MBA 2 Accounting for Decision Making Jan 2014

ACCOUNTING FOR

DECISION-MAKING

STUDY GUIDE

PROGRAMME : MBA Final Year

CREDIT POINTS : 20 points

NOTIONAL LEARNING: 200 hours over 1 semester

TUTOR SUPPORT : [email protected]

Copyright © 2014

MANAGEMENT COLLEGE OF SOUTHERN AFRICA

All rights reserved; no part of this book may be reproduced in any form or by any means, including

photocopying machines, without the written permission of the publisher

REF: ACCDM 2014

Accounting for Decision-Making

MANCOSA - MBA FINAL YEAR 1

MODULE CONTENTS: ACCOUNTING FOR DECISION-MAKING

TOPIC

NUMBER

TOPIC

PAGE(S)

Readings

3

1

Accounting information and managerial decisions

5

2

Financial statements and accounting concepts

17

3

Accounting for and presentation of assets, liabilities and owners’ equity

40

4

Income statement and cash flows

61

5

Financial Analysis

82

6

Cost-volume-profit (CVP) relationships

125

7

Cost analysis for planning, control and decision-making

153

8

Transfer pricing for decentralised enterprises

183

9

Corporate governance

193





READINGS

Prescribed

Marshall D.H., Mcmanus W.W. and Viele D.F. (2011) Accounting: What the numbers mean,

9th

Edition, McGraw-Hill: New York

Recommended

The following books are highly recommended for further reading.

The books that are recommended for each topic are indicated at the start of the topic.

Atrill P and Mc Laney E (2002) Management Accounting for Non-specialists, Third edition,

Pearson Education Limited: Essex

Berry A. and Jarvis R. (2006) Accounting in a business context, Fourth edition, Thomson

Learning: London (Chapter 3)

Davies T. and Pain B. (2002) Business Accounting and Finance, First Edition, McGraw-Hill:

UK

Drury C. (2005) Management Accounting for Business, Third edition, Thomson Learning:

London

Gowthorpe C. (2005) Business Accounting and Finance for non-specialists, Second edition,

Thomson Learning: London

Hand L., Isaaks C. and Sanderson P (2005) Introduction to Accounting for Non-Specialists,

First edition, Thomson Learning: London

Ingram R.W., Albright T.L., Baldwin B.A. and Hill J.W. (2005) Accounting: Information for

Decisions, Third edition, Thomson South-Western: Canada

Jackson S. and Sawyers R (2006) Management Accounting, International Student Edition,

Thomson South-Western: Singapore

Lubbe I. and Watson A. (2006) Accounting: GAAP Principles, First edition, Oxford

University Press Southern Africa: Cape Town

Niemand A.A., Meyer L., Botes V.L. and van Vuuren S.J. (2004) Fundamentals of Cost and

Management Accounting, Fifth edition, LexisNexis Butterworths: Durban

Warren C.S. (2007) Survey of Accounting, Third edition, Thomson South Western: USA

Wood F. and Sangster A. (2005) Business Accounting, Tenth edition, Prentice Hall: China





TOPIC 1

ACCOUNTING INFORMATION AND MANAGERIAL DECISIONS

LEARNING OUTCOMES

Students should be able to:

► identify the wide range of users of financial information.

► describe the uses of financial information.

► compare and contrast management accounting and financial accounting.

► distinguish between the information needs of external and internal users.

► explain the significance of internal auditing.

► describe the role of the management accountant.

► apply a basic decision-making model.

► recognise the risk in decision-making.



CONTENTS

1. Introduction

2. Accounting information and managerial decisions

3. Internal auditing

4. The role of the management accountant

5. A basic decision-making model

6. Role of risk in decision-making

7. Self-assessment activities and solutions

READING

Prescribed


9th

Edition, McGraw-Hill: New York. (Chapter 1)

Recommended


UK (Chapters 1 and 2)


Thomson South-Western: Singapore. (Chapter 1)



1. INTRODUCTION

The original purpose of accounting was to record transactions and present financial

statements. However, accounting has evolved and the American Accounting

Association sees accounting as “the process of identifying, measuring and

communicating economic information to permit judgements and decisions by users of

information”. A major focus of accounting now is the input that it provides for

decision-making.

2.

ACCOUNTING INFORMATION AND MANAGERIAL DECISIONS

All organisations – large or small; manufacturing, retail or service; profit or non-

profit – have a need for accounting information. The primary role of accounting is

to provide useful information for the decision-making needs of financiers (investors,

lenders, owners), managers and others both inside and outside the organisation.

Accounting is link between business activities and business decisions. Ingram et al

(2005: 59) uses the following model to describe the link:

Exhibit 1-1

Business

Activities

Operating

Investing

Financing

Accounting

Measuring

Recording

Reporting

Analysing

Business

Decisions

Actions Based on Business Decisions

Business environments have changed dramatically. Companies of all sizes now

compete in a dynamic global marketplace. Clients demand specialised products and

services and information relating to product availability, order status and delivery

times. Suppliers require information on their clients’ sales and stock levels in order

to tailor their production schedules and delivery times. Shareholders demand greater

returns and capital gains from their investments.

All these changes necessitate more effective management of knowledge within an

organisation. Organisations generate great volumes of data. Data becomes



information when it is organised, processed and summarised. Information becomes

knowledge when it is shared and exploited to add value to an organisation.

Accounting information includes both financial and non-financial information used

by decision-makers. Jackson and Sawyers (2006: 5) portray a contemporary view of

accounting information as follows:

Exhibit 1-2

Accounting information

Traditional Financial

Accounting

Information

Non-financial

Information

Financial

information

▪ Balance sheet

▪ Income statement

▪ Cost of goods

manufactured

▪ Gross profit

▪ Operating expenses

Other quantitative

information

▪ Percentage of defects

▪ Number of customer

complaints

▪ Warranty claims

▪ Units in inventory

▪ Budgeted hours

Qualitative

information

▪ Customer satisfaction

▪ Employee satisfaction

▪ Product or service quality

▪ Reputation

The responsibilities of accountants within an organisation tend to be split between the

main functions of financial accounting and management accounting. Financial

accounting is the area of accounting that is primarily concerned with the preparation

of general use financial statements for use by creditors, investors and other users

outside the business (external users). Management accounting, on the other hand, is

primarily concerned with generating financial and non-financial information for use

by managers in their decision-making roles within the organisation (internal users).



? THINK POINT

What are the information needs of external users?

The major differences between financial and management may be tabulated as

follows:

Management accounting Financial accounting

User groups Internal users: Managers External: Owner(s); Lenders,

Creditors; Investors

Nature of reports Reports tend to be specific usually

with some decision in mind.

Reports tend to be general-purpose

useful to a wide range of users.

Legal

requirements

Management accounting reports

are not required by law since they

are for internal use only.

Financial reports are required by law

and are also regulated in terms of

content and format.

GAAP Management accounting reports

are not subject to the practices and

principles of GAAP (Generally

Accepted Accounting Practice).

Financial reports must conform to

the practices and principles set by

GAAP.

Time focus The emphasis is on the future but

also provides information on past

performance.

It reflects on the financial result and

financial position for the past period.

Nature of

information

Information used may be less

objective and verifiable.

Objective and verifiable information

is needed to prepare reports.

Frequency of

reporting

Reports are produced as often as

required by managers even on a

weekly basis.

Reports are produced annually

although some businesses prepare

half-yearly or even quarterly reports.

Focus on the

whole or parts of

the business

Focuses on parts of the business

e.g. a certain department as well

as the business as a whole.

Focuses on the performance of the

business as a whole.



●

●

●

●

The information needs of external users (refer to think point above) may be

summarised as follows:

Investors have invested money in an enterprise. They require information on the

return on their investments and the financial position of the enterprise.

Creditors and lenders of money (e.g. banks) will be interested to know whether the

amounts owing to them will be paid on the due date.

Employees concern with accounting information has to do with job security,

employment opportunities and salary negotiations.

Government: Financial results are required by the government tax collection agency

to calculate the taxes payable to the government. Statistical analyses are also done by

the government to enable it to plan and draft policies.

●

The information needs of internal users (managers) may be summarised as

follows:

Information is needed to enable managers to make better and informed decisions.

Management requires a steady flow of information to respond to possible problems.

This information could be in the form of reports, spreadsheets, graphs etc. Managers

have to evaluate the information and make their decisions.

● Up-to-date accounting information is needed for effective planning. Planning relate

to the setting of goals or objectives and the formulation of policy.

● Information is also required for control purposes. It can help decision-makers to

determine that they are not where they want to be. The accounting information can

help them to determine what went wrong and what they might do get back on track.

3.

INTERNAL AUDITING

An annual audit of accounts is a legal requirement for public companies. According

to Davies and Pain (2002: 248) the main duty of external auditors is to report to

shareholders and others whether, in their opinion, the financial statements show a true

and fair view, and comply with statutory, regulatory and accounting standard

requirements. However, the report does not guarantee that the financial statements are

correct, that the organisation will not fail and that there has been no fraud. As a result

internal auditing became a necessity.



According to the Institute for Internal Auditors (UK) internal audit “is an

independent appraisal function established within an organisation to examine and

evaluate its activities as a service to the organisation. The objective of internal

auditing is to assist members of the organisation in the effective discharge of their

responsibilities. To this end, internal auditing furnishes them with analyses,

appraisals, recommendations, counsel and information concerning the activities

reviewed.”

The internal auditors report to the audit committee of the company. The committee

should consist of members of the board of directors who are not part of the

organisation’s management.

4. THE ROLE OF THE MANAGEMENT ACCOUNTANT

As a consequence of the advances made in accounting information systems and the

automation of accounting functions, the role of the management accountant has

shifted from collecting data to analysing information and creating knowledge from

this information. The role of management accountants is to interpret information and

put it into a suitable format for other managers, thereby facilitating management

decision-making. The work of management accountants often involves close co-

ordination with the financial, production and marketing functions of an organisation.

5.

A BASIC DECISION-MAKING MODEL

Decision-making, a key element of management accounting, is a process of

identifying various courses of action (alternatives) and selecting the most appropriate

one. Jackson and Sawyers (2006: 13) suggest a four-step decision-making model that

allows one to approach complex decisions in an orderly manner. Although the model

may not guarantee that all decisions will be correct, it does increase the probability of

making a good decision. The model may be illustrated as follows in Exhibit 1-3:



Exhibit 1-3

TThhee DDeecciissiioonn––MMaakkiinngg mmooddeell

Step 4 Select the best option

Step 3 Identify and analyse available options

Step 2 Identify objectives

Step 1 Define the problem

Step 1: Define the problem

Defining the problem accurately is important as many decision-makers make bad

decisions through trying to solve the wrong problem. The input of managers of all the

functional areas is advised in order to get a clearer picture of the underlying problem.

For example, if the organisation is experiencing a problem with it’s control over

expenses, the co-operation of all functional mangers is essential in getting to the root

of the problem.

Step 2: Identify objectives

This step involves the identification of objectives in finding a solution to the problem.

The objectives may be quantitative (e.g. reduce expenses by 20 per cent) or

qualitative (train employees in cost reduction techniques) or a combination of both.

Step 3: Identify and analyse available options

The options available to attain the objectives must now be identified and analysed.

One must consider the relevant variables that affect the problem as well as alternative

courses of action. It is recommended that more than one option and multiple variables

be considered.

Step 4: Select the best option

The decision-maker must examine the extent to which each of the options will

achieve the objective(s). Decisions should be based on both quantitative and

qualitative information. It must be borne in mind that decisions are often made

against the backdrop of uncertainty and the element of risk is usually present. Once

the best option is selected, the decision is implemented and the results are evaluated.



6.

ROLE OF RISK IN DECISION-MAKING

As mentioned above, most decisions involve risk. The attitude of the decision-maker

towards risk has a significant influence on the option that is chosen. Decision makers

who are risk seekers will rate alternatives differently from decision-makers who are

risk-averse. For example, risk-averse decision makers may rate more highly a

machine needed in production that is made by established manufacturers than one

made by a new company.

Another way of adjusting for risk is by taking into account the possibility that

certain events may occur. For example, in the choice of a machine, it is possible that

the price of the machine may increase before the decision to purchase is made.

The third way of considering risk is to establish the sensitivity of the decisions to

changes in the key variables that were considered during the analysis. For example,

the purchaser of the machine may not be totally sure of getting the best financing

options from all the manufacturers. The purchaser may now consider the cost of the

machine taking into account all possible financing options. If this adjustment changes

the decision, then the decision is sensitive to changes in that variable. If not, then the

decision is not sensitive to that variable.

7.

7.1

7.1.1

7.1.2

7.1.3

7.1.4

7.1.5

7.1.6

SELF-ASSESSMENT ACTIVITIES AND SOLUTIONS

Accounting information is used by individuals and organisations for a variety of

reasons. Identify the type of accounting information that may be of interest to each of

the following potential users:

Loan manager of a bank

Labour union representing employees

Production manager

Shareholders

Sales managers

President of the company



7.2

Financial and management accounting information serve different purposes.

State whether the following phrases describe management accounting or financial

accounting:

7.2.1

7.2.2

7.2.3

7.2.4

7.2.5

7.2.6

7.2.7

7.2.8

Must adhere to GAAP

Future orientation

Reports results by segments

Focus is on past performance

Emphasises reporting on the whole company

Information is often less precise

Highly customisable

Reports are produced as often as required

7.3

Why do you think that the internal auditors of a public company should report to the

audit committee and not to the finance director?

7.4

Your company wants to replace the existing office computer. After a lot of thought

and investigation, you are now seriously considering three options. The basic

information about each computer is as follows (Note the basic price includes the

central processing unit (CPU) with 80 gigabite (GB) hard drive, keyboard and

mouse):

Basic price

Processor speed

Monitor (17 inch)

CD or DVD writer

Speakers

Upgrade hard drive

Microsoft office package

Total price

Computer A

R4 800

2.8 Gigahertz

R800 (ordinary)

R200 (CD)

R200

R350 (120 GB)

R1 200

R7 550

Computer B

R5 200

3.0 Gigahertz

R850 (ordinary)

R450 (DVD)

R250

R400 (160 GB)

R1 400

R8 550

Computer C

R5 400

3.2 Gigahertz

R1 300 (LCD)

R400 (DVD)

R200

R520 (200 GB)

R1 350

R9 170



Required

7.4.1

7.4.2

7.4.3

7.4.4

Define the problem that may have led to the consideration of replacing the existing

office computer.

What are the objectives in choosing a computer? Identify both quantitative and

qualitative objectives. Which is the most important objective to you? Why?

Given the circumstances in your company, what are the available options in choosing

a new computer? Name the quantitative and qualitative factors affecting these

options.

From the options available, which is the best choice? Why?

SOLUTIONS

7.1

7.1.1

7.1.2

7.1.3

7.1.4

7.1.5

7.1.6

Loan manager of a bank

Labour union representing

employees

Production manager

Shareholders

Sales managers

President of the company

Some examples include:

Ability to service debt and repay capital

Ability to compensate employees; job security

Production costs; budgeted figures

Profitability; Earnings per share; Net asset

value

Sales forecasts; actual sales; selling expenses

Profitability; market share; share price

7.2

7.2.1

7.2.2

7.2.3

7.2.4

7.2.5

7.2.6

7.2.7

7.2.8

Must adhere to GAAP

Future orientation

Reports results by segments

Focus is on past performance

Emphasises reporting on the whole company

Information is often less precise

Highly customisable

Reports are produced as often as required

Financial accounting

Management accounting







7.3

The responsibility for the system of recording transactions rests with the finance

director. The finance director could prevent crucial information from being passed

on to others in the organisation. The audit committee meets on several occasions

during the year and it offers a degree of objectivity.



7.4

7.4.1

7.4.2

7.4.3

7.4.4

A variety of answers are possible. The following is one example:

The existing computer has inadequate memory and is too slow.

Quantitative

Acquire a computer that has at least twice the memory capacity as the existing one.

Purchase at a reasonable price.

Processing speed must be great.

Qualitative

Computer components must be of good quality.

Use as less space as possible.

Available options: Computer B and C (Monitor of Computer A takes up too much

desk space.)

Quantitative factors

Memory size

Speed of processor

Qualitative factors

Desk space

Quality of components

Computer C

LCD monitor takes less space and is more aesthetically pleasing.

Adequate memory (200 GB).

Processor speed is suitable.

Price is reasonable.



TOPIC 2

FINANCIAL STATEMENTS AND ACCOUNTING CONCEPTS

LEARNING OUTCOMES


► explain what transactions are.

► describe the kind of information contained in financial statements.

► describe the integration of the financial statements.

► explain the purpose of financial statements.

► outline the main accounting concepts.

► outline the meaning and usefulness of the accounting equation.

► show the effects of transactions on the accounting equation and subsequently on the

financial statements.



CONTENTS

1. What is a transaction?

2. Financial statements

3. Accounting concepts

4. Accounting equation


READING

Prescribed


9th

Edition, McGraw-Hill: New York. (Chapters 2 and 4)

Recommended

Berry A. and Jarvis R. (2006) Accounting in a business context, Fourth edition, Thomson

Learning: London. (Chapter 3)


UK (Chapters 1 – 4)


Decisions, Third edition, Thomson South-Western: Canada. (Chapter F4)

Warren A.S. (2007) Survey of Accounting, Third Edition, Thomson South-Western: USA

(Chapter 1)



1. WHAT IS A TRANSACTION?

According to Warren (2007: 48) a transaction is an economic event that under

generally accepted accounting practice affects one or more elements of the financial

statements and must therefore be recorded. Transactions are initially recorded in

journals, then summarised in accounts in a ledger and the effects of them are later

reflected in the financial statements.

2.

FINANCIAL STATEMENTS

Financial statements report on the financial position of an organisation at a certain

point in time and the changes in the financial position over a period of time. The

financial statements and what they are intended to report on are illustrated below:

FINANCIAL STATEMENT REPORTS ON:

Balance sheet Financial position on a certain date.

Income statement Profit for a particular period.

Statement of changes in equity Investments by and distributions to owners.

Statement of cash flows Cash flows during the period.

The financial statements are usually accompanied by notes on the accounting policies

and detailed information about many of the amounts reflected in the financial

statements. The notes are intended to assist the reader of the statements by providing

additional information that is deemed necessary by the organisation and its auditors.

The kind of information contained in financial statements, financial statement

relationships and the purpose of financial statements are now discussed.

2.1

Balance sheet

The balance sheet reports on the financial position of an organisation at a specified

point in time. It is basically a summary of an organisation’s assets, equity and

liabilities at a point in time. This is in contrast to the income statement, statement of

cash flows and statement of changes in equity that report changes in the financial

position. The following is an example of a balance sheet in a simple form:



Exhibit 2-1

MVN ENTERPRISES

BALANCE SHEET AS AT 31 MARCH 20.6

ASSETS

Property, plant and equipment

Inventory (merchandise)

Accounts receivables

Cash

Total assets

EQUITY AND LIABILITIES

Equity

Liabilities

Non-current debt

Accounts payables

Total equity and liabilities

R

247 000

19 000

28 500

151 400

445 900

220 650

100 000

125 250

445 900

The two main sections of the balance sheet are:

* Assets

* Equity and liabilities

Notice that the amounts for these two sections are the same viz. R445 900.

This equality is also known as the accounting equation:

Assets = Equity + Liabilities

R445 900 = R220 650 + R225 250

The following are brief explanations of the items in the balance sheet:

Assets are the resources that are controlled by an enterprise from which economic

benefits will be derived either now or in the future.

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

an organisation owes.

Equity or Owner’s equity may be viewed as the residual claim that the owner(s) has

on the assets of the organisation after all the liabilities have been settled. It normally

consists of two parts viz. that which is invested in the organisation and that which is

earned by the organisation and left in the organisation (i.e. retained profits).



Property, plant and equipment refer to non-current assets such as land, buildings,

vehicles, machines and equipment that have a useful life of more than one year.

Inventory refers to the merchandise that has been purchased but not yet sold.

Accounts receivable represents the amounts owing by customers for merchandise

sold to them on credit.

Cash represents cash on hand and cash kept at the bank.

Non-current debts are debts that are payable after more than one year from the

balance sheet date.

Accounts payable represents amounts owing to suppliers for merchandise purchased

on credit.

A major purpose of the balance sheet is to provide financial information to external

users. It is an important statement to creditors who require information about assets

and claims to these assets.

2.2

Income statement

The income statement reports on the profit (or loss) made by an organisation over a

certain period of time. It reflects the revenue generated through its operating

activities (e.g. sales) and then deducting the expenses incurred in generating that

revenue and operating the organisation. Losses and gains arising from non-operating

activities are also reported.

The following is a simplified format of an income statement:

Exhibit 2-2

MVN ENTERPRISES

INCOME STATEMENT FOR THE YEAR ENDED 31 MARCH 20.6

R

Sales 300 000

Cost of sales (200 000)

Gross profit 100 000

Selling, general and administrative expenses (54 950)

Operating profit/Income from operations 45 050

Interest expense (15 000)

Net profit 30 050



The statement starts with sales. The various expenses are deducted to arrive at the net

profit (or net income). Let us examine the items in the income statement.

Sales (sometimes called revenue) reflect the amount earned through the sale of

merchandise to customers less any sales returns.

Cost of sales reflects the cost of the merchandise sold to customers.

Gross profit (also called gross margin) is the difference between sales and cost of

sales. It represents the maximum amount from which all other expenses must be met

before a profit can be realised.

Selling, general and administrative expenses are the operating expenses of the

organisation. In a typical income statement, each expense is shown as a separate item

instead of being grouped together (as is the case here).

Operating profit is often used as a measure of the performance of management.

Interest expense represents the cost of borrowing funds.

Net profit will only result if the income exceeds expenses. A net loss results if

expenses exceed income.

A major purpose of the income statement is to meet the needs of investors who

require information about earnings (profit). In companies, this information about

earnings is useful for evaluating management decisions that affect payments to

shareholders and share prices.



2.3

Statement of changes in equity

The statement of changes in equity (owners equity) reflects the changes to the

components of the equity during the year. The following is a simplified format of a

statement of changes in equity:

Exhibit 2-3

MVN ENTERPRISES

STATEMENT OF CHANGES IN EQUITY FOR THE YEAR

ENDED 31 MARCH 20.6

Balance at 31 March 20.5

Additional capital contributed

Profit for the year

Drawings for the year

Balance at 31 March 20.6

R

0

211 000

30 050

(20 400)

220 650

Balance at 31 March 20.5 includes the investment of the owner(s) in the

organisation as well as any retained profit from the previous year(s). In this example,

the organisation only commenced business on 01 April 20.5 and this is why the

balance at 31 March 20.5 is zero.

