous year are added to this number to arrive at the cash and cash equivalent for the current year. IMM GSM Page 82 of 141 FM101

83 Important! Buy a newspaper that normally publishes financial news and locate the annual financial statements of a company of your choice (preferably a retailing business). Now practice your skill to read the financial statements. You could also find the annual financial statements for a listed company on the company website usually under the heading Investor relations. This concludes the section on the reading of financial statements and the study unit on accounting concepts and terminology. IMM GSM Page 83 of 141 FM101

84 Study Unit 3: Determine the selling price of merchandise This study unit addresses the concept value added tax, and the calculation of selling price of merchandise (inclusive and exclusive of VAT) using mark-up on cost and selling price. Mastering VAT calculations and mark-up is critical to ensure accurate calculation of selling prices. Specific learning outcomes After studying this unit, you should be able to: Calculate cost of sales. Explain VAT concepts and calculate VAT. Calculate mark-ups on cost price and selling price. Calculate selling price (inclusive and exclusive of VAT). Study reference IMM GSM Page 84 of 141 FM101

85 Study Cloete & Marimuthu 2008: Chapter 7 Value added tax. 1. Value added tax 1.1 Introduction Value-added tax (more commonly known by its abbreviation, VAT) is an indirect tax levied by vendors on the supply of goods or services. Vendors, who are registered for VAT, are generally obliged to charge and collect VAT on taxable supplies from their customers or clients on behalf of SARS. VAT is levied and accounted for at the prescribed rate, which is presently 14% (standard rate), and is ultimately paid by the final consumers of goods and services. For certain goods and services, a special rate of 0% VAT (zero rate) is applied, while a limited range of goods and services are exempt. VAT is also levied on the importation of goods and services. VAT is only charged on taxable supplies made by a vendor. Taxable supplies include supplies for which VAT is charged at either the standard rate or zero rate, but does not include: Salaries and wages Hobbies or any private recreational pursuit (unless the hobby becomes a business) Private sale of personal or domestic items Exempt supplies (see section further on in this study unit). 1.2 Vendors When a business is registered as a vendor, it means two things: The vendor must collect VAT from customers and pay this VAT to SARS. IMM GSM Page 85 of 141 FM101

86 The vendor can claim back any VAT that is paid on anything bought for the business. If the turnover (the total of all the sales, without subtracting the costs) of a business is more than R1,000,000 per year, then the business must be registered as a vendor by completing VAT101 and VAT127. When you start a business and you think the turnover will be more than R1m, then you have to register as a vendor. If the turnover of the business is less than R1m per year, the owner can choose to register or not if taxable supplies of more than R50,000 per year is made. If you register, this is called voluntary registration. It takes a lot of effort and work to pay VAT to SARS regularly and to keep all the records the SARS wants a vendor to have. If you don t have to register, it is only a good idea to register if the business buys lots of things from suppliers and can claim back VAT to reduce the amount of VAT you owe SARS. If the business is a sole trader or a partnership, the owners must register in their own names. If the business is a CC or a company, the owners must register in the name of the business. 1.3 Types of supply Supplies fall into two categories: Taxable supplies (standard rate and zero rate) Exempt supplies Taxable supplies Standard rate Standard rated supplies are taxed at the rate of 14%. Zero-rate IMM GSM Page 86 of 141 FM101

87 Zero-rated supplies of goods and services are subject to VAT at the rate of zero percent. Vendors who make zero rated supplies may recover related input tax unless it is specifically prohibited. The application of the zero rate to any transaction must be supported by documentation acceptable to SARS. Zero-rated supplies include: Exports Goods rented out for use outside South Africa Going concern sales International transport of goods and/or passengers Services relating to foreign land Processing and repairing imported goods which are to be re-exported Services rendered physically outside South Africa Certain services rendered to non-residents The sale of maize meal, bread, milk, fresh fruit and vegetables, rice, vegetable oil, eggs, legumes and certain other specified basic foodstuffs Certain gold coins, including Kruger Rands Gold supplied to the SA Reserve Bank, SA Mint or to any registered bank Exempt supplies Exempt supplies are supplies of goods or services on which VAT is not chargeable at either the standard rate or the zero rate and does not form part of taxable turnover. If a business makes only exempt supplies, it cannot register as a vendor for VAT purposes. Accordingly, VAT incurred on any expenses in order to make exempt supplies may not be claimed as input tax. Exempt supplies include the following: Financial services (interest, life insurance, medical schemes, provident, pension and retirement annuity funds) Donated goods or services sold by non-profit bodies (e.g. church bazaars) IMM GSM Page 87 of 141 FM101

88 Renting a dwelling for use as a private home (but not holiday accommodation) Passenger transport in South Africa by taxi, bus, or train Educational services (crèches, primary and secondary schools, universities, and other institutions registered under an educational Act). 1.4 Paying VAT Input tax A vendor can claim back any VAT that is paid on anything bought for the business. The VAT which the vendor can claim back is called an input credit and it means tax charged and payable by a supplier on the supply of goods or services made by that supplier to a vendor, or the vendor on the importation of goods, or a vendor on excise duty in certain circumstances. The notional input tax paid by a vendor in respect of second-hand and repossessed goods (see Notional input tax below). Notional input tax may be claimed by a vendor in certain circumstances, that is, he/she may claim an amount of input tax which he/she has not actually paid to the supplier. This applies in respect of Second-hand goods acquired by the vendor from a non-registered vendor for the purpose of making a taxable supply, and goods repossessed by the vendor under an instalment credit agreement Output tax The VAT that is charged by a vendor to customers is called output tax. Output tax is the tax charged in respect of the supply of goods and services by a vendor, a supply deemed to have been made during the tax period. For example, the following transactions are deemed to be supplies for the purposes of VAT: IMM GSM Page 88 of 141 FM101

89 where goods have been removed from stock for private consumption, where payment has been received from the State in respect of a taxable supply of goods and services, receipt of an indemnity payment under a contract of insurance, provision of certain fringe benefits, and certain other adjustments that is, bad debts recovered debit and credit notes VAT payable/refund Output tax less the input tax in a particular tax period equals the amount payable/refundable to/by SARS. Example: A canning factory buys pineapple pieces from a farmer (registered for VAT) for R1.14 (including 14c VAT). The factory sells the tin of pineapple pieces to a supermarket for R2.00 (excluding VAT), and charges VAT of 28c (R2.00 x 14%) on the sale. The total selling price would thus be R2.28. The 28c VAT is the supermarket s input tax and the canning factory s output tax. The supermarket sells the tin of pineapple pieces to the customer (not registered for VAT) for R3.42 inclusive of VAT (R c VAT). The 42c VAT is the supermarket s output tax. There is no input tax on the 42c as the customer is not a vendor. Important! Please ensure that you now work through illustrative examples 1 and 2. IMM GSM Page 89 of 141 FM101