Additional capital contributed reflects an increase in the investment by the

owner(s) in the organisation during the year.

Profit for the year refers to the net profit available to the owner(s) as calculated in

the income statement.

Drawings for the year reflects the portion of the profit earned which has been

withdrawn by the owner(s) for personal use.

The purpose of a statement of changes in equity is to describe transactions regarding

capital (shares) and the amount and use of retained earnings.

2.4

Statement of cash flows

This statement reflects the sources of cash and how the cash was used during the

year. This is done by reporting on the changes in all the other balance sheet items.

The changes in all these other balance sheet items will equal to the change in cash.



The following is an example of a simple statement of cash flows:

Exhibit 2-4

MVN ENTERPRISES

CASH FLOW STATEMENT FOR THE YEAR ENDED 31 MARCH

20.6

R

Cash flows from operating activities 120 800

Operating profit 45 050

Non cash flow adjustment: Depreciation 13 000

Profit before working capital changes 58 050

Working capital changes: 77 750

Increase in inventory (19 000)

Increase in accounts receivable (28 500)

Increase in accounts payable 125 250

Cash generated from operations 135 800

Interest paid (15 000)

Cash flows from investing activities (260 000)

Non-current assets purchased (260 000)

Cash flows from financing activities 290 600

Cash received from owner 190 600

Cash received from non -current loan 100 000

Increase in cash 151 400

Cash flows from operating activities is a focal point for most stakeholders as an

organisation cannot survive in the long-term unless it generates sufficient cash flows

from its operating activities.

Depreciation is added back to profit as it is a book entry and cash is not affected.

The increase in inventory is subtracted because cash was paid to increase inventory.



The increase in accounts receivable is subtracted since it reflects sales that have not

yet been received.

The increase in accounts payable is added since cash has not been paid for products

or services received.

Cash flows from investing activities reflect the cash used to purchase assets that

have a long life.

Cash flows from financing activities include amounts received from the owner(s) to

increase capital and amounts received (or paid) through long-term borrowing.

The net increase in cash can be verified as it is also equal to the difference in the

cash balances at 31 March 20.5 (0) and 31 March 20.6 (R151 400).

The purpose of the statement of cash flows is to provide information to investors,

creditors and other users to assess the ability of the organisation to meet its cash

requirements.

2.5

Financial statement relationships

The financial statements of MVN Enterprises (discussed above) will be used to

illustrate the financial statement relationships. Refer to exhibit 2-5.

The balance sheet at 31 March 20.5 has no amounts since MVN Enterprises only

commenced business on 01 April 20.5. The integration of the financial statements is

as follows:

The net profit in the income statement also appears in the statement of changes in

equity as an addition to retained earnings. The net profit also affects the retained

earnings component of equity in the balance sheet.

The statement of changes in equity and balance sheet are integrated. The retained

earnings on 31 March 20.6 also appears as part of equity in the balance sheet.

The balance sheet and the statement of cash flows are also integrated. The cash that

appears in the balance sheet also appears as the end of the financial year cash in the

statement of cash flows.



Exhibit 2-5

FFIINNAANNCCIIAALL SSTTAATTEEMMEENNTT RREELLAATTIIOONNSSHHIIPPSS

*31 March 20.5 Financial year 20.6 31 March 20.6*

MVN Enterprises

Statement of cash flows for the

year ended 31 March 20.6

Operating activities 120 800

Investing activities (260 000)

Financing activities 290 600

Net change in cash 151 400

MVN Enterprises Cash on 31 March 20.5 151 400 MVN Enterprises

Balance Sheet at 31 Mar 20.5 Balance Sheet at 31 Mar 20.6

Assets MVN Enterprises MVN Enterprises Assets

Cash - Income statement for the year Statement of changes in equity Cash 151 400

All other assets - ended 31 March 20.6 for the year ended 31 March 20.6 All other assets 294 500

- Revenue 300 000 Paid-in capital 211 000 445 900

Expenses (269 950) Retained earnings:

Equity & liabilities Net profit 30 050 Opening balance 0 Equity & liabilities

Equity Net profit 30 050 Equity

Capital - Drawings (20 400) Capital 211 000

Retained earnings - Closing balance 9 650 Retained earnings 9 650

Total equity - Total change in equity 220 650 Total equity 220 650

Liabilities - Liabilities 225 250

- 445 900



? THINK POINT

Davies and Pain (2002: 23) uses the imagery of a video cassette player with pause and play

buttons to associate with the financial statements viz. income statement, balance sheet and

statement of cash flows. Can you explain the imagery?

3.

ACCOUNTING CONCEPTS

Many important decisions are made from financial statements and it is important to

understand the principles or concepts that underpin the preparation of financial information.

These concepts are practices that accountants have agreed upon over a period of time.

Marshall et al (2011: 47) use the following model to illustrate the concepts:

Exhibit 2-6

Accounting entity

Assets = Equity + Liabilities Going concern

(Accounting equation) (continuity)

Procedures for sorting,

classifying, and presenting

(bookkeeping)

Selection of alternative

methods of reflecting the

effect of certain transactions

(accounting)

Transactions Financial statements

- Unit of measurement - Accounting period - Consistency

- Cost principle - Matching revenue and expense - Full disclosure

- Objectivity - Revenue recognised at time of sale - Materiality

- Accrual concept - Conservatism



3.1

The accounting concepts may be explained as follows:

Concepts related to the whole model

The accounting equation must be in balance every time transactions are recorded in the

accounting records.

Accounting entity refers to the entity (organisation) for which the financial statements are

prepared.

In terms of the going concern concept it is presumed that the entity will continue to operate

in the future. The amounts reflected in the balance sheet thus do not reflect the liquidation

value of the assets.

3.2

Concepts related to transactions

In South Africa, the Rand is the unit of measurement for all transactions. Adjustments are

not made to the buying power of the Rand.

In terms of the cost principle transactions are recorded at their original cost to the entity as

measured in Rands.

Objectivity ensures that transactions are recorded the same way in all situations. The use of

the Rand as a unit of measurement and the cost principle facilitates objectivity.

3.3

Concepts related to bookkeeping procedures and the accounting process

These concepts apply to the accounting period. The accounting period, which is usually

one year, is the period of time chosen to report on the results of operations and the financial

position.

In terms of the matching concept all income earned and expenses incurred to earn the

income are matched with each other to calculate the profit (or loss) for the period for which

they relate.

Revenue is recognised at the time of sale, which is when ownership of the product is

passed to the buyer.

In terms of the accrual concept revenue is recognised at the point of sale and expenses are

recognised as they are incurred, even if the cash receipt or payment occurs at another time

or in another accounting period.



3.4

Concepts related to financial statements

The consistency concept is based on the principle uniformity that prevails in the

accounting treatment of like items within each accounting period and from one period to

the next. This will ensure that meaningful comparisons can be made using an entity’s

financial statements for several years.

Full disclosure requires that financial statements and notes include all the necessary

information that will prevent the users of the financial statements from being misled.

Information is regarded as material if its omission or misrepresentation could influence the

economic decision of users taken on the basis of the financial statements. The concept of

materiality also implies that the amounts reflected in the financials statements need not be

stated with absolute preciseness.

Conservatism in accounting requires accountants to be conservative when in doubt. When

the principle of conservatism is applied to making judgements, lower profits and asset

valuations are estimated rather than higher values.

4.

ACCOUNTING EQUATION

We already know that the accounting equation (derived from the balance sheet) is

expressed as follows:


Every financial transaction will cause a change in the accounting equation. However, the

equation will remain in balance after every transaction. The equation can be stated in an

expanded form as to include items in each of the three elements of the equation:


Equipment Inventory Receivables Bank = Capital Income Expenses + Payables

Note that income and expenses appear under equity as they are used to calculate the net

profit/loss that in turn increases/decreases equity.



The following example will be used to illustrate the operation of the accounting equation.

Example 1

02

06

10

14

28

31

Transactions for March 20.6

The owner of Tulani Enterprises commenced her business by investing R65 000 cash.

Purchased equipment for R15 000 cash.

The owner obtained a long-term loan of R30 000 from the bank.

Purchased merchandise on credit, R40 000.

Sold merchandise that cost R15 000 for R26 000 on credit.

Paid salaries to the employees, R6 000

Exhibit 2-7 illustrates the effect of the above transactions on the accounting equation.



Exhibit 2-7


Date Equipment Inventory Receivables Bank =

=

Capital Income Expenses +

+

Loan Payables

02

06

10

14

28

31

+R15 000

+R40 000

-R15 000

+R26 000

+R65 000

-R15 000

+R30 000

-R6 000

+R65 000

+R26 000

-R15 000

-R6 000

+R30 000

+R40 000

Total +R15 000 +R25 000 +R26 000 +R74 000 +R65 000 +R26 000 -R21 000 +R30 000 +R40 000

■

REMARKS

The transaction on the 28th

is done over two lines as there are two effects. One shows the revenue and the other shows the cost of the

merchandise sold.

■ When an expense increases, one of the effects is that the owner’s equity will decrease. Thus for the entries on 28th

and 30th

March the

minus sign in the expenses column is to indicate that the owner’s equity is decreasing (not the expenses).



The simplified formats of the financial statements from the data from exhibit 2-7 are

presented below in exhibit 2-8:

Exhibit 2-8

TULANI ENTERPRISES

INCOME STATEMENT FOR THE MONTH ENDED 31 MARCH 20.6

R

Revenue 26 000

Expenses (21 000)

Net profit 5 000

TULANI ENTERPRISES

STATEMENT OF CHANGES IN EQUITY FOR THE MONTH

ENDED 31 MARCH 20.6

Opening balance


Net profit

Closing balance

R

0

65 000

5 000

70 000

TULANI ENTERPRISES

BALANCE SHEET AS AT 31 MARCH 20.6

ASSETS




Cash

Total assets


Equity

Liabilities

Long-term debt

Accounts payables


R

15 000

25 000

26 000

74 000

140 000

70 000

30 000

40 000

140 000



TULANI ENTERPRISES

STATEMENT OF CHANGES IN CASH FLOWS FOR THE

MONTH ENDED 31 MARCH 20.6

R

Cash flows from operating activities (6 000)

Net profit 5 000

Add (Deduct) items not affecting cash

Increase in inventory (25 000)

Increase in accounts receivable (26 000)

Increase in accounts payable 40 000

Cash flows from investing activities (15 000)

Purchase of plant, machinery and equipment (15 000)

Cash flows from financing activities 95 000

Capital contributed 65 000

Cash received from long-term loan 30 000

Net increase in cash for the year 74 000

Cash (opening balance) 0

Cash (closing balance) 74 000

5.

5.1


Indicate whether each of the following is regarded as a financing activity (F), investing

activity (I) or operating activity (O). Write down the letter F, I or O in the spaces provided.

5.1.1.

5.1.2

5.1.3

5.1.4

5.1.5

5.1.6

___

___

___

___

___

___

New machinery was purchased for installing in the factory.

A loan was obtained from the bank.

R1 000 was received from a customer for goods sold.

The organisation’s old computer was sold for R900.

The owner increased her capital contribution in the business.

Two more secretaries were employed.

5.2

A balance sheet may be said to represent assets and claims to assets. Who has claims to the

assets of an entity?

5.3 Assume that you are reviewing a balance sheet that has two sections viz. assets as well

equity and liabilities. What questions can you answer by examining the assets? What

questions can you answer by examining the equity and liabilities?



5.4 The income statement as well as the statement of cash flows provides information about

the operating activities during a financial year. Apart from possible statutory requirements,

why are both statements included in an organisation’s financial report? How can decision-

makers use of information in each statement?

5.5 You are considering a move from a small well-established retailer to a public company

that was established 18 months ago. You have a job interview next week. Your business

friends advised you to investigate the company before the interview. They say that if the

company’s business plan fails, there is a great chance that the company may not be a going

concern. Name some questions that you would like to get answers to before the interview?

5.6 Discuss the implications of the preparation of the income statement if there were no

accounting concepts.

5.7 Valpre Enterprises had the following transactions during its first month of business, May

20.6.

May

01

Patricia Zuma set up a bank account in the name of the business and deposited R70 000 of

her own funds into the account.

04 She supplemented her capital by taking a long-term loan with her bank, R40 000.

05 The rent for May 20.6 was paid by cheque, R2 000.

12 Goods for resale costing R25 000 were purchased by cheque.

15 A cash register machine was purchased on account, R2 500.

20 Paid advertising costs for the grand opening of the firm, R3 500.

28 Employees were paid R2 800 in wages.

31 Sold goods that cost R13 000 for R25 000 on credit.

Required

5.7.1 Use the format presented in exhibit 2-7 to analyse the above transactions.

5.7.2 Use the total of the effects of the transactions (as calculated in 5.7.1) to prepare the:

5.7.2.1 Income statement for May 20.6.

5.7.2.1 Statement of changes in equity for the month ended 31 May 20.6.

5.7.2.2 Balance sheet on 31 May 20.6.



SOLUTIONS

? THINK POINT

The balance sheet is a financial snapshot at a moment in time. The financial position of an

organisation is comparable to pressing the “pause” button on a video player. The video in

play mode shows what is happening as time goes on. When you press “pause” the video

stops on a picture. However, this picture does not tell what has happened over the period of

time up to the pause.

The income statement is the video in “play” mode. Net profit is calculated from revenues

earned throughout the period between two “pauses”, minus expenses incurred from earning

those revenues.

The statement of cash flows is the video again in “play” mode. It summarises the cash

inflows and outflows and calculates the net change in the cash position throughout the

period between two “pauses”.

5.1

5.1.1.

5.1.2

5.1.3

5.1.4

5.1.5

5.1.6

I

F

O

I

F

O

New machinery was purchased for installing in the factory.

A loan was obtained from the bank.

R1 000 was received from a customer for goods sold.

The organisation’s old computer was sold for R900.

The owner increased her capital contribution in the business.

Two more secretaries were employed.

5.2

Firstly, the suppliers of credit and loans (liabilities).

Secondly, after liabilities have been settled, the investor(s) in the business.



5.3

Are the non-current assets optimally utilised?

Which non-current assets need replacement because they are reaching the end of their

economic life?

Are the investments providing a satisfactory return?

Are there any capital gains on the investment?

Is the organisation holding too much inventory?

Is there too much owing by debtors?

Is there too much of cash lying idle in the bank?

How much of borrowed capital is there compared to own capital?

Did the owner(s) get a satisfactory return on investment?

Will the business be able to make repayments on loans and service the debt?

Will the organisation be able to pay off its short-term debts?

To what extent is the organisation taking advantage of credit offered by suppliers?

5.4

The income statement shows how the profit or loss has been achieved during the year. It

does this by showing us the revenues that have been generated and the costs that were

incurred to generate those revenues. Consequently, it shows the increase or decrease in

wealth of the business during the period. The statement of cash flows on the other hand

describes the events that affected the organisation’s cash during the financial year. The

statement identifies how much cash an organisation has, where the cash came from and

how the organisation used the cash during the financial year.

Use of the statements by decision-makers

Owners and decision-makers use the income statement to evaluate how well the

organisation has performed. However, the income statement (or the balance sheet for that

matter) does not show or analyse the key changes that have taken place in an organisation’s

financial position that a statement of cash flows will reveal. For example:

■ how much capital expenditure (e.g. buildings, machinery) was made and how it was

financed?

■ what was the extent of the new borrowing and how much debt was repaid?

■ how much did the organisation need to fund increases in debtors and stock requirements?

■ how much of the company’s funding was obtained from funds generated from its operating

activities and how much by new external funding?



5.5

Are there any published financial statements available for analysis?

How much has been invested in the company by shareholders?

Is the company profitable?

Is the company generating sufficient cash to meet its cash payments?

Are any analyses by the press available?

What is the present customer base?

5.6

If accountants prepare income statements as they see fit, comparability between

organisations and across time periods would be extremely difficult.

The lack of accounting concepts will open the way for accountants to manipulate figures in

the income statement. Some may “window dress” the income statement to make it look

better than it actually is. The reliability of figures in the income statement would then be

brought into question.



5.7.1


Date Equipment Inventory Receivables Bank =

=

Capital Income Expenses +

+

Loan Payables

01

04

05

12

15

20

28

31

+R2 500

+R25 000

-R13 000

+R25 000

+R70 000

+R40 000

-R2 000

-R25 000

-R3 500

-R2 800

+R70 000

+R25 000

-R2 000

-R3 500

-R2 800

-R13 000

+R40 000

+R2 500

Total +R2 500 +R12 000 +R25 000 +R76 700 +R70 000 +R25 000 -R21 300 +R40 000 +R2 500



VALPRE ENTERPRISES

INCOME STATEMENT FOR THE MONTH ENDED 31 MAY 20.6

R

Revenue 25 000

Expenses (21 300)

Net profit 3 700

VALPRE ENTERPRISES

STATEMENT OF CHANGES IN EQUITY FOR THE MONTH ENDED

31 MAY 20.6

Opening balance


Net profit

Closing balance

R

0

70 000

3 700

73 700

VALPRE ENTERPRISES

BALANCE SHEET AS AT 31 MAY 20.6

ASSETS




Cash

Total assets


Equity

Liabilities

Non-current debt

Accounts payables


R

2 500

12 000

25 000

76 700

116 200

73 700

40 000

2 500

116 200



TOPIC 3

ACCOUNTING FOR AND PRESENTATION OF ASSETS, LIABILITIES

AND OWNERS’ EQUITY

LEARNING OUTCOMES


► identify the various current assets and report them correctly in the balance sheet.

► explain why internal controls are important.

► identify the various non-current assets and be able to report them in the balance sheet.

► explain the different methods of depreciation for financial accounting purposes.

► present the various current and non-current liabilities in the balance sheet.

► describe how the components of owners’ equity are reported in the balance sheet.

► interpret information presented in the balance sheet.



CONTENTS

1. Introduction

2. Assets

3. Owners’ equity

4. Liabilities


READING

Prescribed


9th

Edition, McGraw-Hill: New York. (Chapters 5, 6, 7 and 8)

Recommended

Davies T. and Pain B. (2002) Business Accounting and Finance, First Edition, McGraw-Hill: UK

(Chapter 2)


Decisions, Third edition, Thomson South-Western: Canada. (Chapter F4)

Lubbe I. and Watson A. (2006) Accounting: GAAP Principles, First edition, Oxford University

Press Southern Africa: Cape Town. (Chapter 17)


(Chapter 5, 6, 7 and 8)



1.

INTRODUCTION

As previously mentioned, a balance sheet summarises an entity’s assets, liabilities and

owners’ equity at a specific time in point. The focus of this topic is to make sense of the

presentation of assets, owners’ equity and liabilities in a balance sheet. The following

illustration (balance sheet of a company) is a picture of what is to follow:

Exhibit 3-1

BALANCE SHEET Paragraph

Non-current assets

Land

Buildings and equipment

Assets acquired by lease

Intangible assets

Natural resources

Other non-current assets

Current assets

Inventories

Notes receivable

Accounts receivable

Short-term marketable securities

Cash and cash equivalents

2.1

2.2

2.3

2.4

2.5

2.6

2.7

2.8

2.9

2.10

2.11

Owners’ equity

Ordinary shares

Preference shares

Retained earnings

Non-current liabilities

Long-term debt

Other long-term liabilities

Current liabilities

Accounts payable

Short-term debt

Current maturities of long-term debt

3.1

3.2

3.3

4.1

4.2

4.3

4.4

4.5



2.

ASSETS

Assets, as we already know, are the resources that are controlled by an enterprise from

which economic benefits will be derived either now or in the future. Assets may be

classified as current or non-current. Current assets include cash and those assets that are

expected to be turned into cash within one year. Non-current assets include land, buildings,

equipment, intangible assets and natural resources. Let us examine the presentation of

assets in the balance sheet.

2.1

NON-CURRENT ASSETS

Land

Land that is owned by an organisation is shown on the balance sheet at its original cost.

This is in keeping with the cost principle. The costs that the organisation incur to ensure

that the land is ready for use is regarded as being part of the original cost. These costs

include the purchase price of the land, legal fees and any other costs related to acquiring the

land. Land that is purchased for investment purposes is classified as a separate non-current

asset and is also reported at its original cost. No depreciation is calculated for land. If land

is sold, the profit or loss on the sale will be reported in the income statement during the

period in which the sale occurred.

2.2

Buildings and equipment

Building and equipment, like land, are reported at their original cost which includes the

purchase price and any other costs necessary to get them ready for use. Interest costs

incurred on loans acquired to finance the construction of buildings are capitalised (i.e.

recorded as an asset rather than an expense) until the buildings are ready for use. Costs that

are incurred to install new equipment are also capitalised.

In terms of the matching concept depreciation is calculated on buildings and equipment.

When buildings or equipment are purchased the original cost is regarded as a prepayment

of economic benefits that the organisation will reap in the future years. A part of the asset’s

cost is deducted from income that was generated through the use of the asset. Depreciation

expense is recorded in each financial year. In the balance sheet, the cost of the asset and its

accumulated depreciation (cumulative total of all the depreciation expense that has been

recorded over the life of the asset up to the balance sheet date) are reported as follows:



Buildings

Accumulated depreciation

R400 000

(80 000)

Net book value of buildings R320 000

It is more commonly reported as follows

Building, less accumulated depreciation of R80 000 R320 000

These are many methods of calculating depreciation that result in different patterns of

depreciation by financial year. The two broad categories of calculating depreciation are the

accelerated depreciation methods and the straight-line depreciation method. Accelerated

depreciation methods (e.g. declining balance and sum-of-the-years’ digits) result in a

higher depreciation expense (and thus lower net profit) in the early years of the life of the

asset. In the later years, deprecation expense will be less and net profit will be higher.

Using the straight-line method the depreciation expense is spread evenly over the life of

the asset.

? THINK POINT 1

According to a survey of American companies in 2000, it was found that 82% of companies

used the straight-line method to calculate depreciation. What motivation could there be for

the higher preference of the straight-line method.

When a depreciable asset is sold or scrapped, the cost of the asset and its accumulated

depreciation must be removed from the books. Profits or losses on disposal of depreciable

assets are not considered to be part of operating income. If the amount is material, it is

shown separately as either other income or other expenses. If the amount is not material, it

will be reported as miscellaneous other income.

2.3 Assets acquired by capital lease

Sometimes an organisation may lease (rent) an asset instead of purchasing it. If the lease

agreement results in the lessee assuming the benefits and risk of ownership of the leased

asset, it is called a capital lease. Such an asset will be reported in the lessee’s balance sheet



with the purchased assets. The accompanying liability will also be reported in the balance

sheet. In the lessee’s income statement the cost of the leased asset will be taken as the

depreciation amount and the financing cost will be reflected as interest expense.

2.4

Intangible assets

Marshall et al (2011: 213) defines an intangible asset as “a long-lived asset represented by a

contractual right, or an asset that is not physically identifiable”. One type of intangible asset

includes leasehold improvements, patents and trademarks; another type is called goodwill.

The cost of most intangibles is spread over time as expenses and this is known as

amortization. In other words the cost of an intangible asset from the balance sheet is

allocated to the income statement as an expense.

When a tenant makes modifications to the building it leases (e.g. constructing private

offices), the cost of such modifications (called leasehold improvements) is amortised over

their useful life to the tenant or over the life of the lease (whichever is shorter).

A patent is a licence granted by a government giving the owner sole control or use of an

invention for a period of 20 years.

A trademark is a name, term or symbol used to identify a business and its product.

Organisations can gain exclusive use of a trademark by registering it.

The exclusive right to publish and sell a literary, artistic or musical composition is granted

by a copyright.

The cost of obtaining a patent, trademark or copyright is capitalised and amortized over its

estimated useful life or statutory life (whichever is shorter). The cost of developing a

patent, trademark or copyright is usually not significant compared to purchasing them from

another organisation.

Goodwill refers to an intangible asset of an organisation that is created from such

favourable factors as good location, product quality, reputation, high customer loyalty and

managerial skill. Goodwill is recorded in the accounts only after it is determined

objectively by a transaction e.g. purchase of an entity for more than the market value of the

net assets. The excess is recorded as goodwill and reported as an intangible asset and is not

amortized. However, goodwill is tested annually for impairment. If the book value of the

goodwill is greater than the fair value, an impairment loss is realised equal to that excess.

The impairment loss is recorded in the income statement and the book value of the goodwill

will be decreased in the balance sheet.



2.5

Natural resources

Paper, petroleum and mining companies purchase or lease land that contains oil, wood or

minerals. The cost of the land primarily reflects the natural resources. The amount that is

reported for natural resources in the balance sheet is the cost of the asset minus depletion.

Depletion is the allocation of the cost of the natural resources to the periods that benefited

from their use.

2.6


Examples of other non-current assets include long-tem investments and notes receivable

that mature more than 12 months after the balance sheet date. When they become

receivable within a year, they will be re-classified as current assets.

2.7

CURRENT ASSETS

Inventories

Inventories in service organisations consist mainly of office supplies and other items of a

relatively low value. For manufacturing and merchandising organisations, the sale of

merchandise is the most important source of operating income. Cost of sales is usually the

largest expense that is deducted from sales to determine net profit. For these entities

inventories is an important current asset. Turning over inventory as quickly as possible will

enhance return on investment. The cost of items of inventory purchased includes not only

the invoice amount but also other purchasing costs e.g. freight and materials handling

charge.

There are several accepted practices of valuing inventory for reporting purposes. Inventory

valuations (and thus cost of sales) differ from method to method due to the change in the

cost of items of inventory during the financial year. The specific identification, weighted

average, first-in first-out (FIFO) and last-in first-out (LIFO) methods will now be briefly

discussed.

According to the specific identification method, when an item is sold the cost of the item is

obtained from the entity’s records. This amount is transferred from the Inventory account to

the Cost of sales account. The cost of the items held in inventory at the end of the year will

be disclosed in the balance sheet.



The weighted average is applied to individual items of inventory. The average cost is

weighted by taking into account the number of units of opening inventory and each

purchase. This average is used to calculate the cost of sales and the value of closing

inventory.

The first-in first-out (FIFO) method transfers to the Cost of sales account the oldest costs

incurred in purchasing the inventory that was sold and thus values closing inventory at the

most recent costs of the merchandise purchased.

Under the last-in first-out (LIFO) method, the most recent costs of the merchandise

purchased are taken as Cost of sales and the closing inventory is valued at the oldest costs.

It is clear from the above that inventory valuation has an impact on both profitability and

liquidity. The impact of each of the four methods described above must be understood in

making judgements and decisions especially when comparing different entities. Consider

the following:

When costs are increasing during the year, the cost of sales will be lower and profits higher

under FIFO than under LIFO. The reverse happens when costs decrease during the year.

Inventories are reported in the balance sheet at the lower of cost or market. Sometimes

for some items of inventory the market value is lower than cost due to factors such as

obsolescence or damage. Reporting inventory at lower of cost or market is the application

of the accounting concept of conservatism.

2.8

Notes receivable

If a debtor experiences difficulty in settling a debt on due date, the entity may convert the

debt to a note receivable. The effect of this on the balance sheet is that accounts receivable

will decrease and notes receivable will increase. A note usually includes provisions relating

to maturity date, some form of security, penalties for non-payment and interest rate

associated with the loan. A note receivable may also be used when an entity lends money to

another entity and takes a note from that entity.



2.9

Accounts receivable

Accounts receivable refer to amounts receivable from customers for merchandise sold or

for services rendered on credit. Accounts receivable are reported at net realisable value i.e.

the amount expected to be received from debtors. The net realisable value is less than the

amount of the receivable originally recorded because of bad debts and cash discounts.

Despite doing a thorough check on the creditworthiness of customers, losses through bad

debts are inevitable. The credit manager is expected to estimate as accurately as possible,

from the accounts receivable, the expected bad debts (known as allowance/provision for

bad debts). Obviously, recent collection experience and the current economic conditions

prevailing would be taken into account. An adjustment entry is made to reduce the carrying

value of the accounts receivable. The presentation of allowance for bad debts under current

assets in the balance sheet is as follows:

Accounts receivable

Allowance for bad debts

R20 000

(1 000)

Net accounts receivable R19 000

Cash discounts are often allowed to debtors if the account is paid within a stated period

e.g. within 10 days of the date of sale. Credit terms allowed to customers usually state that

if the amount owing is not paid within the discount period, it must be paid in full within 30

days of the invoice date. The credit term is often abbreviated as 2/10, n30. In the balance

sheet, accounts receivable is reduced to allow for the estimated cash discounts that are

expected to be granted to debtors who pay within the discount period. The accounting

treatment of cash discounts is similar to that of allowance for bad debts.

2.10 Short-term marketable securities

An entity can improve its return on investment by investing cash that is not required for

daily operations in short-term marketable securities. For this to materialise, the drawing up

of cash budgets is essential. Marketable securities that mature with one year of the balance

sheet date are presented as cash equivalents (part of current assets) in the balance sheet. A

security that is held to its maturity date is reported in the balance sheet at cost since it is

usually the same as its market value. Debt and equity securities that may be classified as

trading or available-for-sale are reported at market value. Furthermore, any unrealised

profit or loss is recognised.



2.11


Cash includes money kept for change, petty cash funds, undeposited cash and cash

immediately available to the organisation in its bank accounts. Cash equivalents are short-

term investments readily convertible into cash. Since cash on hand and cash in cheque

accounts earn little or no interest, there must be a cash management system in place to

invest cash that is not currently required for the organisation’s operation. Management must

also have policies in place to reduce the chances of embezzlement of cash.

? THINK POINT 2

As a financial manager, what control measures would you put in place to reduce the

chances of embezzlement of cash by employees?

An internal control system is important in the management of cash and may consist of

financial and administrative controls. Using financial control, there must be a separation of

duties i.e. more than one person must be responsible for a transaction from beginning to

end. Administrative controls are usually included in policy and procedure manuals e.g.

investigation of a customer’s creditworthiness before credit is granted. The process of bank

reconciliation is also a form of internal control.

3.

OWNERS’ EQUITY

A company issues share capital to its shareholders under certain conditions and with certain

rights and obligations. The owners’ equity of a company (also called shareholders’ equity)

is made up of the capital provided by shareholders to the company, plus the net profit (after

tax) and gains retained in the company, less any dividends distributed to shareholders.

3.1

Ordinary shares

The ordinary shareholders are the ultimate owners of the company. They have a claim to all

the assets that remain in the company after all liabilities and preference shareholders claims

have been settled. Ordinary shareholders are not entitled to receive any stated dividend

amount and could even not receive dividends in some years at all. They have the right to

elect the directors of the company.



The ordinary share capital can be issued at its par value (monetary value assigned to a

share), or at a premium (higher than the par value). Ordinary shares with a par value are

reflected in the share capital account. Ordinary shares with no par value are reflected in

the stated capital account. When par value shares are issued at a premium, the amount of

the premium received is reflected in a separate account called share premium account.

Shares with no par value obviously cannot be issued at a premium.

3.2

Preference shares

Preference shares are usually sold after the first issue of ordinary shares. These shares may

be cumulative, non-cumulative, participating and/or redeemable. However, they are all

entitled to a fixed dividend from the profits before any other shares participate. They also

enjoy priority for return of capital if the company winds up. Cumulative preference

shareholders are entitled to a fixed dividend every year but any arrear dividends must be

made up for in subsequent years. Holders of participating preference shares, having

gained a fixed dividend each year, may also share in any of the profits that remain after

ordinary dividends are paid. Redeemable preference shares may be issued with optional or

compulsory rights of redemption (where capital is paid back). Preference shares may be

sold at par or at a premium. When they are issued at a premium, the premium received is

recorded separately in the share premium account.

3.3

Retained earnings

The retained earnings (retained income) account shows the cumulative profits of the

company that has been retained for use in the company rather than being distributed as

dividends to the shareholders. This account can only be changed for the following reasons:

Previous year adjustments (for correction of error or change in accounting policy)

Transfer of current year net profit

Declaration of current year dividends (ordinary and preference)

Transfers to other reserves

Release of other reserves

Write-off of share-issue costs that exceed costs written off against the share premium

account.



3.4

Disclosing shareholders equity

A separate statement of changes in equity must show, on the face of the statement:

the net profit (or loss) for the period.

each income or expense for the period that is recognised directly in equity.

the cumulative effects of changes in accounting policy and correction of errors.

The following changes can be presented in the statement of changes in equity or in the

notes to the financial statements:

transactions with the shareholders, with distribution to shareholders shown separately.

balance of accumulated profit (or loss) and any movements in this account.

reconciliation between carrying values of each class of equity, showing details of each

change.

The following is a summary of the note disclosure requirements related to the equity of a

company:

3.4.1

Authorised share capital

This must be stated specifying the classes of shares, number and nominal value of par value

shares in each class and number of no par value shares in each class.

3.4.2

Issued share capital

The sale of new shares, the issue of rights and any other increases to the share capital must

be disclosed in the statement of changes in equity. Likewise any decreases in share capital

(e.g. redemption of preference shares) must also be disclosed.

3.4.3 Share premium

This should be shown under issued capital and grouped with the particular share to which it

relates.

3.4.4 Redeemable preference shares

The following should be stated:

the earliest and latest dates on which the company has the power to redeem.

whether the shares must be redeemed at a fixed future date as well as whether they are

redeemable at the option of the shareholders or the company.

the dividend rights of these shareholders.



3.4.5 Directors’ authority to issue shares

The following should be stated by way of a note:

Number of shares or amount of share capital directors are authorised to issue.

Period for which authority is granted.

Terms of the authority.

3.4.6 Movements in reserves

A company must state the nature and purpose of each reserve. The opening and closing

balances and movements in each reserve should be disclosed.

3.4.7 Dividends declared and/or paid

The total amount of the dividends paid or declared for each class of share must be disclosed

in the statement of changes in equity.

4.

LIABILITIES

As noted previously, liabilities are the claims that creditors have on the assets of the

organisation. Liabilities that must be settled within 12 months of the balance sheet date are

called current liabilities while those that will be paid more than 12 months after balance

sheet date are called non-current liabilities. Liabilities are presented under current and

non-current categories in the balance sheet in order of liquidity i.e. how soon the obligation

is payable. Let us examine the presentation of liabilities in the balance sheet.

4.1

NON-CURRENT LIABILITIES

Long-term debt

Many organisations rely on debt and owner’s equity to finance the purchase of assets.

Although interest has to be paid on borrowings, interest expense is tax-deductible.

Furthermore, if an organisation can borrow money at an interest rate of 12 % and use the

money to purchase assets that realise a return that is greater than 12%, then the owners’

would get a greater return on investment than if they provided the funding. The use of debt

with a fixed interest rate that causes a difference between the return on investment and

return on equity is called financial leverage. The possibility of a positive financial leverage

favours the use of long-term debt by organisations.



4.2

Other long-term liabilities

These liabilities include pension obligations, other post-retirement benefit plan obligations

(e.g. medical and hospitalisation benefits to retired employees), warranty obligations and

estimated values of lawsuits in progress.

4.3

CURRENT LIABILITIES

Accounts payable

Accounts payable arise from amounts payable to suppliers for goods and services that have

been supplied on credit. Most suppliers require payment within a relatively short period of

time. When reporting accounts payable in the balance sheet, cash discounts that may be

expected to be received for prompt payment is not deducted. In keeping with the materiality

concept, the amount involved is unlikely to influence the financial position or results of

operations.

4.4

Short-term debt

Organisations sometimes obtain short-term loans in order to increase inventory and to be

able to make payments for various expenses. These loans are expected to be repaid from the

proceeds of the sale of inventory. Loans have a specific maturity date unless a revolving

credit facility is negotiated. Interest payable on loans is reported in the income statement in

the year during which the money was owed.

4.5

Current maturities of long-term debt

Long-term loans are usually payable in instalments. Each year a portion of the loan is

repaid. Any portion of a long-term debt that is payable within 12 months of the balance

sheet date is reclassified from a non-current liability to a current liability. This portion of

the debt is reported as “Current maturities of long-term debt” in the balance sheet.



5. SELF-ASSESSMENT ACTIVITIES AND SOLUTIONS

5.1 Listed below are the account balances and other information for Reno Ltd for the financial

year ended 30 September 20.6.

(Note: The net profit after tax for the year ended 30 September 20.6 amounted to R58 000.)

Accounts payable

Accounts receivable


Buildings

Cash (in bank)

Ordinary share capital

Dividends (declared and paid)

Share premium

Equipment

Goodwill

Income tax payable

Interest payable

Land

Long-term investments

Merchandise inventory

Loan payable, current portion

Long-term loan

Prepaid insurance

Retained earnings (30 September 20.5)

Consumable inventory

Wages payable

R

44 000

22 000

328 000

824 000

32 000

550 000

34 000

50 000

490 000

26 000

12 000

28 000

70 000

70 000

124 000

20 000

556 000

14 000

50 000

26 000

36 000

Required

From the information provided above, calculate the amount to be reflected for each of the

following items for the Balance sheet of Reno Ltd for the year ended 30 September 20.6:

5.1.1 Land, buildings and equipment

5.1.2 Intangible assets

5.1.3 Other non-current assets

5.1.4 Current assets

5.1.5 Total assets



5.1.6 Total owners’ (shareholders’) equity

5.1.7 Retained earnings (on 30 September 20.6)

5.1.8 Non-current liabilities

5.1.9 Current liabilities

5.1.10 Total liabilities

5.1.11 Total owners’ equity and liabilities

5.2

5.3

5.3.1

5.3.2

5.4

5.5

5.6

One of the facts that credit rating agencies and credit grantors want to know about an entity

when evaluating its liquidity (ability to pay short-term debts) and creditworthiness is

whether or not the entity consistently takes advantage of cash discounts. How will credit

grantors interpret an entity that does not consistently take advantage of cash discounts?

The annual credit sales of RNI Ltd is R400 000. The company grants a 2% cash discount

for payment within 10 days of invoice date. Eighty percent of the accounts receivable is

paid within the discount period.

Required

Calculate the total cash discounts allowed during the year.

Calculate the approximate annual rate of return on investment that the company’s discount

terms represent to customers who take the discount.

What is the impact of the carrying value of inventory (in the balance sheet) and the cost of

goods sold (in the income statement) when LIFO rather than FIFO is used during periods of

inflation?

“Balance sheet values usually do not represent the fair value of assets that have a long life.”

Do you agree with this statement? Motivate your answer.

Compare the relative effect on the income statement and balance sheet of accelerated

depreciation methods and straight-line methods.

5.7

The balance sheet and accompanying notes provide useful information relating to a

company’s debt. What information would readers be looking for?

5.8

Preference shares generally pay a higher return to investors than do bonds but a smaller

return than earned by ordinary shareholders. Why?



SOLUTIONS

? THINK POINT 1

In the early years of an asset’s life the straight-line method results in a lower depreciation

expense and a higher net profit than accelerated depreciation. In later years, when

accelerated depreciation is less than straight-line depreciation, total depreciation using the

straight-line method will still be lower than under accelerated method if the investment in

assets has increased each year as is typical for organisations that are growing.

? THINK POINT 2

Some measures would include the following:

Daily amounts of cash on hand at the end of the day must match receipts, cash register

tapes and bank deposits.

All receipts must be banked intact the next banking day.

The cashier’s duties should be confined to receiving cash only. The cash receipts journal

and bank deposits should be prepared by other clerks.

Division of duties should apply. No person must control a transaction from data capture

until recording in the ledger.

Cheques should not be cashed by the cashier from monies received.

An independent senior staff member should daily unlock the cash register, record its

total, remove the printed tape, clear the cash register and balance the cash.

All payments except petty cash payments should be made by cheque or by electronic

transfers.

Cheques should be signed by two persons. These persons should not handle cash, or

authorize payments or record transactions in the books of account.

Payments should only be made when supported by authorised vouchers.

A bank reconciliation statement must be prepared monthly.



5.1.1

Land, buildings and equipment

Land

Buildings

Equipment


R

70 000

824 000

490 000

(328 000)

1 056 000

5.1.2

Intangible assets

Goodwill

R

26 000

26 000

5.1.3


Long-term investments

R

70 000

70 000

5.1.4

Current assets

Merchandise inventory

Consumable inventory

Accounts receivable

Prepaid expenses (insurance )

Cash

R

124 000

26 000

22 000

14 000

32 000

218 000

5.1.5

Total assets

Land, buildings and equipment

Intangible assets


Current assets

R

1 056 000

26 000

70 000

218 000

1 370 000

5.1.6

Total owners’ equity

Ordinary share capital

Share premium

Retained earnings (refer to 5.1.7)

R

550 000

50 000

74 000

674 000



5.1.7

Retained earnings

Balance (30 September 20.5)

Net profit

Dividends

R

50 000

58 000

(34 000)

Balance (30 September 20.6) 74 000

5.1.8


Long-term loan

R

556 000

556 000

5.1.9

Current liabilities

Accounts payable

Income tax payable

Accrued expenses (Interest

R28 000 and Wages R36 000)

Loan payable, current portion

R

44 000

12 000

64 000

20 000

140 000

5.1.10

Total liabilities


Current liabilities

R

556 000

140 000

696 000

5.1.11

Total owners’ equity and

liabilities

Owners’ equity

Total liabilities

R

674 000

696 000

1 370 000

5.2

It is an indication that management does not understand the significance of cash discounts.

It is probably unaware that the percentage cash discount, when converted to an annualised

return on investment, can be a very attractive return.

It may appear to credit grantors that the entity cannot borrow money at a lower interest rate

to earn the higher rate from the cash discount.

For any of the above reasons, the credit grantors may consider the entity to be a poor credit

risk.



5.3

5.3.1

(R400 000 X 80%) X 2% = R6 400

5.3.2 R6 400 X 100

R393 600

= 1,63 %

for 20 days

Annualised return = 1,63 % X 18 = 29,3%

Remarks:

If the invoices are paid by the 10th

day, a discount of R6 400 is allowed and the customers

give up the use of R393 600 paid for 20 days because the alternative is to keep the money

for another 20 days and pay R400 000 to RNI Ltd. So, by choosing not to pay within 10

days, the customers are “borrowing” R393 600 for another 20 days at a cost of R6 400.

The return on investment for 20 days is 1,63% (calculated above). However, there are 18

available 20-day periods in a year (360 days/20). Thus the annualised return is 29,3%.

5.4

During periods of inflation (when costs are rising), LIFO results in a lower closing

inventory and a higher cost of goods sold than FIFO. This is because the LIFO assumption

results in the most recent, higher, costs being transferred to cost of goods sold (cost of

sales).

5.5

The cost principle requires assets to be recorded at their original cost. The balance sheet,

thus, does not show the market value or replacement value of the assets that have a long

life. Land, for example, that may have been acquired 20 years ago is reported at its original

cost even though its current value is much higher.

Furthermore, the carrying values reflected for assets such as vehicles, equipment and

machinery depend on the amount of depreciation that has been calculated and recorded.

The depreciation expense itself is an estimate as the useful life of the asset and it’s salvage

value are estimated.



5.6

In the financial year in which the asset is purchased, the operating income (calculated in the

income statement) will be higher if the straight-line method is used (since the depreciation

expense will lower than for the accelerated methods). The carrying value of the asset

(reflected in the balance sheet) will also be higher if the straight-line methods are used.

As time passes, depreciation per annum decreases using accelerated methods and a stage

will be reached when the operating income will be higher than straight-line methods. Also

as time passes, using accelerated methods, the carrying value of the assets in the balance

sheet will decrease at a lower rate compared to straight-line methods.

5.7

* The amount of debt that the company has outstanding.

* The changes in debt.

* The interest rates on debt.

* Current and future cash flows associated with the existing debt.

5.8

Return on investment is closely related to risk. Preference shares have dividend and

liquidation preference over ordinary shares. Liquidity preference means that in the event of

the company being liquidated, preference shareholders are repaid for their investments

before ordinary shareholders but after creditors (including bonds). Therefore preference

shares are less risky as an investment than ordinary shares but are more risky than bonds.



TOPIC 4

INCOME STATEMENT AND CASH FLOWS

LEARNING OUTCOMES


► explain what revenue is.

► determine cost of sales using the periodic and perpetual inventory systems.

► explain the significance of the gross profit ratio.

► report the components of “other operating expenses”.

► outline the significance of “income from operations”

► calculate earnings per share.

► describe the purpose and format of the statement of cash flows.

► present “cash flows from operating activities” using the direct and indirect methods.

► outline the significance of the statement of cash flows to investors and other analysts.



CONTENTS

1. Income statement

2. Statement of cash flows


READING

Prescribed


9th


Recommended


(Chapter 4)


Decisions, Third edition, Thomson South-Western: Canada. (Chapters F4 and F5)


Press Southern Africa: Cape Town. (Chapters 11-15 and 18)


(Chapter 4)



1.

INCOME STATEMENT

The income statement, as we already know, provides an indication of the financial results

of an entity for the financial period under review. It achieves this by reporting on the

income, expenses and net profit for a financial period. Income results from economic

benefits flowing to the entity because of various transactions with third parties, other than

the owners of the entity. Income includes both revenue and gains. Revenue is generated in

the course of ordinary activities of an entity e.g. sales, rent, fees. Gains are other items that

meet the definition of income and do not necessarily arise from the course of the ordinary

activities of the entity. Expenses are decreases in economic benefits in the form of outflows

or depletion of assets or the incurrence of liabilities that result in a decrease in equity

excluding distribution to equity participants.

The following exhibit represents a simple framework of the main items that are reported in

an income statement.

Exhibit 4-1

INCOME STATEMENT Paragraph

Sales

Cost of sales

Gross profit

Other operating expenses

Income from operations

Interest expense

Interest income

Gains (losses) on sale of assets

Income tax expense

Net profit

Earnings per share

1.1

1.2

1.3

1.4

1.5

1.6

1.6

1.6

1.7

1.8

1.8



We now examine how the above items are reported in the income statement.

1.1

Sales

Sales reflect the amount an entity earns through selling products that it has purchased or

manufactured. In terms of the accrual basis of accounting, revenue from the sale of goods is

recognised when earned, and this may not necessarily coincide with the timing of the

receipt of cash. If a customer returns merchandise, the customer may be given a cash refund

(if sales were for cash) or the accounts receivable may be decreased (in respect of credit

sales). Sometimes an allowance is given to a customer instead of having the goods returned.

These sales returns and allowances are recorded separately for internal control purposes

but the amount is subtracted from sales to arrive at net sales. Cash discounts to customers

are also deducted from sales to arrive at net sales. Some companies show how the net sales

are calculated by means of a note to the financial statements.

? THINK POINT 1

A customer ordered and paid for equipment that has still to be manufactured, so the

equipment is presently not available for sale. How will this be accounted for in the financial

statements?

1.2

Cost of sales

Cost of sales is the cost of the merchandise sold to customers. In compliance with the

matching principle cost of sales is recognised concurrently with the income it relates to viz.

sales. The determination of the cost of sales amount depends on:

* The practices used for valuing inventory viz. FIFO, LIFO, Weighted average (topic 3).

* The inventory accounting system used viz. periodic or perpetual.

Under the perpetual inventory system, when merchandise is sold its cost (as calculated

according to the practice for valuing inventory e.g. FIFO) is transferred from the inventory

account (asset) to the cost of sales account (expense). The important thing about the

perpetual inventory system is that the cost must be determined when the sale takes place.

The use of bar code scanners have facilitated the use of the perpetual inventory system.



In the periodic inventory system, physical stocktaking of the inventory on hand is done

periodically (including the end of the financial year) and the cost of inventory on hand is

then determined. The cost of sales is then calculated as follows (figures included to

illustrate the calculation):

Exhibit 4-2

Cost of opening inventory

+ Net purchases

R

40 000

120 000

= Cost of goods available for sale

– Cost of closing inventory

160 000

(50 000)

= Cost of sales 110 000

When using the periodic inventory system freight expenses as well as purchases returns and

allowances are accounted for in separate accounts and each account balance is classified

with purchases. Net purchases is then calculated as follows:

Exhibit 4-3

Purchases

+ Freight charges

– Purchases returns and allowances

R

118 000

5 000

(3 000)

Net purchases 120 000

1.3

Gross profit

Gross profit (also called gross margin) is the difference between sales revenue and cost of

sales. If the net sales of an entity is R200 000 and the cost of sales is R110 000 (using the

amount from exhibit 4-2), then the gross profit will be reported as follows:

Exhibit 4-4

Net sales

Cost of sales

R

200 000

(110 000)

Gross profit 90 000



When the gross profit is expressed as a percentage of sales, this ratio is called the gross

profit ratio (or gross margin ratio). Using the figures from exhibit 4-4, the gross profit

ratio is calculated as follows:

Exhibit 4-5

Gross profit ratio = Gross profit X 100

Net sales

= R90 000 X 100

R200 000

= 45%

This ratio is of significance to managers in the following ways:

Since the ratio measures the amount of each Rand of sales that is available to cover

operating expenses and profit, one of its main uses is to determine whether the entity is

operating at a level of sales that will lead to profitability in the current period. Managers

will know from past experience the gross profit ratio that is required to be profitable.

The gross profit ratio can be used to estimate the cost of sales and closing inventory for

periods in which physical stocktaking was not done. An estimate of inventory destroyed by

fire, floods or other natural disasters can be made.

The gross profit ratio is also used to set selling prices. If the gross profit ratio needed to

achieve profitability at a given level of sales is known, the selling price can be determined

by dividing the cost of the item by the complement of the gross profit ratio. This can be

demonstrated by using the figures from exhibits 4-4 and 4-5. If the cost price of the goods

is R110 000 and the gross profit margin is 45%, then the sales amount is calculated as

follows:

Sales = Cost of sales

100% – Gross profit margin

=

=

R110 000

100% – 45%

R200 000



1.4

Other operating expenses

Operating expenses are the costs of resources used as part of the operating activities during

a financial period and are not directly associated with specific goods and services.

Operating expenses include selling expenses, general and administrative expenses, and

research and development expenses.

These categories may be combined in a variety of ways for the purpose of financial

reporting e.g. selling, general and administrative expenses. Details of the nature and amount

of expense items that are combined in the income statement are sometimes disclosed by

means of a footnote to the financial statements. However, some operating expenses are

shown as separate items to highlight their significance e.g. advertising. Depreciation and

amortization expense is reported as a separate item in the income statement (or explanatory

notes) as it does not involve the payment of cash.

1.5

Income from operations

Income from operations is the difference between the gross profit and operating expenses.

The significance of this amount is that it is often used to measure the ability of management

to utilize the entity’s operating assets. Interest income, interest expense, gains and losses,

income tax and other non-operating transactions are excluded from income from

operations. Many investors thus prefer to use income from operations rather than net profit

to assess the profitability of the entity.

1.6

Interest, gains and losses

These are non-operating items that are reported after income from operations.

Interest expense must be disclosed separately on the face of the income statement as

finance costs. Many users of financial statements would be interested in the interest

expense as it represents an obligation that must be honoured. The greater the interest

expense an entity incurs, the greater the risk will be to shareholders on their investment.

Revenue items, with the exception of sales, are included with “other income” on the face of

the income statement and details of revenue are presented in the notes to the financial

statements. Items that must be disclosed include interest income and dividends earned.



Gains and losses result from increases in the carrying value of assets and liabilities that do

not result from the ordinary operating activities of the entity. When the nature and amount

of transactions are important to the understanding of the entity’s financial performance and

about the financial position of that entity, gains and losses from the disposal of property,

plant and equipment should be disclosed separately from the disposal of long-term

investments. Significant gains and losses should be disclosed separately in the notes to the

financial statements including the tax effect thereof. Gains are normally included as part of

“other income”. Some of the gains and losses that should be separately disclosed in the

notes to the financial statements include profits and losses from property, plant and

equipment, foreign exchange gains and losses, profits and losses from sale of intangible

assets, and profits and losses from the sale of financial instruments.

1.7

Income tax expense

The income tax levied on South African companies is termed “SA Normal Tax” and is

levied on the company’s taxable income. In addition to normal tax, a company is charged

with “Secondary tax on companies” (STC) on the net dividends declared during its

dividend cycle. The tax expense of the entity should be disclosed on the face of the income

statement and the taxes payable are included in current liabilities in the balance sheet.

? THINK POINT 2

Income tax is levied on a company’s taxable income. Why do you think that income tax is

not levied on the company’s net profit before tax?

1.8

Net profit and Earnings per share

Arithmetically, the net profit (or loss) is the difference between revenues and gains on the

one hand and expenses and losses on the other. Since net profit is a prerequisite for

dividends, shareholders and potential investors are especially interested in the net profit.

To facilitate the interpretation of the net profit (or loss), the earnings per (ordinary) share is

reported. Because of its significance, earnings per share are reported on the income

statement just below the amount of the net profit. It is calculated by dividing the net profit

by the number of shares issued.



An entity should also disclose the dividends per share declared or proposed for the period

covered by the financial statements.

? THINK POINT 3

Do you think that dividends declared for the financial period should be reflected in the

income statement? Explain.

2.

CASH FLOW STATEMENT

The cash flow statement (or statement of cash flows), is a relatively new financial

statement, that developed to fulfil the needs of the users of financial statements. This is

largely due to the fact that the income statement is based on the accrual basis and does not

show the cash flows from operating activities and also does not provide valuable

information relating to cash flows from investing and financing activities (except for some

related expenses and income). The main purpose of a cash flow statement is to provide

information about the cash receipts and cash payments of an entity for a specific period.

The statement provides reasons why cash and cash equivalents changed during the period

by reflecting the net cash utilised or generated by operating activities, investing activities

and financing activities.

Having an understanding of a company’s cash flows and the reasons for the cash flows are

important to investors, managers, and other decision-makers. To be able to grow, a

company must generate adequate cash flows to pay its bills, repay its debt, and provide an

adequate return to its owners. Information obtained from a cash flow statement is used for

evaluating past performance and future prospects.

2.1

Operating activities

The cash flows from operating activities are derived from the main revenue-generating

activities of the entity. They are cash flows that result from transactions reflected in the

income statement. However, due to the determination of income and expenses according to

the accrual basis, certain non-cash items are also included and they need to be excluded to

determine the cash resulting from operating activities.



? THINK POINT 4

Of what use is the “cash from operating activities” to the users of financial statements?

The cash flow statement can be presented using two different formats. These formats only

differ in the manner in which “cash generated from operations” is disclosed on the face of

the statement. The remaining parts of the cash flow statement are identical for both formats.

The first format called the direct method prescribes that the operating cash flows be

disclosed according to the entity’s major classes of gross cash receipts and gross cash

payments. The following is an illustration of the disclosure on the face of the cash flow

statement of cash generated from operations using this method.

Exhibit 4-6

Direct method

Cash received from customers

Cash paid to suppliers and employees

R

2 000 000

(950 000)

Cash generated from operations

1 050 000

The second format is called the indirect method. Using this method, the cash flows from

operating activities are calculated by adjusting profit before interest in order to determine

cash generated from operations. The adjustments involve the following:

* items relating to investing and financing decisions e.g. loss on sale of equipment

* non-cash flow adjustments e.g. depreciation

* the effect of using the accrual basis (changes in working capital).

The following is an illustration of the disclosure on the face of the cash flow statement of

cash generated from operations using the indirect method.



Exhibit 4-7

Indirect method

Profit before interest and tax i.e. operating profit

Adjustments to convert to cash from operations

R

1 450 000

Non-cash flow adjustments 100 000

Add: Depreciation

Add: Foreign exchange loss

60 000

40 000

Profit before working capital changes

Working capital changes

(500 000)

Increase in inventory

Increase in receivables

Increase in payables

(400 000)

(200 000)

100 000

Cash generated from operations 1 050 000

When the direct method is used, the reconciliation of operating profit in the income

statement to cash flows from operations is not disclosed in the cash flow statement.

However, it is recommended that the reconciliation between net profit before tax and

interest and cash generated from operations be shown as a note to the cash flow statement.

This reconciliation will allow the user to assess the ability of the enterprise to convert

operating profit into cash. Exhibit 4-7 indicates that when the indirect method is used,

information relating to the reconciliation of operating profit to cash flows from operations

is presented on the face of the cash flow statement.

2.2

Investing activities

This category of the cash flow statement provides details about specific expenditures made

to generate future income and outflows. It relates mainly to the purchase and sale of non-

current assets. Separate disclosure of investing activities to expand operations is

recommended. Examples of cash flows from investing activities include:

payments to acquire non-current assets;

receipts from sale of non-current assets;

payments to acquire other entities and other equity or debt instruments;

receipts from sale of interests in other entities, and sale of other equity or debt instruments;

loans made to other parties or receipts from the repayment of such loans.



The following is an example of how cash flow from investing activities would appear on

the face of the cash flow statement:

Exhibit 4-8

Cash flow from investing activities

R

(50 000)

Additions to plant and equipment

Proceeds from sale of land and buildings

(200 000)

150 000

2.3

Financing activities

Cash flows from financing activities provide information relating to cash flows to and from

providers of capital. This is useful to investors who wish to predict any future claims on the

cash of the entity. Examples of cash flows from financing activities include:

proceeds from the issue of shares and other equity instruments;

proceeds from loans, bonds and issue of debentures;

repayments of amounts borrowed.

The following is an example of the disclosure of cash flow from financing activities on the

face of the cash flow statement:

Exhibit 4-9

Cash flow from financing activities

R

250 000

Long-term borrowings redeemed

Proceeds from shares issued

(50 000)

300 000



2.4

Interpretation of cash flow patterns

Ingram et al (2005: 190) provide a summary (exhibit 4-10) of common cash flow

combinations together with an indication of how well a company may be performing.

Exhibit 4-10

Operating

Cash flows

Investing

Cash flows

Financing

Cash flows

Normal interpretation

+

–

+

The company is prosperous and growing.

Financing cash flow is used to take advantage

of growth opportunities.

–

+

+

The company is facing serious financial

problems. It is selling assets and using

financing activities to meet current cash needs.

+

+ or –

–

The company is prosperous but may not have a

lot of good growth opportunities. It is using

operating cash to pay off debt and pay

shareholders.

+ or –

+

–

The company may be facing a current cash

flow problem. It is selling assets to supplement

current cash flows to cover its financing needs.

This is especially a problem if the company is

short of cash to repay debt.

The amount of the increase or decrease in an entity’s cash balance is usually not of major

importance. Quite often the change is small. A small increase or decrease in cash does not

signify financial problems or strengths. A net decrease in cash must not be interpreted as

being a huge financial problem for an entity. The focus should rather be on the changes in

operating, investing and financing cash flows.



3.

3.1

3.2

3.3

3.4

3.5


Of what significance is the Income statement to managers, shareholders, potential investors

and others?

Explain the implications of the matching principle on the preparation of the income

statement.

In an income statement that is prepared in accordance with accounting principles, what

does a sales figure of R800 000 mean?

Explain the significance of the gross profit ratio to management.

JB Enterprises expects to have a gross profit ratio of 60% for the current financial year.

Opening inventory amounted to R38 000. Net sales and net purchases for the year are

R200 000 and R126 000 respectively. The entire closing inventory was destroyed by fire.

Calculate the estimated value of closing inventory.

3.6 The cost of a kilogram pack of washing powder is R16 to Nino Ltd. What should the

selling price be if a 60% gross profit ratio is desired?

3.7 What may be the consequence of the interest rate on borrowed funds being greater than the

return on assets?

3.8 Study the income statement of Rivonia Ltd for the years ended 30 June 20.6 and 20.5 and

answer the questions that follow:

Income statement for the years ended 30 June 20.6 and 20.5.

Net sales

Cost of sales

20.6 (R)

800 000

450 000

20.5 (R)

680 000

432 500

Gross profit 350 000 247 500

Selling, general and administrative expenses 125 000 106 250

Income from operations 225 000 141 250

Other income (expenses)

Interest expense

Other income

Loss on disposal of asset

16 000

11 000

5 000

14 000

12 000

-

Profit before tax 215 000 139 250

Income tax 95 000 70 000

Net Profit 120 000 69 250

Earnings per share ? R0,14



3.8.1

Questions

Based on the mark-up used to determine the selling price, management expected a gross

profit of R400 000 for 20.6. What are the possible reasons for the gross profit being lower

than expected?

3.8.2 Has the gross profit ratio improved from the financial year ending 20.5 to 20.6? Explain

how this could have happened.

3.8.3 Name some specific expenses that could be included as “Selling, general and administrative

expenses”.

3.8.4 Could there have been any movements in the non-current liabilities? Explain.

3.8.5 If the carrying value of the asset sold was R13 000, calculate the selling price.

3.8.6 The interest rate on loans was 16% whilst the return on assets was 24%. How would

shareholders interpret this?

3.8.7 Has the earnings per share for the financial year ended 20.6 improved over the previous

financial year? How do you think shareholders will feel about this? (Note the number of

shares issued was 500 000.)

3.8.8 Comment on the financial result of the company for 20.6.

3.9

3.9.1

3.9.2

In a cash flow statement, how would you interpret the following:

a positive cash flow from operating activities?

a negative cash flow from operating activities?

3.10

Users of financial statements usually compare the cash used for investing activities with the

cash provided by operating activities? Explain why.

3.11

Answer the following questions based on information gleaned from a cash flow statement

of a company.

3.11.1 Cash flows from operating activities are decreasing even though profits are increasing.

How would you explain this? What are possible consequences?

3.11.2 Of what significance are the details of an entity’s investing activities to an investor?

3.11.3 How would you interpret a combination of positive net cash flows from operating activities

and negative cash flows for investing activities?

3.11.4 A company generates more cash from operating activities than it can use for investing

activities. What would the company probably do with the cash? What does this say about

the performance and prospects of the company?

3.11.5 Cash inflow from financing activities may be a positive sign or a negative sign depending

on how the funds were utilised. Discuss this statement.



SOLUTIONS

? THINK POINT 1

The supplier cannot recognise the revenue of the sale until the equipment has been

manufactured and delivered to the customer. Since the customer has already paid, the

amount received will be reflected as a liability.

? THINK POINT 2

Certain items are treated differently in terms of Generally Accepted Accounting Practice

and the Income Tax Act. As a result the net profit (before tax) will differ from the taxable

income. Examples of such differences include the following:

The company’s accounting depreciation expenses may differ from the tax depreciation

(called “wear-and-tear allowances”) allowed by the Income Tax Act.

Certain expenses may not be allowed as deductions for income tax purposes e.g. traffic

fines.

Certain kinds of income are excluded from taxable income as they are exempt e.g. SA

source dividends received.

? THINK POINT 3

No. A dividend does not reflect the performance of an entity. It is distributed as a result of

the performance of an entity. The income statement reflects the profit of a company where

profit is income less expenses. The definition of an expense excludes the result of

transactions with shareholders. A dividend results from a distribution to shareholders and is

therefore not an expense.



? THINK POINT 4

Cash from operating activities is an important indicator of the extent to which an entity was

able to obtain sufficient cash from its day-to-day operations to (without having to raise

additional finance):

* repay its loans.

* pay dividends.

* make new investments.

Trends that emerge from “cash from operating activities” are useful in predicting future

operating cash flows.

3.1

They would be interested in the financial results of the entity. In particular they may want

to know amongst other things:

* The amount of profit or loss that was made.

* Whether the profit realised is a satisfactory return on the capital invested.

* Whether sales are increasing relative to cost of sales and other operating expenses.

* Whether the entity is exercising effective control over expenses.

* The impact of the financial result on the financial position of the entity.

* How to evaluate the stewardship of the directors.

3.2 * The objective of financial statements is to report transactions to users as and when they

occur.

* Revenue earned and costs incurred are thus reflected in the income statement of the

period in which they relate irrespective of the period of receipt or payment.

* It will be inappropriate to report profit as the difference between cash received and cash

paid during a period because some trading and commercial activities would be excluded

since many transactions are based on credit.

* Applying the matching principle will result in the development of financial statements

that report the entity’s correct financial position to the stakeholders.



3.3

The sales figure does not represent cash received from sales. Rather it represents an

increase in the assets of the entity from the sale of merchandise to customers. The sales

figure thus represents the total assets that are expected to be received from the transactions

irrespective of when the cash was received. Note that the sales figure would have already

been adjusted (decreased) to take into account sales returns and allowances and cash

discounts to customers.

3.4 This ratio is of significance to managers in the following ways:

Since the ratio measures the amount of each Rand of sales that is available to cover

operating expenses and profit, one of its main uses is to determine whether the entity is

operating at a level of sales that will lead to profitability in the current period. Managers

will know from past experience the gross profit ratio that is required to be profitable.

The gross profit ratio can be used to estimate the cost of sales and closing inventory for

periods in which physical stocktaking was not done. An estimate of inventory destroyed by

fire, floods or other natural disasters can be made.

The gross profit ratio is also used to set selling prices. If the gross profit ratio needed to

achieve profitability at a given level of sales, the selling price can be determined by

dividing the cost of the item by the complement of the gross profit ratio.

3.5

Sales

Cost of sales

Cost of opening inventory

Net purchases

R

38 000

126 000

R

200 000

(80 000)

100%

40% of R200 000

Cost of goods available for sale

Cost of closing inventory

164 000

*(84 000)

*R164 000 – R80 000

Gross profit 120 000 60% of R200 000

* Note: The expected cost of closing inventory is calculated last.



3.6

Selling price = R16

40%

= R40

3.7

If the return on assets is less than the interest rate on borrowed funds, this will add risk to

the entity because if the entity does not earn enough to pay the interest on the debt, the

debt-holders can eventually force the entity into bankruptcy.

3.8

3.8.1

Some merchandise may have been sold below the normal selling price.

Monthly or seasonal sales may have been held.

Some merchandise may have been incorrectly priced.

3.8.2

Gross profit ratio

20.6

= Gross profit X 100

Net sales

= R350 000 X 100

R800 000

= 43,75%

20.5

= Gross profit X 100

Net sales

= R247 500 X 100

R680 000

= 36,40%

Yes. The ratio has improved from 36,40 % to 43,75%. This could be attributed to one or

more of the following:

Merchandise may have been procured at a lower price than the previous financial year.

The business may have not been liberal in granting cash discounts to customers.

Fewer sales may have been held.

3.8.3 Salaries, advertising, depreciation, rent expense, insurance, stationery, repairs and

maintenance etc.

3.8.4

Yes. The increase in interest expense indicates that non-current liabilities may have

increased.

3.8.5 Selling price = R13 000 – R 5 000 = R8 000



3.8.6

Since the company borrowed money at an interest cost of 16% and was able to use to earn a

return higher than 16%, the shareholders will have a greater return on their investment than

if they provided all of the funds themselves. In other words, the use of borrowed money

enhanced the return to owners.

3.8.7

Earnings per share =

20.6

Net profit

=

=

No. of shares issued

R120 000

500 000

R0,24

Yes. Earnings per share increased by R0,10 per share. Shareholders should be happy with

this increase as it represents an improvement in the financial performance of the company.

Higher earnings per share means that they can expect a greater dividend per share.

3.8.8

The financial result of the company, as evidenced by the net profit, has improved since

20.5. This is further substantiated by the increase in the earnings per share. This could be

largely attributed to the 17,65% increase in net sales as well as the attainment of a higher

gross profit ratio.

3.9

An entity that has a positive cash flow from operating activities has sufficient funds to

finance its day-to-day activities and may even have sufficient cash to finance investing

activities like the purchase of property, plant and equipment.

A negative cash flow from operating activities usually forces the entity to obtain outside

funding to finance its day-to-day activities as well as its investing activities. A negative

cash flow from operating activities may be expected initially from an entity that has just

started but it is a sign of possible financial weakness to an established entity.

3.10

If the cash from operating activities is greater than the cash used for investing activities,

this indicates that the entity is generating cash it requires to finance its expansion. If the

cash from operating activities is less than the cash used for investing activities, this

indicates that the entity had to obtain cash from financing activities or use cash

accumulated from the previous year. This may not be a serious problem because investment



requirements in one year may be unusually high. However, if cash from operating activities

is less than the cash needed for investing activities year after year, and the difference is

obtained from financing activities then the ability to acquire funds from financing activities

will be brought into question. Creditors will refuse to lend money to an entity that cannot

generate operating cash flows to ensure the repayment of debt.

3.11

3.11.1

It may be that accounts receivable and/or inventories are increasing at a higher rate than

sales.

This is a sign that the business may experience liquidity problems (inability to pay short-

term debts) that may not be detected by liquidity ratios. The inability of the entity to collect

its accounts receivable and/or sell its inventory may artificially increase current assets

thereby creating a false impression that the entity would be able to pay off its short term

obligations.

3.11.2

The details of an entity’s investing activities may give a good idea of its growth strategy.

Users will be able to determine whether the entity is acquiring capacity by investing in

more property, plant and equipment or by purchasing other entities. If property, plant and

equipment is sold, users will want to know the reasons for and consequences of such a sale.

3.11.3

It is a sign of good performance and growth. The excess cash from operating activities is

used for expansion through the purchase of additional assets. The value of a company

increases as it grows. As the company expands by purchasing additional assets, it will be

able to produce and sell more products, which in turn will result in greater profitability and

increased operating cash flows.

3.11.4

It will probably use the cash to repay debt or make payments to shareholders. If the

payments are large, this may indicate that the company is performing well but does not

have a lot of good investing opportunities.

3.11.5

It is a positive sign if the company is using the cash in investing activities i.e. buying more

assets. It is a negative sign if the cash is used for operating activities.



TOPIC 5

FINANCIAL ANALYSIS

LEARNING OUTCOMES


explain why it is important to analyse financial statements.

calculate and interpret ratios from management’s point of view.

calculate and interpret ratios from owners’ point of view.

calculate and interpret ratios from the point of view of creditors and lenders.

CONTENTS

1. Introduction

2. Ratio analysis

3. Ratio analysis: Management’s point of view

4. Ratio analysis: Owners’ point of view

5. Ratio analysis: Lenders’ and creditors’ point of view

6. Self-assessment activities

7. Solutions



READING

Prescribed


9th


Recommended

► Helfert, E.A. (2003) Techniques of Financial Analysis. 11th

Edition. New York:

McGraw-Hill/Irwin. pp.107-144

► Meredith, G. and Williams, B. (2005) Managing finance: Essential Skills for Managers.

1st Edition. North Ryde: McDraw-Hill. pp.75-93



1. INTRODUCTION

According to Helfert (2003:107) when one wishes to assess the performance of a

business, one looks for ways to measure the financial and economic consequences of

past management decisions that shaped investments, operations, and financing over

time. One needs to know whether resources were used effectively, whether

profitability expectations were achieved or even exceeded, and whether financing

choices were made prudently.

In this topic we will analyse business performance based on information contained in

financial statements. Meredith and Williams (2005:76) state that the analysis of

financial statements is important in order to:

■ explain and understand the reasons for levels of performance of sales, control of

expenses, profits, funds, and investment in general.

■ identify trends in performance and owner investment over time.

■ identify the position of the enterprise in an industry in order to identify strengths,

weaknesses, opportunities, and threats.

■ understand past performance in order to plan for the future.

■ assist managers and owners to make the best use of available resources.

2. RATIO ANALYSIS

A ratio may be defined as the relationship between two sets of values obtained from

financial statements. Ratios provide a means to summarise complex accounting

information into a small number of key indicators. They make figures more easily

comparable.

Our discussion will focus on three major viewpoints of financial performance

analysis viz.:

■ Managers

■ Owners

■ Lenders and creditors

Helfert (2003:110) indicates the main performance areas of interest to management,

owners, and lenders in Figure 1-1, together with the most common ratios:



Figure 1-1

MANAGEMENT

OWNERS

LENDERS AND

CREDITORS

Operational analysis Profitability Liquidity

Gross margin Return on equity Current ratio

Operating margin Earnings per share Acid test ratio

Profit margin

Resource management Disposition of earnings Financial leverage

Inventory turnover Dividend per share Debt to assets

Debtors collection period Earnings retention Debt to equity

Creditors payment period

Turnover to net assets

Profitability Market indicators Debt service

Return on assets Price/Earnings ratio Interest coverage

Return on capital employed

We’ll now follow the sequence shown in Figure 1-1 and discuss each sub-grouping

within the three broad viewpoints. For the purposes of illustration we will use

information from Figure 1-2 and Figure 1-3 adapted from Helfert (2003:111) that

represent the simplified Income Statement and Balance Sheet respectively of Reunion

Limited. We will also follow his discussion of the ratios.



Figure 1-2

Reunion Limited

Income Statements for the year ended 31 December 20.9 and 20.8

20.9 20.8

Sales (all credit) 3 344 800 3 149 600

Cost of sales (all credit purchases) (1 757 400) (1 625 200)

Gross profit 1 587 400 1 524 400

Operating expenses: (975 800) (933 200)

Selling, general and administrative

Other expenses

792 600

183 200

742 400

190 800

Operating profit 611 600 591 200

Other income: 5 400 6 600

Interest income 5 400 6 600

Profit before interest 617 000 597 800

Interest expense (103 584) (121 216)

Profit before tax 513 416 476 584

Tax (154 026) (142 974)

Net profit after tax 359 390 333 610

Figure 1-3

Reunion Limited

Balance Sheets the year ended 31 December 20.9 and 20.8

Assets 20.9 20.8

Non-current assets 1 628 600 1 566 000

Current assets: 1 275 800 1 213 200

Inventories

Accounts receivable


462 400

578 200

235 200

406 000

555 600

251 600

Total assets 2 904 400 2 779 200

20.9 20.8



Owners’ equity and liabilities

Owners’ equity 1 306 200 1 257 800

Ordinary share capital (Par value R1 each) 1 200 000 1 200 000

Retained earnings 106 200 57 800

Non-current liabilities (16% p.a.) 647 400 757 600

Current liabilities 950 800 763 800

Accounts payable 216 200 201 600

Other current liabilities 734 600 562 200

Total owners’ equity and liabilities 2 904 400 2 779 200

3. RATIO ANALYSIS: MANAGEMENT’S POINT OF VIEW

Helfert (2003:109) maintains that management has a dual interest in the analysis of

financial performance viz.:

■ To evaluate the efficiency and profitability of operations.

■ To assess how effective the resources of the enterprise are being used.

Evaluating the operations of an enterprise is largely done by an analysis of the

income statement whilst the effectiveness of resources is usually measured by a

review of both the income statement and balance sheet.

3.1 Operational analysis

An evaluation of operational effectiveness may be performed by a percentage analysis

of the income statement. The use of sales as a common base permits a ready

comparison of key costs and expenses from period to period, and against competitor

and industry databases.

3.1.1 Gross margin

Gross margin (also called gross profit margin) is one of the most common ratios in

operational analysis. It reflects the mark-up or value added over cost. It shows

operational effectiveness before expenses are considered. It is calculated by

expressing the gross profit as a percentage of sales:

Gross margin = Gross profit X 100

Sales 1



The gross margin ratio indicates the profit of the firm relative to sales after deducting

the cost of sales. Apart from measuring the efficiency of the enterprise’s operations,

it also indicates how products are priced. In the case of Reunion Limited gross

margin is as follows:

20.9 20.8

Gross margin = Gross profit X 100 Gross margin = Gross profit X 100

Sales 1 Sales 1

= R1 587 400 X 100 = R1 524 400 X 100

R3 344 800 1 R3 149 600 1

= 47.46% = 48.40%

A gross margin decline of 0.94% occurred from the previous year. A lower gross

margin may be the result of a number of factors:

■ The company may have consciously reduced margins in order to increase sales.

■ Margins may have been reduced to maintain sales levels in the face of increased

competition.

■ Price increases may have increased sales but the company may not have been able to

pass all the inflationary increases in the cost of sales to customers.

■ The sales mix may have been unfavourable i.e. a greater number of lower profit-

bearing products were sold.

THINK POINT 1

“One should assume that a fall in gross margin means that a company is becoming less

profitable and an increase in gross margin means that a company is becoming more

profitable. “ Do you agree? Explain.

3.1.2 Operating margin

This ratio shows the operational effectiveness of a company before the cost of

financing (interest expense), other miscellaneous income (e.g. interest income) and

income tax.



Operating margin is calculated by expressing the operating profit as a percentage of

sales:

Operating margin = Operating profit X 100

Sales 1

The operating margin of Reunion Limited is as follows:

20.9 20.8

Operating margin Operating margin

= Operating profit X 100 = Operating profit X 100

Sales 1 Sales 1

= R611 600 X 100 = R591 200 X 100

R3 344 800 1 R3 149 600 1

= 18.29% = 18.77%

A small decline of 0.48% from 20.8 is observed. Operating expenses thus increased

at a higher rate than the increase in sales.

3.1.3 Profit margin

This ratio pertains to the relationship of net profit after taxes to sales and is indicative

of management’s ability to operate the enterprise profitably. This is the margin on

sales that is potentially available for distribution to shareholders. To be successful an

enterprise must not only recover the cost of the merchandise, the operating expenses,

and the cost of borrowed funds but also there must also be reasonable compensation

to the owners for putting their capital at risk. The profit margin ratio is important to

operating managers since it reflects an enterprise’s pricing strategy and its ability to

control operating costs.

Profit margin is calculated by expressing the net profit after taxes as a percentage of

sales:

Profit margin = Net profit after tax X 100

Sales 1



The profit margin of Reunion Limited is as follows:

20.9 20.8

Profit margin Profit margin

= Net profit after tax X 100 = Net profit after tax X 100

Sales 1 Sales 1

= R359 390 X 100 = R333 610 X 100

R3 344 800 1 R3 149 600 1

= 10.74% = 10.59%

The ratio shows that the earnings available to shareholders were 10.74% of sales. A

small improvement of 0.15% from 20.8 is also noted. Net profit margin is

significantly lower than the gross margin and is probably due to the high operating

expenses.

3.2 Resource management

Resource management concerns the effectiveness with which management has

employed the assets entrusted to it by the owners of the enterprise. We will focus on

the rate at which inventory is sold, the time taken by debtors to pay accounts, the time

taken to settle creditors accounts and turnover to net assets..

3.2.1 Inventory turnover

In evaluating the effectiveness of an enterprise’s inventory management, it is

common to use the number of times inventory has turned over during the period of

analysis. The higher the turnover rate the better, since low inventories usually

suggest a minimal risk of non-saleable merchandise and also indicates efficient use of

capital. Inventory turnover is calculated as follows:

Inventory turnover = Cost of sales

Average inventory

Average inventories refer to the average of the beginning and ending inventories.

The inventory turnover of Reunion Limited is calculated as follows (Note:

Inventories for 20.7 amounted to R449 360.):



20.9 20.8

Inventory turnover Inventory turnover

= Cost of sales = Cost of sales

Average inventory Average inventory

= R1 757 400 = R1 625 200

R434 200 R427 680

= 4.05 times = 3.80 times

Note: Average inventory is calculated as follows:

20.9 20.8

= R462 400 + R406 000 = R406 000 + R449 360

2 2

= R434 200 = R427 680

The inventory turnover of Reunion Limited shows an increase from 3.80 times to

4.05 times per annum, indicating an improvement in efficiency. The analyst must

check that the improvement is not a result of dumping inventory on dealers etc. The

inventory turnover of 4.05 times for 20.9 implies that merchandise remains in

inventory for an average of 90 days (365 days ÷ 4.05 times) before being sold.

THINK POINT 2

What do you think are the implications for an enterprise if:

inventory turnover is low?

inventory turnover is high?

3.2.2 Debtor collection period

This ratio is useful in assessing the effectiveness of the credit administration of a

company. It ratio tells us how long, on average, trade debtors meet their obligations

to pay following the sale on credit. It highlight’s the enterprise’s management of

debtors (or accounts receivable). One would want to know whether the accounts

receivable that are outstanding at the end of the period closely approximate the

amount of credit sales one would expect to remain outstanding under prevailing

credit terms.



This is done as follows:

Debtor collection period = Accounts receivable X 365

Credit sales

20.9 20.8

Debtor collection period Debtor collection period

= Accounts receivable X 365 = Accounts receivable X 365

Credit sales Credit sales

= R578 200 X 365 = R555 600 X 365

R3 344 800 R3 149 600

= 63.10 days = 64.39 days

The debtor collection period may be interpreted in two ways. One can say that

Reunion Limited has an average of 63.10 days worth of credit sales tied up in

accounts receivable, or one can say that the average time lag between sale and receipt

of cash from the sale is 63.10 days. This collection period allows us to compare it

with the terms of sale. Thus if Reunion Limited sells on 30 day terms, the collection

period is very unsatisfactory. It could mean that some customers had difficulty

paying, or were abusing their credit privileges, or that some sales were made on

extended terms.

An increasing ratio indicates that a company is experiencing difficulties in collecting

debts. This may be an early warning sign of large bad debts.

3.2.3 Creditor payment period

This ratio tells us how long, on average, an enterprise takes to pay for goods bought

following the purchase on credit. It is used to evaluate an enterprise’s performance

with regard to the management of accounts payable (creditors). The number of days

of accounts payable (or creditor payment period) is compared to the credit terms

under which the enterprise makes purchases. Significant deviations from this norm

can be detected. Optimal management of accounts payable requires making payment

within the stated terms and no earlier except taking advantage of discounts whenever

offered for early payment. The ratio could thus indicate whether the company is

taking more time than usual to pay or if it is having difficulty in paying.



It will also indicate whether the company is taking full advantage of credit facilities

given to it.

Creditor payment period may be calculated as follows:

Creditor payment period = Accounts payable X 365

Credit purchases

20.9 20.8

Creditor payment period Creditor payment period

= Accounts payable X 365 = Accounts payable X 365

Credit purchases Credit purchases

= R216 200 X 365 = R201 600 X 365

R1 813 800 R1 581 840

= 43.51 days = 46.52 days

Note: Credit purchases are calculated as follows:

20.9 20.8

Cost of sales 1 757 400 1 625 200

Add: Closing inventory 462 400 406 000

2 219 800 2 031 200

Less opening inventory (406 000) (449 360)

Purchases (all credit) 1 813 800 1 581 840

Reunion Limited is probably allowed credit terms of between 30 days and 60 days by

creditors.

3.2.4 Turnover to net assets

This ratio is a measure of the sales rands generated by each rand of net assets.

Conversely it indicates the size of the net asset commitment required to support a

particular level of sales. Using net assets eliminates current liabilities from the total

assets. The assumption is that current liabilities are available to the company as a

matter of course. Thus the amount of assets employed in the business is effectively

reduced through these ongoing operational credit relationships.



Turnover to net assets is calculated simply as follows :

Turnover to net assets = Sales

Net assets

Turnover to net assets of Reunion Limited is calculated as follows:

20.9 20.8

Turnover to net assets Turnover to net assets

Sales Sales

Net assets Net assets

= R3 344 800 = R3 149 600

R2 904 400 – R950 800 R2 779 200 – R763 800

= R3 344 800 = R3 149 600

R1 953 600 R2 015 400

= 1.71:1 = 1.56:1

The sales generated by each rand of net assets have increased from R1.56 to R1.71.

This also indicates that the net assets required to support a level of sales have

decreased. The reasons for the improvement must be investigated.

3.3 Profitability

Here we examine how effectively management has employed the total assets and

capital as recorded in the balance sheet. This is evaluated by relating net profit,

defined in a variety of ways, to resources used to generate the profit. A satisfactory

return is one that:

■ exceeds the inflation rate.

■ is higher than alternative investments e.g. fixed deposits.

■ is higher than the cost of borrowing funds.

3.3.1 Return on assets (Operating profit on total assets)

Return on assets (ROA) measures the efficiency with which an enterprise allocates

and manages its resources i.e. whether the assets of the company are adequately and

effectively used.



A company that does not have a good return on total assets cannot generate a good

return on equity. ROA is calculated as follows:

Return on assets = Operating profit X 100

Total assets 1

Return on assets of Reunion Limited is calculated as follows:

20.9 20.8

Return on assets Return on assets


Total assets 1 Total assets 1

= R611 600 X 100 = R591 200 X 100

R2 904 400 1 R2 779 200 1

= 21.06% = 21.27%

Reunion Limited experienced a slight decline in profitability. It needs to compare

this return to other similar companies, the inflation rate, return on alternative

investments, and interest rate on borrowed capital to determine whether it is satisfied

with the return.

3.3.2 Return on capital employed

This ratio enables the analyst to determine whether the return earned is in excess of

what could be earned elsewhere. The return must, at the least, be greater than the

prevailing rates of interest and the weighted average cost of borrowings. This ratio is

an important comparison to the cost of the company’s capital. The calculation is as

follows:

Return on capital employed = Operating profit X 100

Capital employed 1

Capital employed consists of owners’ equity and non-current liabilities. Return on

capital employed for Reunion Limited is as follows:



20.9


= Operating profit X 100

Capital employed 1

= R611 600 X 100

R1 953 600 1

= 31.31%

20.8



Capital employed 1

= R591 200 X 100

R2 015 400 1

= 29.33%

The return on capital employed has improved. Since the return (31.31%) is greater

than the prevailing rate of interest (16%), the return is considered to be satisfactory.

4. RATIO ANALYSIS: OWNERS’ POINT OF VIEW

Owners are mainly interested in the profitability of the company. In this context

profitability refers to the returns earned through the efforts of management on the

funds invested by the owners. The owners would also be interested on the disposition

of earnings i.e. how much is paid out to them versus how much is reinvested in the

company. Lastly, they are concerned about the effect of the business results on the

market value of their shares.

4.1 Profitability

Financial analysts keep a close watch on the relationship between the profits earned

to the shareholders’ stated investment. Several key measures that express the

company’s performance in relation to the owners’ stake may be used.



The return on equity measures the profitability of the total ownership investment

while the earnings per share measures the proportional participation of each unit of

investment in corporate earnings for the period.

4.1.1 Return on equity (ROE)

Return on equity measures the rate of return on shareholders’ investment. It enables

one to check whether the return made on an investment is better than alternatives

available. It is calculated by expressing (as a percentage) the net profit after tax on

the average owners’ (shareholders’) equity:

Return on equity = Profit after tax X 100

Owners’ equity 1

Return on equity for Reunion Limited is calculated as follows:

20.9

Return on equity

= Profit after tax X 100

Owners’ equity 1

= R359 390 X 100

R1 306 200 1

= 27.51%

20.8

Return on equity


Owners’ equity 1

= R333 610 X 100

R1 257 800 1

= 26.52%



The return on equity has improved slightly. If alternative investments carrying a

similar risk yield a return in excess of this (27.51%), this would indicate that the

company’s profitability is low. However, it is unlikely to be the case here.

A good return on equity fuels investment interest from prospective investors. It

increases share prices and makes it easier for the company to borrow money.

4.1.2 Earnings per share (EPS)

Earnings per share is often considered to be an indicator of profitability. It is a

measure that both management and shareholders pay a great deal of attention to. It is

widely used to value ordinary shares and is often the basis for setting specific

corporate objectives and goals as part of strategic planning. The ratio simply

involves dividing net profit after tax by the number of ordinary shares in issue:

Earnings per share = Net profit after tax

Number of ordinary shares issued

Earnings per share for Reunion Limited is calculated as follows:

20.9 20.8

Earnings per share Earnings per share

= Net profit after tax Net profit after tax

Number of ordinary shares issued Number of ordinary shares issued

= R359 390 X 100 = R333 610 X 100

1 200 000 1 200 000

= 29.95 cents = 27.80 cents

The earnings per share has increased by 2.15 cents per share.

4.2 Disposition of earnings

The periodic separation of the net profit after tax (earnings) into dividends paid and

earnings retained is closely monitored by shareholders and the financial community

because the retained residual builds up the owners’ equity and is a source of funds for

management’s use.



Earnings may thus be either reinvested in the company to fund further growth or paid

out in part or full as dividends.

4.2.1 Dividend per share (DPS)

Dividends are usually declared on a per share basis by the company’s board of

directors. The board of directors usually has a dividend policy in place. Because the

value of ordinary shares is partly influenced by dividends paid and anticipated, the

board has to deal with this periodic decision very carefully. DPS is calculated by

dividing the dividends for the year by the number of ordinary shares issued:

Dividend per share = Dividends for the year


If the dividends of Reunion Limited for 20.9 and 20.8 were R220 000 and

R200 000 respectively, then the dividend per share is calculated as follows:

20.9 20.8

Dividend per share Dividend per share

= Dividends for the year Dividends for the year


= R220 000 X 100 = R200 000 X 100

1 200 000 1 200 000

= 18.33 cents = 16.67 cents

The dividend per share has risen by 1.66 cents per share, most likely due to the

increase in earnings per share.

4.2.2 Earnings retention

This ratio gives an indication of the amount of profit put back into the company and

is a useful ratio when determining the long-term prospects of a company. The

alternative to doing this ratio is to calculate the dividend payout ratio which is

calculated by dividing the dividend per share by the earnings per share.



Since most companies have a policy of paying dividends that are a relatively constant

proportion of earnings (e.g. 30 to 40%), these ratios permit shareholders to project

dividends from an assessment of the firm’s earnings prospects. Earnings retention

ratio is calculated as follows:

Earnings retention ratio = Earnings per share – Dividend per share X 100

Earnings per share

OR

Earnings retention ratio = Retained earnings for the year X 100

Profit due to ordinary shareholders

(Retained earnings = Profit due to ordinary shareholders – Ordinary dividend for the year)

The earnings retention ratio for Reunion Limited is calculated as follows:

20.9

Earnings retention ratio

= Earnings per share – Dividend per share X 100

Earnings per share 1

= 29.95 cents – 18.33 cents X 100

29.95 cents 1

= 11.62 cents X 100

29.95 cents 1

= 38.80%



OR

20.9


= Retained earnings for the year X 100

Profit due to ordinary shareholders 1

= R359 390 – R220 000 X 100

R359 390 1

= R139 390 X 100

R359 390 1

= 38.79%

20.8




= 27.80 cents – 16.67 cents X 100

27.80 cents 1

= 11.13 cents X 100

27.80 cents 1

= 40.04%

OR

20.8




= R333 610 – R200 000 X 100

R333 610 1

= R133 610 X 100

R333 610 1

= 40.05%



It appears that the company retains about 40% of the profit. This implies that the

dividend payout ratio is about 60% which is a fairly high payout and this can cause

problems with liquidity in difficult years. Also, adequate funds may not be available

for expansion when the need arises.

4.3 Market indicators

Here we will discuss one of the common indicators of stock market values viz.

price/earnings ratio.

4.3.1 Price/Earnings (P/E) ratio

According to Marshall et al (2011: 421) this ratio is one of the most important

measures used by investors and managers to evaluate the market price of a

company’s ordinary shares. It is also used to indicate how the stock market is

judging the company’s earnings performance and prospects. This is one reason why

the EPS is reported prominently on the face of the income statement. Earnings

multiple is another term for price/earnings ratio. This term merely reflects the fact

that the market price of a share is equal to the EPS multiplied by the P/E ratio.

Price/earnings ratio is calculated as follows:

Price/Earnings ratio = Market price per share

Earnings per share

The Price/Earnings ratio for Reunion Limited (market price per share for 20.9 and

20.8 was 130 cents and 120 cents respectively) is calculated as follows:

20.9 20.8

Price/Earnings ratio Price/Earnings ratio

= Market price per share = Market price per share


= 130 cents = 120 cents

29.95 cents 27.80 cents




The ratio shows that investors are willing to pay approximately 4.34 times earnings

for the shares. This ratio needs to be compared to the average P/E ratio of similar

companies. An above-average P/E ratio indicates that the market price is high

relative to the company’s current earnings, possibly because investors anticipate

favourable future developments such as increased EPS or higher DPS. Low P/E

ratios usually indicate poor earnings expectations.

5. RATIO ANALYSIS: LENDERS’ AND CREDITORS’ POINT OF VIEW

Lenders and creditors are interested in funding the needs of a successful enterprise

that will perform according to expectations. However, they have to also consider the

negative consequences of default and liquidation. Lenders and creditors have to

carefully assess the risk involved in recovering the funds extended. They therefore

have to look for a margin of safety in the assets held by the enterprise. Several ratios

are used to evaluate this protection by testing the liquidity of the enterprise. Another

set of ratios tests the leverage of the enterprise in order to weigh the position of

lenders versus owners. Lastly, there are coverage ratios that relate to the enterprise’s

ability to provide debt service from the funds generated by operations.

5.1 Liquidity

Liquidity ratios measure the ability of an enterprise to meet its short-term obligations.

They focus on the liquid assets of the enterprise i.e. current assets that can readily be

converted into cash on the assumption that they form a cushion against default. The

most commonly used liquidity ratios are the current ratio and acid test ratio.

5.1.1 Current ratio

The current ratio shows the relationship between current assets and current liabilities

and is an attempt to show the safety of current debt holders’ claims in the case of

default. Current ratio is calculated as follows:

Current ratio = Current assets

Current liabilities



The current ratio for Reunion Limited is as follows:

20.9 20.8

Current ratio Current ratio

= Current assets = Current assets

Current liabilities Current liabilities

= R1 275 800 = R1 213 200

R950 800 R763 800

= 1.34:1 = 1.59:1

A decline in the ratio (from 1.59:1 to 1.34:1) is largely due to the increase in current

liabilities from the previous year. An enterprise with a low current ratio may not be

able to convert its current assets into cash to meet maturing obligations. From a debt

holder’s point of view, a higher ratio appears to provide a cushion against losses in

the event of business failure. A large excess of current assets over current liabilities

seems to protect claims. However, from a management point of view a very high

current ratio may point towards slack management practices. It may indicate idle

cash, high inventory levels that may be unnecessary and poor credit management

resulting in overextended accounts receivable. The norm of 2:1 may also be used.

5.1.2 Acid test ratio

This ratio is a more stringent test of liquidity. The intention of the acid test ratio is to

test the collectability of current liabilities under distress conditions, on the

assumption that inventories would have no value at all. In the case of a real crisis

creditors may realise little cash from the sale of inventory. The acid test ratio is

similar to the current ratio except that the current assets (numerator) are reduced by

the value of the inventory. The calculation is done as follows:

Acid test ratio = Current assets – Inventory

Current liabilities



Reunion Limited acid test ratio is as follows:

20.9 20.8

Acid test ratio Acid test ratio

= Current assets – Inventory = Current assets – Inventories


= R1 275 800 – R462 400 = R1 213 200 – R406 000

R950 800 R763 800

= R813 400 = R807 200

R950 800 R763 800

= 0.86:1 = 1.06:1

It is clear that a ratio of less than 1:1 would pose liquidity problems in the event of a

crisis. Reunion Limited faces this position at the end of 20.9 as the ratio indicates

there only R0.86 of liquid assets is available to settle every R1 of current liabilities.

5.2 Financial leverage

An enterprise increases its financial leverage when it raises the proportion of debt

relative to equity to finance the business. The successful use of debt enhances the

earnings for the owners of the enterprises since returns on these funds, over and

above the interest paid, belongs to the owners, and therefore increases the return on

owners’ equity. However, from the point of view of the lender, when earnings are

insufficient to cover the interest cost, fixed interest and principal commitments must

still be met. The positive and negative effects of leverage increase with the

proportion of debt in the enterprise. The most common measures of leverage

compare the book value of an enterprise’s liabilities to the book value of its assets or

equity.

5.2.1 Debt to assets

Debt to assets is used to reflect the proportion of debt to the total claims against the

assets of the enterprise. The greater the ratio, the higher the risk. Debt to asset ratio

is expressed as follows:



Debt to assets = Total debt X 100

Total assets 1

The Debt to assets ratio of Reunion Limited is as follows:

20.9 20.8

Debt to assets Debt to assets

= Total debt X 100 = Total debt X 100


= R1 598 200 X 100 = R1 521 400 X 100

R2 904 400 1 R2 779 200 1

= 55.03% = 54.74%

The ratio indicates that 55.03% of Reunion Limited assets, in book value terms, come

from creditors of one type or another. Creditors normally prefer low debt ratios since

the lower the ratio the greater the cushion against creditors’ losses in the event of

liquidation, a fall in demand, and low profits. Owners on the other hand, may seek

high gearing since it magnifies earnings and the sale of new shares means giving up

some degree of control.

5.2.2 Debt to equity

This ratio attempts to show the relative proportions of non-current claims to

ownership claims, and is used as a measure of debt exposure. Debt to equity ratio is

expressed as follows:

Debt to equity = Non-current debt X 100

Owners equity 1



The Debt to equity ratio of Reunion Limited is as follows:

20.9 20.8

Debt to equity Debt to equity

= Non-current debt X 100 = Non-current debt X 100

Owners’ equity 1 Owners’ equity 1

= R647 400 X 100 = R757 600 X 100

R1 306 200 1 R1 257 800 1

= 49.56% = 60.23%

The ratio indicates that the non-current creditors supply Reunion Limited with 49.65

cents for every Rand supplied by the owners. The ratios over the two year period

show a decrease in the use of non-current debt by the company. This ratio is

important because many lending agreements of companies contain covenants

regarding debt exposure expressed in terms of long-term debt to capitalisation

proportions.

5.3 Debt service

The above ratios still don’t reveal a lot about the creditworthiness of the enterprise,

which involves the ability of the enterprise to meet its interest and principal on

schedule as contractually agreed upon. Our focus will be on interest coverage.

5.3.1 Interest coverage

This ratio is based on the premise that annual operating earnings are the basic source

for debt service, and that any major change in this relationship may signal difficulties.

Debt holders often stipulate the number of times the business is expected to cover its

debt service obligations. This ratio is of prime importance to a creditor. It measures

whether a company has sufficient profits to meet the interest payments on its debts.

The ratio for interest coverage is as follows:

Interest coverage = Operating profit

Interest expense



Reunion Limited interest coverage ratio is as follows:

20.9 20.8

Interest coverage Interest coverage

= Operating profit = Operating profit

Interest expense Interest expense

= R611 600 = R591 200

R103 584 R121 216


Reunion Limited interest coverage of 5.90 times means that the enterprise earned its

interest obligations 5.90 times over in 20.9; profit before interest and tax was 5.90

times as large as interest. The company can therefore meet its interest obligations.



6. SUMMARY OF THE RATIOS

MANAGEMENT

6.1 Operational analysis

6.1.1 Gross margin = Gross profit X 100

Sales 1

6.1.2 Operating margin = Operating profit X 100

Sales 1

6.1.3 Profit margin = Net profit after tax X 100

Sales 1

6.2 Resource management

6.2.1 Inventory turnover = Cost of sales

Average inventory

6.2.2 Debtor collection period = Accounts receivable X 365

Credit sales

6.2.3 Creditor payment period = Accounts payable X 365

Credit purchases

6.2.4 Turnover to net assets = Sales

Net assets

6.3 Profitability

6.3.1 Return on assets = Operating profit X 100

Total assets 1

6.3.2 Return on capital employed = Operating profit X 100

Capital employed 1

OWNERS

6.4 Profitability

6.4.1 Return on equity = Profit after tax X 100

Owners’ equity 1

6.4.2 Earnings per share = Net profit after tax




6.5 Disposition of earnings

6.5.1 Dividend per share = Dividends for the year


6.5.2 Earnings retention ratio = Earnings per share – Dividend per share X 100

Earnings per share

OR

6.5.2 Earnings retention ratio = Retained earnings for the year X 100

Profit due to ordinary shareholders

6.6 Market indicators

6.6.1 Price earnings ratio = Market price per share

Earnings per share

LENDERS AND CREDITORS

6.7 Liquidity

6.7.1 Current ratio = Current assets

Current liabilities

6.7.2 Acid test ratio = Current assets – Inventory

Current liabilities

6.8 Financial leverage

6.8.1 Debt to assets = Total debt X 100

Total assets 1

6.8.2 Debt to equity = Non-current debt X 100

Owners equity 1

6.9 Debt service

6 9.1 Interest coverage = Operating profit

Interest expense



7. SELF-ASSESSMENT ACTIVITIES

The following information relates to Simba Limited:

Income Statements for the year ended 31 December 20.9 and 20.8

20.9 20.8

Sales (all credit) 35 000 000 30 000 000

Cost of sales (all credit) (23 000 000) (20 000 000)

Gross profit 12 000 000 10 000 000

Operating expenses: (5 100 000) (4 000 000)

Distribution costs

Administrative expenses

2 000 000

3 100 000

1 500 000

2 500 000

Operating profit 6 900 000 6 000 000

Finance costs (400 000) (500 000)

Profit before tax 6 500 000 5 500 000

Income tax (1 500 000) (1 500 000)

Net profit after tax 5 000 000 4 000 000

Balance Sheets the year ended 31 December 20.9 and 20.8

Assets 20.9 20.8

Non-current assets 20 000 000 18 000 000

Property, plant and equipment 20 000 000 18 000 000

Current assets: 12 000 000 12 000 000

Inventories

Accounts receivable


6 000 000

5 000 000

1 000 000

6 000 000

4 000 000

2 000 000

Total assets 32 000 000 30 000 000

Owners’ equity and liabilities

Owners’ equity 20 000 000 18 000 000

Ordinary share capital 10 000 000 10 000 000

Retained earnings 10 000 000 8 000 000

Non-current liabilities 4 000 000 6 000 000

Current liabilities 8 000 000 6 000 000

Accounts payable 8 000 000 6 000 000

Total owners’ equity and liabilities 32 000 000 30 000 000



Statement of changes in equity for the year ended 31 December 20.9 and 20.8

20.9 20.8

Balance at end of previous year 18 000 000 16 500 000

Profit for the year 5 000 000 4 000 000

Ordinary share dividends (3 000 000) (2 500 000)

Balance at end of current year 20 000 000 18 000 000

Additional information

■ Simba Limited’s ordinary share capital consists of 10 000 000 ordinary shares with a

par value of R1 each.

■ The market price of the shares was R5.60 on 31 December 20.08 and R7.50 on

31 December 20.9.

Required

Calculate the following ratios for Simba Limited for 20.8 and 20.9 and comment on

your answers:

1. Gross margin

2. Operating margin

3. Profit margin

4. Inventory turnover (N.B. Inventories on 31 December 20.7 amounted to R6 000 000)

5. Debtors collection period

6. Creditors payment period

7. Turnover to net assets

8. Return on assets

9. Return on capital employed

10. Return on equity

11. Earnings per share

12. Dividend per share

13. Earnings retention

14. Price/Earnings ratio

15. Current ratio

16. Acid test ratio

17. Debt to assets

18. Debt to equity

19. Interest coverage



8. SOLUTIONS

THINK POINT 1

No, one cannot assume this all the time. A fall in gross margin could be the result of

a deliberate decision to increase sales. Likewise an increase in gross margin may be

due to a price increase that may actually show a fall in sales. One should therefore

determine the reasons behind the variation in the gross margin to arrive at a

conclusion on the performance of the company.

THINK POINT 2!

A low inventory turnover may mean that:

■ Demand for merchandise available on sale is low.

■ Items of inventory may be obsolete.

■ There is too much inventory.

A high inventory turnover may mean that:

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

■ Too little inventory is being carried in relation to the volume of sales.

■ There is a lower dependency on capital to carry inventory.

1.

20.9 20.8

Gross margin = Gross profit X 100 Gross margin = Gross profit X 100

Sales 1 Sales 1

= R12 000 000 X 100 = R10 000 000 X 100

R35 000 000 1 R30 000 000 1

= 34.29% = 33.33%

The gross margin has improved slightly. The improvement could be due to an

increase in selling price and/or reduced cost of purchases.



2.

20.9 20.8

Operating margin Operating margin


Sales 1 Sales 1

= R6 900 000 X 100 = R6 000 000 X 100

R35 000 000 1 R30 000 000 1

= 19.71% = 20%

Operating margin has decreased slightly. This may be due to operating expenses

increasing by a larger proportion than sales.

3.

20.9 20.8

Profit margin Profit margin

= Net profit after tax X 100 = Net profit after tax X 100

Sales 1 Sales 1

= R5 000 000 X 100 = R4 000 000 X 100

R35 000 000 1 R30 000 000 1

= 14.29% = 13.33%

Profit margin has improved despite the fact that operating expenses increased by a

larger proportion than sales. The increase is attributable to the decrease in finance

costs (a result of loan repayment).



4.

20.9 20.8

Inventory turnover Inventory turnover

= Cost of sales = Cost of sales

Average inventory Average inventory

= R23 000 000 = R20 000 000

R6 000 000 R6 000 000


Inventory levels have remained constant while sales have increased, resulting in a

higher inventory turnover for 20.9.

5.

20.9 20.8

Debtor collection period Debtor collection period

= Accounts receivable X 365 = Accounts receivable X 365

Credit sales Credit sales

= R5 000 000 X 365 = R4 000 000 X 365

R35 000 000 R30 000 000

= 52.14 days = 48.67 days

It is taking the company a few days longer than the previous year to collect money

from debtors. If the credit terms are 30 days, then debtors are taking too long to pay

and steps need to be taken to improve the collection period.



6.

20.9 20.8

Creditor payment period Creditor payment period

= Accounts payable X 365 = Accounts payable X 365

Credit purchases Credit purchases

= R8 000 000 X 365 = R6 000 000 X 365

R23 000 000 R20 000 000

= 126.96 days = 109.50 days

Note: Total purchases equal cost of sales since opening and closing inventories have not

changed. All purchases are on credit.

Creditors have increased by a larger proportion than credit purchases. The company

is taking longer to pay its creditors than the previous year and is almost certainly

exceeding the credit terms allowed by creditors (usually between 30 and 90 days).

7.

20.9 20.8

Turnover to net assets Turnover to net assets

Sales Sales

Net assets Net assets

= R35 000 000 = R30 000 000

R32 000 000 – R8 000 000 R30 000 000 – R6 000 000

= R35 000 000 = R30 000 000

R24 000 000 R24 000 000

= 1.46:1 = 1.25:1

The sales generated by each rand of net assets have increased from R1.25 to R1.46.

There has been an improvement in the utilisation of assets.



8.

20.9 20.8

Return on assets Return on assets



= R6 900 000 X 100 = R6 000 000 X 100

R32 000 000 1 R30 000 000 1

= 21.56% = 20%

Reunion Limited experienced a slight improvement in profitability. It needs to

compare this return to other similar companies, the inflation rate, return on alternative

investments, and interest rate on borrowed capital to determine whether it is satisfied

with the return.

9.

20.9



Capital employed 1

= R6 900 000 X 100

R24 000 000 1

= 28.75%



20.8



Capital employed 1

= R6 000 000 X 100

R24 000 000 1

= 25%

The return on capital employed has improved. The return appears to be greater than

the prevailing rate of interest and it is therefore considered to be satisfactory.

10.

20.9

Return on equity


Owners’ equity 1

= R5 000 000 X 100

20 000 000 1

= 25%

20.8

Return on equity


Owners’ equity 1

= R4 000 000 X 100

R18 000 000 1

= 22.22%

Profitability for shareholders has increased since profits have increased more than the

increase in owners’ equity. When compared to alternative investment opportunities,

shareholders should be fairly satisfied with this return.



11.

20.9 20.8


= Net profit after tax Net profit after tax


= R5 000 000 X 100 = R4 000 000 X 100

10 000 000 10 000 000


The improvement in the profitability of the company is evident in the EPS which has

increased by 10 cents per share.

12.

20.9 20.8

Dividend per share Dividend per share

= Dividends for the year Dividends for the year


= R3 000 000 X 100 = R2 500 000 X 100

10 000 000 10 000 000


DPS has increased by 5 cents per share. The increase in the EPS allowed the

company to declare higher dividends during 20.9.



13.

20.9




= 50 cents – 30 cents X 100

50 cents 1

= 20 cents

50 cents

= 40%

OR

20.9




= R5 000 000 – R3 000 000 X 100

R5 000 000 1

= R2 000 000 X 100

R5 000 000 1

= 40%

20.8




= 40 cents – 25 cents X 100

40 cents 1

= 15 cents

40 cents

= 37.50%



OR

20.8




= R4 000 000 – R2 500 000 X 100

R4 000 000 1

= R1 500 000 X 100

R4 000 000 1

= 37.50%

It appears that the company retains about 40% of the profit. This implies that the

dividend payout ratio is about 60% which is a fairly high. The earnings retention has

increased from 37.5% to 40%.

14.

20.9 20.8

Price earnings ratio Price earnings ratio

= Market price per share = Market price per share



50 cents 40 cents

= 15 times = 14 times

The market price of the shares has increased by an even greater proportion than the

earnings per share suggesting investor optimism in the company.



15.

20.9 20.8

Current ratio Current ratio

= Current assets = Current assets


= R12 000 000 = R12 000 000

R8 000 000 R6 000 000

= 1.50:1 = 2:1

Liquidity position has deteriorated due to the increase in current liabilities. Since

only R1.50 is available for every R1 short-term debt, the company may experience

difficulty in paying its short term debts as it is not easy to convert current assets such

as inventories into cash at short notice.

16.

20.9 20.8

Acid test ratio Acid test ratio

= Current assets – Inventory = Current assets – Inventories


= R12 000 000 – R6 000 000 = R12 000 000 – R6 000 000

R8 000 000 R6 000 000

= R6 000 000 = R6 000 000

R8 000 000 R6 000 000

= 0.75:1 = 1:1

Liquidity position has deteriorated. Without relying on the sale of inventories, the

company would not be able to pay its short-term debts (only R0.75 available for

every R1 owed).



17.

20.9 20.8

Debt to assets Debt to assets

= Total debt X 100 = Total debt X 100


= R12 000 000 X 100 = R12 000 000 X 100

R32 000 000 1 R30 000 000 1

= 37.50% = 40%

The proportion of debt to assets has decreased. 37.50% of assets are financed by

debt. From a creditor’s point of view the risk in the company is lower.

18.

20.9 20.8

Debt to equity Debt to equity

= Non-current debt X 100 = Non-current debt X 100

Owners’ equity 1 Owners’ equity 1

= R4 000 000 X 100 = R6 000 000 X 100

R20 000 000 1 R18 000 000 1

= 20% = 33.33%

The financial risk in the company is lower. This is due to the decrease in non-current

debt as well as an increase in owners’ equity. The low ratio leaves the door open to

take additional loans should the need arise.



19.

20.9 20.8

Interest coverage Interest coverage

= Operating profit = Operating profit

Interest expense Interest expense

= R6 900 000 = R6 000 000

R400 000 R500 000

= 17.25 times = 12 times

Interest coverage has increased which reduces the risk for lenders. The improvement

is due the reduced borrowings, reduced interest expense and higher operating profit.



TOPIC 6

COST-VOLUME-PROFIT RELATIONSHIPS

LEARNING OUTCOMES


► classify cost by their behaviour as fixed costs, variable costs, or mixed costs.

► describe what is meant by cost-volume-profit (CVP) analysis.

► outline the assumptions that CVP analysis depend on.

► calculate the contribution margin, the contribution margin ratio, and the unit contribution

margin, and explain its importance and usefulness to managers.

► explain how changes in the sales mix can affect projections using CVP analysis.

► explain the meaning and significance of the break-even point.

► calculate break-even point.

► determine the effects of changes in selling price, sales volume and fixed costs on operating

profit.

► determine volume necessary to achieve a target profit using the unit contribution margin.

► calculate operating leverage and margin of safety and understand the use of these concepts to

managers.



CONTENTS

1. Cost behaviour

2. Cost classifications

3. Cost-volume-profit relationships


READING

Prescribed


9th


Recommended


Thomson Learning: London. (Chapter 18)


Decisions, Third edition, Thomson South-Western: Canada. (Chapter M7)


Thomson South-Western: Singapore. (Chapter 6)


(Chapter 11)



1.

COST BEHAVIOUR

Having knowledge of how costs behave is important to management for a number of

reasons. Amongst other things it allows management to forecast profits as sales, costs and

production volume change. It is also useful for estimating costs. Estimated costs themselves

affect a number of management decisions e.g. whether to use excess capacity to produce

and sell a product at a lower price. Cost behaviour refers to the way in which a cost

changes as a related activity changes.

2.

COST CLASSIFICATIONS

The most common classification of cost behaviour is variable costs, fixed costs and semi-

variable (mixed) costs. Variable costs are costs that change in proportion to changes in the

volume of activity e.g. raw material cost to produce a product has a variable cost behaviour

pattern because an increase in the number of units produced will increase the total raw

materials cost. Fixed costs are costs that remain the same in total Rand amount as the level

of activity varies. For example rent expense is a fixed cost because rent expense will not

change irrespective of the level of production. The label of fixed or variable refers to the

behaviour of total cost in relation to a change in activity. However, when one examines

the behaviour of unit costs, the labels may be confusing since variable costs are the same

per unit but fixed cost per unit will vary as the level of activity changes.

? THINK POINT 1

Will you consider wages paid to employees in a factory to be a fixed cost or a variable

cost? Why?

An important assumption in cost behaviour pattern relates to the relevant range. Relevant

range refers to the range of activity over which the changes in the cost are of interest. This

relevant range assumption applies mostly to fixed costs. Returning to the example of rent

expense, it is apparent that a significant increase in the volume of production would require

more building space, and the rent expense would increase. To say that rent expense is fixed

means that over some relevant rage of production the total cost would not change. Another

important assumption is that the cost behaviour pattern is linear. This assumption

applies mainly to variable costs. As a result of economies of scale, quantity discounts and



other factors, variable costs will change slightly when expressed on a per unit basis. This

must be remembered when cost behaviour patterns are analysed.

Not all costs can be classified as either fixed or variable. Some are a combination of fixed

costs and variable costs and are called semi-variable or mixed costs. For example the total

electricity consumption at a factory changes with production levels as the number of

machine hours changes. However, if production drops to zero, electricity would still be

used for lighting and heating or cooling of plant facilities.

3. COST-VOLUME-PROFIT RELATIONSHIPS

Cost-volume-profit (CVP) analysis is an examination of the relationships among selling

prices, sales and production volume, costs and profits. In particular it examines the effect

on profits when there are changes in factors such as selling price, variable costs, fixed costs,

volume and the number of products marketed. CVP analysis puts management in a better

position to cope with various short-term planning decisions.

Using CVP analysis, managers would be able to get information to use in decision-making

relating to the following:

How profits are affected by a change in costs.

What effect a change in sales volume will have on profit.

The profit that is expected from a certain sales volume.

How many units need to be sold to achieve a targeted profit.

At what output of production will the income and costs be the same.

Setting selling prices.

Selecting the mix of products to sell.

In today’s competitive business environment, management must make such decisions

quickly and correctly.



3.1

Contribution margin concept

One relationship among cost, volume and profit is the contribution margin. Contribution

margin is the difference between sales revenues and variable costs. The contribution margin

concept is useful as it gives insight into the profit potential of an entity.

3.2

The traditional income statement format and the contribution margin income

statement format

The following exhibit illustrates the difference between an income statement prepared

according to the traditional format and an income statement prepared according to a

contribution margin format:

Exhibit 5-1

INCOME STATEMENTS

Traditional format Contribution margin format

Sales

Cost of sales

R600 000

(400 000)

Sales

Variable costs

R600 000

(480 000)

Gross profit

Operating expenses

200 000

(120 000)

Contribution margin

Fixed costs

120 000

(40 000)

Operating profit R80 000 Operating profit R80 000

Contribution margin (as reflected in exhibit 5-1) means that this amount is the contribution

to fixed expenses and operating profit. As sales increases variable expenses will increase

proportionately, and so will contribution margin. However, fixed costs will not increase.

When the traditional income statement is used, incorrect conclusions may be drawn when

changes in activity levels are being considered because it is assumed that all expenses

change in proportion to changes in activity. This error is avoided when the contribution

model is used correctly.



3.3

An expanded contribution margin model

Marshall et al (2011: 463) recommend an expanded version of the contribution model for

analytical purposes. Its benefits are best understood when applying it to a single product.

The expanded model is:

Exhibit 5-2

Per unit x Volume = Total %

Sales

Variable costs

R

Contribution margin R x = R %

Fixed costs

Operating profit R

The following steps are recommended when using the model:

Express sales, variable costs and contribution margin on a per unit basis.

Multiply contribution margin per unit by volume to obtain total contribution margin.

Subtract fixed costs from total contribution margin to obtain operating profit.

Express contribution margin as a percentage of sales.

The above expanded model demonstrates the effect on operating profit of changes in selling

price, variable costs, fixed costs, or the volume of activity. In the examples that follow, you

will observe the following four relationships constantly interacting with one another:

Sales – Variable costs = Contribution margin

Contribution margin ÷ Sales = Contribution margin ratio

Total contribution margin depends on the volume of activity

Contribution must cover fixed costs before an operating profit is earned.



Example 1 – Calculation of operating profit

Suppose management needs to know the operating profit from a product with the following

sales, cost and volume figures:

Exhibit 5-3

Selling price per crate

Variable costs per crate

Fixed costs in respect of the product

Sales volume in crates

R30

R18

R80 000

8 000 crates

Applying the figures in the model results in the following operating profit:

Exhibit 5-4


Sales

Variable costs

R30

R18

Contribution margin R12 x 8 000 = R96 000 40%

Fixed costs (80 000)

Operating profit R16 000

Example 2 – Drop in selling price and increase in sales volume

Suppose that management wants to know what would happen to operating profit if a R6 per

unit drop in selling price were to result in a sales volume increase of 4 000 units, to a total

of 12 000 units.

The operating profit will be:

Exhibit 5-5


Sales

Variable costs

R24

18



Operating loss (R8 000)

The calculations above clearly demonstrates to management not to implement the drop in

selling price by R6 as the result will be an operating loss of R8 000.



Example 3 – Decrease in selling price accompanied by an increase in advertising

expense and an expected increase in sales volume

Suppose management wants to implement the same R6 drop in the selling price per unit

accompanied by a R6 000 increase in advertising expense, with the prediction that sales

volume will increase to 19 000 crates.

Operating profit is expected to be:

Exhibit 5-6


Sales

Variable costs

R24

18




The calculations suggest that if the sales volume increase is possible from the price cut and

increased advertising (fixed cost), then operating profit will increase from its current level.

However, the relevant range assumption must be considered here as a large increase in sales

volume is likely to have an impact on fixed costs.

Example 4 – Calculating the volume of sales required to achieve a target level of

operating profit

Using the original data from example 1, suppose management wants to know the sales

volume required to achieve an operating profit of R46 000. The solution entails recording

the known data in the model and working to the middle to obtain the required sales volume:

Exhibit 5-7


Sales

Variable costs

R30

R18

Contribution margin R12 x ? = R126 000 40%



The required sales volume is 10 500 units (R126 000 ÷ R12).



Example 5 – Effect on contribution margin and operating profit when a change in

operations is expressed in terms of total sales.

Suppose the contribution margin is 40% and total sales are predicted to increase by

R24 000.

Using the marginal income ratio, it is expected that contribution margin and operating

profit will increase by R9 600 (R24 000 X 40%) provided that fixed costs did not change.

Example 6 – Increase in sales and sales volume required to cover an increase in fixed

costs

Suppose fixed costs were to increase by R18 000, selling price is R15 per unit and the

contribution margin ratio is 40%.

The contribution margin has to increase by the same amount if operating profit was to

remain the same. Sales will have to increase by R45 000 (R18 000 ÷ 40%) to earn a

R18 000 increase in contribution margin. The sales volume increase that is required to

generate the additional sales is calculated by dividing R45 000 by the selling price per unit,

which is R15. The volume increase is 3 000 units (which can also be calculated by dividing

the increased contribution margin required R18 000 by the margin contribution of R6 per

unit).

Example 7 – Determining sales and contribution margin changes when per unit data

is not available or applicable

The contribution margin model is often used to analyse the impact of an entire product line

(e.g. a chocolate bar brand) that is sold in a variety of package or size configurations (with

each configuration having virtually the same contribution margin ratio). Suppose a product

line had a contribution margin of 40%, would an advertising programme costing R36 000

be effective if it generated an additional R100 000 of sales?

The increase in contribution margin would be R40 000 (R100 000 X 40%) which is R4 000

more than the cost of the advertising. Thus the program would be cost effective.



3.4

Sales mix considerations

The sales mix issue must be considered when applying the contribution margin model using

data for more than one product. Sales mix is the relative distribution of sales among the

various products sold by an entity. Since different products often have different

contribution margin ratios, the average contribution margin ratio for a given mix of

products will vary if the sales mix of the products vary.

Exhibit 5-8 illustrates the effect of a change in the sales mix. You will notice that though

sales volume remained the same (6 000 units), total sales increased (from R135 000 to

R138 000) and operating profit decreased (from R16 000 to R14 800). This can attributed

to the sale of more units of product X (with a lower contribution margin ratio) than product

Y (which had a higher contribution margin ratio). Consequently the company’s average

contribution margin ratio also dropped (from 35,6% to 33,9%).

When an entity markets products of varying degrees of quality, products of a higher quality

usually have higher contribution margin ratios and marketing efforts are usually

concentrated on those products. Entities that market products with similar contribution

margin ratios do not have to be concerned about changes in the sales mix. Marketing efforts

can be more evenly spread.



Exhibit 5-8

(1). Assume that a company market 2 products. Shown below are per unit sales, variable costs and product volumes for current operations:

Product X Product Y Total for company

Per

unit

x

Volume

=

Total

%

Per

unit

x

Volume

=

Total

%

Total

%

Sales

Variable costs

R25

R18

3 000 R75 000

Sales

Variable costs

R20

R11

3 000 R60 000 135 000 100%

Contribution margin R7 x 3 000 = R21 000 28% Contribution margin R9 x 3 000 = R27 000 45% R48 000 35,6%

Fixed costs Fixed costs (32 000)

Operating profit Operating profit R16 000

(2). Now assume a change in the sales mix: Sales volume of product X increases to 3 600 units and sales volume of product Y drops to 2 400.

Product X Product Y Total for company

Per

unit

x

Volume

=

Total

%

Per

unit

x

Volume

=

Total

%

Total

%

Sales

Variable costs

R25

R18

3 600 R90 000

Sales

Variable costs

R20

R11

2 400 R48 000 138 000 100%

Contribution margin R7 x 3 600 = R25 200 28% Contribution margin R9 x 2 400 = R21 600 45% R46 800 33,9%





3.5

Break-even point

The break-even point is the level of operations at which the revenues of an entity are equal

to its total costs. In other words the entity has neither a profit nor a loss from operations.

Expressed in another way it is the point at which operating profit is equal to zero.

? THINK POINT 2

Of what significance is the break-even point to management?

There are various ways of calculating the break-even point. We will use the contribution

margin model to determine the break-even point. The break-even point can be calculated in

terms of units and revenues (Rand value). The following exhibit will be used to illustrate

this:

Exhibit 5-9


Sales

Variable costs

R30

R18

Contribution margin R12 x ? = ? 40%


Operating profit 0

In terms of the model, contribution margin must be equal to the fixed costs in order to

break-even. Therefore:

Exhibit 5-10

Break even quantity =

Fixed costs

=

=

Contribution margin per unit

R96 000

R12

8 000 units



Total revenues at break even =

Fixed costs

OR

=

=

Contribution margin ratio

R96 000

40%

R240 000

No. of units X Revenue

per unit

= 8 000 X R30

= R240 000

3.6

Target-profit analysis

A target profit is the operating profit that an entity wants to achieve over a stated period.

CVP analysis can also be used to determine the sales (in units or Rand value) needed to

achieve a target profit. This can be done by modifying the break-even formula stated above.

Using the information from exhibit 5-9 and a target profit of R24 000:

Exhibit 5-11

Target sales volume = Fixed costs + Target profit

=

=


R96 000 + R24 000

R12

10 000 units

Target sales value = Fixed costs + Target profit

=

=


R96 000 + R24 000

40%

R300 000

3.7

Operating leverage

Each change to an entity’s revenue due to volume of activity changes results in a

proportionate change to variable expenses and contribution margin. However, since fixed

costs will not change, operating profit will change proportionately more than changes in

sales. The extent of the effect on operating profit due to a change in sales is called

operating leverage. Operating leverage is calculated as follows:

Exhibit 5-12

Operating leverage = Contribution margin

Operating profit



A high contribution margin ratio results in a high operating leverage. Thus entities with

high fixed costs will have a high operating leverage. This is characteristic of capital-

intensive industries e.g. airline industry. A high operating leverage increases the risk that a

small percentage drop in sales will cause a relatively larger percentage decrease in

operating profit. Entities that are labour-intensive usually have a low operating leverage.

Exhibit 5-13 illustrates the impact of high- and low- operating leverage. Part A indicates

the current position (before any changes in sales volume). Part B indicates the effect of an

increase in sales volume from 20 000 to 22 000 units. Macro Ltd’s operating profit

increased by 30% (72 000/240 000 X 100) and the increase is at a much greater rate than

the 15% (36 000/240 000 X 100) achieved by Micro Ltd. Part C indicates the effect of a

decrease in sales volume from 20 000 to 18 000 units. It shows that Macro Ltd’s operating

income decreased at a much greater rate (R72 000/R240 000 = 30%) than Micro Ltd (R36

000/R240 000 = 15%).



Exhibit 5-13

Two entities manufacture similar products but they chose different cost structures. Micro Ltd is labour intensive with relatively high variable costs and

relatively low fixed costs. Macro Ltd is capital intensive with relatively low variable costs and relatively high fixed costs. Each entity currently sells 20 000

units of the product. The following is the contribution model for each firm.

A.

Micro Ltd Macro Ltd

Per

unit

x

Volume

=

Total

%

Per

unit

x

Volume

=

Total

%

Sales

Variable costs

R60

R42

Sales

Variable costs

R60

R24

Contribution margin R18 x 20 000 = R360 000 30% Contribution margin R36 x 20 000 = R720 000 60%

Fixed costs (R120 000) Fixed costs (R480 000)


Parts B and C of this exhibit will examine the effects of an increase and a decrease in sales volume respectively.



B. Effect on operating profit of an increase in sales volume from 20 000 units to 22 000 units.

Micro Ltd Macro Ltd

Per

unit

x

Volume

=

Total

%

Per

unit

x

Volume

=

Total

%

Sales

Variable costs

R60

R42

Sales

Variable costs

R60

R24




C. Effect on operating profit of a decease in sales volume from 20 000 units to 18 000 units.

Micro Ltd Macro Ltd

Per

unit

x

Volume

=

Total

%

Per

unit

x

Volume

=

Total

%

Sales

Variable costs

R60

R42

Sales

Variable costs

R60

R24






NOTES:



3.8

Margin of safety

The margin of safety is the amount by which the actual level of sales exceeds the break-

even point. It is the amount by which the sales volume may drop before losses are incurred.

If the margin of safety is low, even a small decrease in sales revenue may result in an

operating loss. The margin of safety may be expressed as a percentage and is calculated as

follows:

Exhibit 5-14

Margin of safety =

Sales – Break-even sales

X 100

Sales

If sales are R125 000, the unit selling price is R12,50, and the sales at break-even point are

R100 000, the margin of safety is 20%, calculated as follows:

Exhibit 5-15

Margin of safety =


X 100

=

=

Sales

R125 000 – R100 000

R125 000

20%

X 100

The margin of safety in terms of Rand sales is R25 000 (R125 000 – R100 000 or

R125 000 X 20%). The margin of safety can also be expressed in units. In this case it

would be 2 000 units (R25 000 ÷ R12,50). This means that present sales may decrease by

R25 000 or 2 000 units before an operating loss results.



4. SELF-ASSESSMENT ACTIVITIES AND SOLUTIONS

4.1 Classify the following costs as fixed or variable in terms of the level of output. Place a tick

in the appropriate column.

No. Cost Fixed cost Variable cost

1. Rent expense

2. Direct materials

3. Property rates and taxes

4. Commission of salesperson

5. Depreciation using straight-line method

6. Direct labour

7. Insurance

8. Salary of factory manager

4.2

AIM Ltd supplies component J to furniture manufacturers. The marketing manager is of the

opinion that if the selling price of component J is reduced, sales could increase by 25%.

The following information is available:

Selling price per unit

Sales volume

Variable cost per unit

Fixed costs

Operating profit

Present

R6

100 000 units

R4

R140 000

R60 000

Proposed

R5

25% more

R4

R140 000

?

4.2.1

4.2.2

4.2.3

Required

Calculate the expected profit or loss on the marketing manager’s proposal.

Calculate the number of sales units required under the proposed price to make a profit of

R60 000.

Calculate the sales value required under the proposed price to make a profit of R60 000.



4.3 Yashik CC manufactures one product. The following details relating to the product applies:

Variable costs per unit

Total fixed cost


Number of units sold

R72

R36 000

R82

6 000

4.3.1

4.3.2

Required

Calculate the break-even quantity and break-even value.

Calculate the margin of safety in terms of units and value.

4.4

Kivi Ltd manufactures and sells only one product. The budgeted details for 20.7 are as

follows:

Sales (units)


Variable cost per unit

Total fixed cost

150 000 per month

R3

R1,40

R1 350 000

4.4.1

4.4.2

4.4.3

4.4.3.1

4.4.3.2

4.4.3.3

Required

Calculate the budgeted profit for 20.7.

Calculate the break-even quantity and value.

Suppose Kivi (Pty) Ltd wants to make provision for a 10% increase in fixed costs and an

increase in variable costs by R0,20 per unit. Taking these increases into account, calculate

the following:

New break-even quantity and value

Safety margin (in terms of value)

The number of units that need to be sold to earn an operating profit of R400 000

4.5

HJK Limited sells two products viz. product A and product B. The fixed costs are

R300 000 and the sales mix is 60% product A and 40% product B. The unit selling price

and unit variable cost for each product are as follows:

Products Unit selling price Unit variable cost

Product A

Product B

R2,80

R2,00

R1,10

R0,80



4.5.1

4.5.2

Required:

Calculate the total break-even quantity.

How many units of each product would be sold at break-even point?

4.6

FMB Enterprises sales for March 20.7 was R200 000. Operating profit was R20 000.

Variable costs are usually 60% of sales. Suppose sales dropped by 15% in April to

R170 000. Would it be correct to say that operating profit will decline by 15% to R17 000?

Motivate your answer.

4.7

4.8

Explain the effect of a high operating leverage on profit from operations when there is a

small increase in sales.

How can an entity with a low operating leverage increase its operating profit significantly?

4.9

When an entity’s operating leverage becomes high, so too does the operating risk. What

steps could you, as a manager, take to reduce the risk?

4.10

Furnichum Manufacturers manufacture lounge suites that sell for R3 000 per suite. They

have the same basic design but may vary the fabric coverings. It has the capacity to produce

1 400 lounge suites each month although production very seldom exceeds 1 000 per month.

The sales manager received a request from a cut-price discounter (with many branches)

who made an offer to buy 300 lounge suites at R2 400 per suite. The latest monthly figures

reveal the following:

Per unit x Volume = Total

Sales

Variable costs

R3 000

R1 800

x

x

900

900

R2 700 000

(1 620 000)

Contribution margin R1 200 x 900 = R1 080 000



Would you advise the sales manager to accept or reject the sales offer? Substantiate your

answer.



4.11

Wheeler Ltd, a small company, is a mini-bus builder. It has the capacity to build 50 mini-

buses per year. The company has been able to sell all the mini-buses it produced each year.

The selling price of each mini-bus is R200 000. Variable costs are R76 000 per mini-bus.

The fixed costs of running the business are R2 500 000 per year. Last year the company

made an operating profit of R3 700 000 on sales of R10 000 000.

The directors are considering expanding the operations especially now that the property

next to the company is vacant and it would be possible to produce another 20 mini-buses

per year. They are confident that with the government’s new laws on re-capitalisation in the

taxi industry (which forces taxi owners to change their existing small mini-buses to larger,

safer ones) will favour them as their mini-buses comply with the government’s

specifications. They thus believe that they will be able to sell another 20 buses per year.

They estimate that the expansion will result in an additional R2 000 000 fixed costs with no

change to the variable costs per mini-bus. Should the directors accept or reject the proposal

to expand? Motivate your answer.

SOLUTIONS

? THINK POINT 1

Wages appears to be a variable cost since total wage costs vary according to the number of

hours worked. However, when a factory is producing below expected volume, in many

cases the employees are not asked to go home but remain at work. In other words, each

employee still works for the normal working week duration (e.g. 45 hours). In this case the

wages of the hourly paid employees is considered to be a fixed cost as the total hours

worked does not vary with production.

? THINK POINT 2

It provides the minimum sales target that must be achieved before an entity can start

showing a profit. Expressed another way, it is the sales level that must be reached before an

entity ceases to be unprofitable. Many managers find it simpler to think in terms of sales

rather than fixed and variable costs. Break-even point is a useful planning tool, especially

when decisions have to be made whether to increase or decrease operations.



4.1

No. Cost Fixed cost Variable cost

1. Rent expense

2. Direct materials

3. Property rates and taxes

4. Commission of salesperson

5. Depreciation using straight-line method

6. Direct labour

7. Insurance

8. Salary of factory manager

4.2.1 Expected profit or loss Per unit x Volume = Total %

Sales

Variable costs

R5

R4

Contribution margin R1 x 125 000 = 125 000 20%


Operating loss (15 000)

4.2.2 Target sales volume = Fixed costs + Target profit

=

=


R140 000 + R60 000

R1

200 000 units

4.2.3

Target sales value = 200 000 X R5 = R1 000 000

This amount can also be calculated as follows:

4.2.3 Target sales value = Fixed costs + Target profit

=

=


R140 000 + R60 000

20%

R1 000 000



4.3 Per unit x Volume = Total %

Sales

Variable costs

R82

R72

6 000

6 000

492 000

(432 000)

Contribution margin R10 x 6 000 = 60 000 12,195%


Operating profit 24 000

4.3.1


Fixed costs

=

=


R36 000

R10

3 600 units

4.3.1


Fixed costs

=

=


R36 000

12,195%

R295 200 (rounded off)

(OR 3 600 X R82)

4.3.2

Margin of safety =

(in terms of units)

=

=

Sales units – Break-even sales units

6 000 – 3 600

2 400 units

4.3.2

Margin of safety =

(in terms of value) =

=


R492 000 – R295 200

R196 800



4.4.1 Per unit x Volume = Total %

Sales

Variable costs

R3

R1,40

Contribution margin R1,60 x 1 800 000 = 2 880 000 53,333%

Fixed costs (1 350 000)

Operating profit 1 530 000

Note: Sales volume = 150 000 X 12 months = 1 800 000

4.4.2


Fixed costs

=

=


R1350 000

R1,60

843 750 units

4.4.2


Fixed costs

=

=


R1 350 000

53,333%

R2 531 250 (rounded off)

(OR 843 750 X R3)

4.4.3 Per

unit

x Volume = Total %

Sales (Volume:150 000 X 12)

Variable costs (R1,40 + R0,20)

R3

R1,60

1 800 000 5 400 000

Contribution margin R1,40 x 1 800 000 = 2 520 000 46,667%

Fixed costs (R1 350 000 +R135 000) 1 485 000




4.4.3.1


Fixed costs

=

=


R1 485 000

R1,40

1 060 714 units


Fixed costs

=

=


R1 485 000

46,667%

R3 182 120 (rounded off)

(OR 1 060 714 X R3)

4.4.3.2

Margin of safety =

(in terms of value) =

=

Budgeted sales – Break-even sales

R5 400 000 – R3 182 120

R2 217 880

4.4.3.3 Target sales volume = Fixed costs + Target profit

=

=


R1 485 000 + R400 000

R1,40

1 346 429 units

4.5

Product A + Product B = Total

Selling price R2,80 R2,00

Variable cost per unit R1,10 R0,80

Contribution margin per unit (R1,70 X 60%) + (R1,20 X 40%) = R1,50



4.5.1


Fixed costs

=

=


R300 000

R1,50

200 000 units

4.5.2

Break-even quantity of product A = 200 000 X 60% = 120 000 units

Break-even quantity of product B = 200 000 X 40% = 80 000 units

4.6 INCOME STATEMENTS

May 20.7 April 20.7

Sales

Variable costs (60%)

200 000

(120 000)

Sales

Variable costs (60%)

170 000

(102 000)

Contribution margin

Fixed costs

80 000

(60 000)

Contribution margin

Fixed costs

68 000

(60 000)

Operating profit 20 000 Operating profit 8 000

The answer is no. From the calculations above it is clear that operating profit will drop by

R12 000 to R8 000 (and not drop to R17 000). Since fixed costs remained unchanged, the

R12 000 decrease in contribution margin (resulting from the 15% decrease in sales) reduced

the operating profit by the same amount. This illustrates the point that fixed costs behave

differently from variable costs.

4.7

A high operating leverage indicates that a small increase in sales will result in a large

percentage increase in operating profit.

4.8

An entity with a low operating leverage requires a large increase in sales to increase its

operating profit significantly.

4.9

In order to reduce the operating risk, it is necessary to reduce fixed costs. This may not be

easy to do especially with costs that cannot be eliminated in the short-term e.g. long-term

lease of the premises. However, one needs to identify fixed costs that can be eliminated in a

relatively short term e.g. a renewable monthly advertising contract.



4.10

First, we need to determine whether the contribution margin of the proposal is positive or

not:

Per unit

Sales

Variable costs

R2 400

R1 800

Contribution margin R600

Since the contribution margin is positive, the sale at a discount of R600 per lounge suite is

still profitable. However other factors must also be considered. These include:

Once the discounter starts selling the lounge suites at R600 less than the usual price, the

manufacturer’s other customers will refuse to pay the normal price of R3 000 in future.

If the manufacturer had a reputation for high quality, this could be damaged by its

association with a price discounter.

4.11

If the proposal is to be accepted, the increase in revenue (incremental revenue) must be

greater than the increase in costs (incremental costs). The increase in profit (incremental

profit) is calculated as follows:

Incremental sales (20 X R200 000)

Incremental variable costs (20 X R76 000)

R

4 000 000

(1 520 000)

Incremental contribution margin

Fixed costs

2 480 000

(2 000 000)

Incremental operating profit 480 000

Decision: Since the incremental profit is a positive, it appears as though the company

should increase its capacity. However, the directors should also consider that the operating

profit percentage on the additional sales at 12% is much lower than the existing operating

profit percentage of 37% (R3 700 000/R10 000 000 X 100).



TOPIC 7

COST ANALYSIS FOR PLANNING, CONTROL AND DECISION-MAKING

LEARNING OUTCOMES


► explain the role of budgeting in planning and control.

► outline the significance of the sales budget to the overall operating budget.

► describe and how a purchases or production budget is drawn up.

► explain how the other budgets are essential to the preparation of a budgeted income

statement, cash budget and a budgeted balance sheet.

► define and what standard costing means.

► explain the advantages of standard costing.

► calculate material, labour, manufacturing overheads and sales variances

► explain the meaning of cost terminology used in the decision-making process.

► outline how costs are determined for short-run decisions.

► appreciate the importance of relevant costs in short-term decision-making.

► evaluate capital investment proposals using the following methods: payback period,

accounting rate of return, net present value and internal rate of return.



CONTENTS

1. Cost analysis for planning

2. Cost analysis for control

3. Cost analysis for decision-making


READING

Prescribed


9th

Edition, McGraw-Hill: New York. (Chapter 14, 15, 16)

Recommended


(Chapters 11 and 12)


Thomson Learning: London. (Chapters 16, 17)

Hand L., Isaaks C. and Sanderson P (2005) Introduction to Accounting for Non-Specialists, First

edition, Thomson Learning: London. (Chapter 9)


Decisions, Third edition, Thomson South-Western: Canada. (Chapters M1, M8 and M9)


Thomson South-Western: Singapore. (Chapters 9 and 10)


Management Accounting, Fifth edition, LexisNexis Butterworths: Durban. (Chapter 12)


(Chapters 11 and 12)


(Chapters 38, 39 and 40)



1.

COST ANALYSIS FOR PLANNING

Planning is an integral element of management. Planning involves creating a path for

achieving the entity’s goals and objectives. Strategic planning involves an identification of

the long-term goals and drawing up plans to achieve them. Examples of strategic decisions

include entering a new market, producing a new product and extending the plant.

Operational planning involves developing objectives for day-to-day activities e.g.

determining how much to produce each day to meet sales requirements.

Managerial accounting plays an important role in both strategic and operational planning.

Long-term financial planning is an important part of strategic planning. Strategic long-term

financial plans set targets in terms of financial performance over many years in the future.

These strategic financial plans are supported by operational plans that forecast monthly,

quarterly or annual financial results needed to achieve the long-term financial plans.

1.1

1.1.1

Budgeting

A budget is a plan in financial terms that extends for a period in the future. It forms part of

the broader process of planning.

Advantages of budgets

Budgets are useful for the following reasons:

It forces management to plan thereby reducing the number of opportunities for “off the

cuff” decisions.

If the budget process is effective, staff may feel motivated to work hard to achieve both

strategic and operational objectives.

It allows managers to control business activities by comparing actual outcomes to the

budget.

It provides a basis by which performance can be measured.

? THINK POINT 1

What problems do you think may arise as a result of drawing up budgets?



1.1.2

Approaches to budgeting

The starting point of most budgets is the actual results for the present period. After

examining the recent costs and revenue, these amounts are adjusted for changes that are

expected in the following period. The problem with this incremental approach is that

inefficiencies in the ways things are done currently are carried into the future. Another

budgeting technique is called zero-based budgeting. With zero-based budgeting cost

estimates are built up from zero level and it rests on the philosophy that all spending must

be justified. It is not automatically accepted that if some activity was financed this year it

will be financed again in the future. A good case must be made for the allocation of scarce

resources for that activity.

1.1.3

The budgeting process

Budgets are often prepared for a budget period of one year and this is called a single-

period budget. However, the budget period can extend over a shorter or sometimes longer

period. Another, related type of budgeting is known as the rolling budget. The budget is

initially prepared for an appropriate budget period e.g. one year. With each month that

elapses, another month is added to the end of the budget, so that there will always be a full

12 month budget.

According to Marshall et al (2011: 543) the first step in budgeting is to develop a set of

broad assumptions about the economy, the industry and the entity’s strategy for the budget

period. The operating budget (or master budget) is a collection of related budgets that

include the sales, purchases/production, material purchases, direct labour, manufacturing

overhead, operating expense, income statement, cash and balance sheet budgets.

The sales budget is first prepared. All other budgets depend on the sales forecast. The

quantity to be purchased or produced depends on expected sales and inventory levels. The

materials purchases, direct labour and manufacturing overhead budgets are prepared after

the production budget is drawn up. Selling expenses depend on sales while other operating

expenses depend on sales and purchases. A forecast income statement can now be prepared.

The cash budget can next be prepared followed, finally, by the forecast balance sheet.

A sales budget may be described as a forecast of the number of units the enterprise expects

to sell for a predetermined period. The reliability of the sales budget is important as all



other budgets are based on it. After the number of units that may be sold is estimated, the

number of units that can be produced may be determined. Whilst the sales budget depends

a lot on previous sales figures, consideration is also given to sales trends, future predictions

and competitors. Example of a simplified sales budget:

Exhibit 6-1

Sales budget for March 20.7

200 000 bottles of cooldrink @ R3each = R600 000

The purchases/production budget must be compatible with the sales budget. However,

other factors such as the inventory level held by the entity are important. The

purchases/production budget thus states the quantity of a product that must be purchased or

produced to meet an entity’s sales and inventory requirements. A basic

purchases/production budget is as follows:

Exhibit 6-2

Sales forecast (in units)

Desired closing inventory of finished goods

200 000

30 000

Total budgeted purchases/production needs

Opening inventory of finished goods

230 000

(20 000)

Required purchases/production 210 000

Cost of sales budgets are drawn up by both merchandising and manufacturing entities. For

a merchandising entity, the cost of goods available for sale is first calculated by adding the

opening merchandise inventory to the budgeted purchases. Closing inventory requirements

are then deducted from this amount to determine the budgeted cost of sales. The process is

identical for a manufacturing entity except that expected cost of goods manufactured

replaces expected purchases.

The materials purchases budget is prepared once the production budget has been drawn

up. Many entities keep materials on hand at all times to accommodate unforeseen changes

in demand. A basic materials purchases budget for plastic bottles is as follows:



Exhibit 6-3

Plastic bottles required in production (Exhibit 6-2)

Desired closing inventory of plastic bottles

210 000

42 000

Total budgeted need for plastic bottles

Opening inventory of plastic bottles

252 000

(52 000)

Required purchase of plastic bottles 200 000

Cost per plastic bottle R0,30

Cost of plastic bottles to be purchased R60 000

The direct labour budget also depends on the production budget. It is prepared by

multiplying the number of direct labour hours needed to produce each unit by the number

of units to be produced. The following is an example of a direct labour budget:

Exhibit 6-4

Required production (in bottles) (exhibit 6-2)

Direct labour hours per bottle (500 bottles per hour)

210 000

1/500

Total direct labour hours needed for production

Direct labour cost per hour

420

R20

Total direct labour cost R8 400

In a manufacturing overhead budget overhead costs are estimated. These costs may be

determined in a number of ways including department predetermined overhead rates and

activity-based costing. The following is an example of a manufacturing overhead budget

using a predetermined overhead rate:

Exhibit 6-5

Budgeted machine hours (same as labour hours)

Variable overhead rate per hour

420

R50

Variable manufacturing overhead

Fixed manufacturing overhead

R21 000

R120 000

Total manufacturing overhead R141 000



The operating expense budget includes selling, general, administrative and other

operating expenses. Some of these expenses are variable e.g. commissions, delivery

expenses while others are fixed e.g. rent expense, insurance. The following is an example

of an operating expense budget:

Exhibit 6-6

Variable selling and administrative expenses

Sales commissions

Delivery costs

Supplies

R

27 000

10 000

2 000

Fixed selling and administrative expenses

Rent expense

Salaries

Depreciation

Other fixed expenses

20 000

15 000

1 000

8 000

Total selling and administrative expenses 83 000

The budgeted income statement is drawn up from the sales budget, cost of sales budget

and operating expense budget. It is a summary of the various component projections of

income and expenses for the budget period.

Once all the other budgets including the sales budget are prepared, the cash budget can be

drawn up. The cash budget shows the expected receipts and expected payments for a

certain period of time. It usually depicts the monthly cash position of the enterprise. The

cash budget is prepared for the purpose of cash planning and control. It helps in avoiding to

keep cash lying idle for long periods and identifying possible cash shortages.

A schedule showing the amounts expected to be collected from debtors for credit sales is

usually attached to the cash budget. Note that a cash budget only involves amounts that

affect the cash balance of the enterprise. Therefore non-cash items such as depreciation,

bad debts, discount allowed and discount received are not included. Since budgets are used

internally by an enterprise, the style may vary from business to business.



However, most cash budgets have the following features:

- The budget period is broken down into sub-periods usually months.

- Receipts of cash are identified and totalled.

- Payments of cash are identified and totalled.

- The surplus (or shortfall) in cash for each month is calculated (receipts minus payments).

- The closing cash balance is calculated by taking into account the cash surplus (or

shortfall) and the opening cash balance.

An example of the format of a cash budget appears in the self-assessment activities

(question 4.4).

A budgeted balance sheet is prepared by starting with the balance sheet for the period just

ended and adjusting it using all the activities which are expected to take place during the

budgeted period. A budgeted balance sheet can help management to calculate a variety of

ratios. It also highlights future resources, obligations and possible unfavourable conditions.

The budgeted balance sheet is affected by all the other budgets. Production and purchases

budgets will indicate inventory estimates. Depreciation reflected in the operating expenses

budget will affect the carrying value of non-current assets in the balance sheet. The

expected net profit or loss reflected in the budgeted income statement will affect retained

earnings. The cash budget is a source of many balance sheet amounts e.g. purchase of

equipment, payment of dividends etc.

2.

COST ANALYSIS FOR CONTROL

Control involves the comparison of actual outcomes with planned outcomes as stated in the

entity’s strategic and operating plans. Control decisions involve matters relating to how

performance is evaluated, what measures to use and what types of incentives to use. At the

end of a particular period (e.g. a month, quarter, year etc), managers use the budget as a

control mechanism by comparing budgeted sales, purchases, and manufacturing costs to

actual sales, purchases and manufacturing costs. These comparisons are done through a

process called variance analysis. Variance analysis allows managers to determine whether

sales, purchasing and manufacturing costs are higher or lower than planned and more

importantly the reasons for the variance.



? THINK POINT 2

Managers are often advised to take action only when actual results deviate significantly

from planned. What could be possible reasons for this advice?

Standard costing is useful in variance analysis. A standard cost is a predetermined target

cost that aims to provide a benchmark against which to measure actual performance.

Factors such as quantities, prices, rates of pay and quality are considered in the setting of a

standard. Standards may be set for materials, labour, manufacturing overheads and selling

prices. All variances from the standard cost are the result of two factors viz. price and

quantity. The variance could be either favourable or unfavourable to the enterprise.

2.1

Material standards and variances

When material standards are set consideration is given to prices, quantity, quality, grades,

wastages etc. A price and a quantity standard are set for material. The standard material

price is usually based on past, present and expected future prices and also gives

consideration to economic order quantities, suppliers’ quotations and market factors. The

standard material quantity specifies the quantity required to manufacture one unit of a

completed product. Two main variances can occur with respect to material viz. a price

variance and a quantity variance.

Raw materials price variance is calculated when raw materials are issued to production.

It is based on the number of units issued and used. It is the difference between the actual

quantity issued at actual cost and the actual quantity issued at standard price. The formula

for is:

Raw materials price variance

(Actual price – Standard price) X Actual quantity issued

Raw material usage variance is the difference between the actual quantity of material

used (at the standard price) and the standard quantity of material allowed (at standard

price). Assume that 2 kg of raw material is used to manufacture one unit of a finished

product. If 200 units are manufactured, then the standard material quantity allowed is 400

kg (200 X 2 kg).



The formula is:

Raw material usage variance

(Actual quantity – Standard quantity) X Standard price

2.2

Direct labour standards and variances

Direct labour standards are set in terms of rate (tariff) and efficiency (time). With respect to

rate, wages scales that have been devised for various types of labour usually form the basis

of the rate standards. Efficiency relates to how long it should take to complete a task.

Let us examine the two variances concerning direct labour viz. direct labour rate variance

and direct labour efficiency variance.

The direct labour rate variance is calculated by multiplying the difference between the

standard rate and the actual rate to the number of hours worked.

The formula is:

Direct labour rate variance

(Actual rate – Standard rate) X Actual hours worked

The direct labour efficiency variance is related to the time it takes to manufacture a single

product. It is calculated by finding the difference between the actual hours worked (at

standard rate) and the standard time (hours) allowed for the actual production (at standard

rate).

The formula is:

Direct labour efficiency variance

(Actual time worked – Standard time allowed) X Standard rate

2.3

Manufacturing overheads standards and variances

Manufacturing overheads may be classified as fixed or variable and standards are set

separately. Variable costs (the same for each product) change in direct proportion to level

of business activity. The fixed overhead rate is calculated according to a predetermined

level of business activity. Overhead variances may be due to equipment lying idle,

absenteeism, changes in demand, efficiency of employees, working conditions etc.



Separate variances in respect of variable and fixed overheads may be calculated as follows:

Variable overhead variance

Overhead rates are often based on direct labour hours (used in this module) or machine

hours.

The efficiency variance is calculated as follows:

Variable overhead efficiency variance

(Actual hours – Standard hours allowed) X Standard rate

Note:

Standard hours allowed = Number of units produced X standard time to make one product

Standard rate = Standard variable overheads ÷ standard number of labour hours

The spending variance is calculated as follows:

Variable overhead spending variance

(Actual rate – Standard rate) X Actual hours

Note:

Actual rate = Actual variable overheads ÷ actual number of labour hours

Standard rate = Standard variable overheads ÷ standard number of labour hours

The total fixed overheads variance is the difference between the actual fixed overheads

and the standard fixed overheads allowed. The spending variance and the volume variance

are the main fixed manufacturing overheads variances.

The spending variance is calculated as follows:

Fixed overhead spending variance

Actual fixed overheads – Budgeted fixed overheads



The volume variance is calculated as follows:

Fixed overhead volume variance

Budgeted fixed overheads – Standard fixed overheads

Note:

Standard fixed overheads = Number of units produced X Standard time to make 1 product

X Standard rate per hour

Standard rate per hour = Standard fixed overheads ÷ standard number of labour hours

2.4

Interpreting favourable and unfavourable variances

Variances that are favourable or unfavourable may not necessarily be interpreted as good or

bad. In order to interpret variances, the underlying causes must be determined. Suppose an

entity is investigating an unfavourable direct labour efficiency variance. The problem could

be with worker efficiency but the investigation may reveal that the workforce is fixed in the

short-term and there are not enough orders to keep the workers busy. The entity may not

want to lay off workers for short periods as the workers may find other jobs or it may be

costly to re-hire them.

An unfavourable direct material usage variance may point to a problem in production.

However, usage could be high because the purchasing manager may have purchased

inferior quality materials resulting in many defective products produced. In this case the

direct material usage variance would be unfavourable but the material price variance will

most likely be favourable.

Management’s objectives are also important in interpreting variances. If, for example, cost

control takes priority, an unfavourable direct material price variance will most likely be

considered unacceptable. However, if management’s main objective is to provide high-

quality products, an unfavourable material price variance may be acceptable if a higher

price is necessary to procure high quality materials.

Once managers have identified the root causes of the variance and have considered their

own objectives in using variance analysis, they can now effectively consider alternatives

available to resolve the problem.



3.

COST ANALYSIS FOR DECISION-MAKING

We now examine how costs are involved in the decision-making process and especially in

the short-term. We first start by explaining certain cost terminology used in decision-

making. Differential cost is the increase or decrease in cost that is expected from a course

of action as compared to an alternative. For example, if adding a new feature to an existing

product is being considered, only the changes in the cost resulting from the new feature

need to be considered relative to the additional revenues expected to be generated from

adding the new feature. Costs that still continue to be incurred, whether or not the new

feature is added, are not relevant to the decision.

Allocated costs are costs that are assigned to a product or activity e.g. overhead costs

allocated to production runs using a predetermined overhead rate. Since many cost

allocation methods are arbitrary, managers must be circumspect about decisions made from

an analysis that includes allocated costs.

A sunk cost is a past cost that cannot be changed or cancelled by some future action. An

example of such a cost is a long-term lease.

An opportunity cost refers to some measurable advantage that could have been gained

from the alternative use of resources. For example, a manufacturer has the option of renting

part of his factory for R3 000 per month or using it to manufacture an additional product. If

he decides to manufacture the additional product, he will sacrifice rent income that he could

have received. This is considered an opportunity cost.

3.1

Short-term decisions

When making decisions, some costs are relevant to a decision that is to be taken, while

other costs are irrelevant costs. The relevant costs are those costs that will be affected by

the decision, whilst the irrelevant coats will not be affected. Examples of short-term

decisions include the acceptance or rejection of a sales offer and make or buy decisions.

3.1.1

Acceptance of a sales offer

Suppose the monthly capacity of a South African sporting goods manufacturer is 13 000

soccer balls. Current sales and production average 10 000 soccer balls per month. The

current manufacturing cost consists of variable costs of R30 per unit and total fixed costs of



R260 000. The normal selling price of the soccer ball is R65 each. The manufacturer

receives an offer from the soccer world cup committee for 2 000 soccer balls at R45 each

for the 2010 soccer world cup. The pricing policies of its markets will not be affected.

Should the offer be accepted?

A comparison of the sales offer of R45 with the selling price of R65 indicates that the offer

should be rejected. However, by focussing on the relevant cost, which in this case is the

variable cost, the decision is different. Exhibit 6-7 illustrates why.

Exhibit 6-7

Differential revenue from accepting the offer:

2 000 units @ R45

Differential cost by accepting the offer:

2 000 units @ R30

R90 000

(R60 000)

Differential profit from accepting the offer. R30 000

The special offer price of R45 generates a contribution margin of R15 (R45 – R30) and this

brings in R30 000 additional operating profit as no additional fixed costs were incurred

(given the idle capacity).

Let us examine what the operating profit would be if the entity was operating at full

capacity (13 000 units). If the entity rejects the sales offer, the operating profit at full

capacity would be:

Exhibit 6-8

Total: 13 000 units

Unit (R) Total (R)

Sales

Variable costs

65

30

845 000

(390 000)

Contribution margin

Fixed costs

35

20

455 000

(260 000)




If the entity accepts the offer while operating at full capacity, the effect on operating profit

is illustrated below:

Exhibit 6-9

Current sales

(11 000 units)

Sales offer

(2 000 units)

Total (R)

(13 000 units)

Unit (R) Total (R) Unit (R) Total (R) Total (R)

Sales

Variable costs

65

30

715 000

(330 000)

45

30

90 000

(60 000)

805 000

(390 000)

Contribution margin 35 385 000 15 30 000 415 000

Fixed costs (260 000) - (260 000)

Operating profit 125 000 30 000 155 000

By accepting the offer when operating at full capacity, the operating profit will decline by

R40 000 (R195 000 – R155 000) i.e. 20,5% decrease. The difference in the contribution

margin of R20 (R35 – R15) per soccer ball is the relevant opportunity cost – the operating

profit foregone by accepting the offer than rejecting it.

3.1.2

Make or buy decision

The assembly of components is often a substantial element in the production of products

such as motor vehicles. The components may be made by the manufacturer of the product

or they can be purchased. In the make or buy decision the relevant cost of making a

component is the cost that can be avoided by acquiring the component from a source

outside the company. Costs that will continue to be incurred regardless of whether the

component is made internally or purchased from outside are not relevant to the decision.

Suppose a motor car manufacturer has been purchasing dash boards for R480 each. The

factory is presently operating at 85% of capacity, and no major increase in production is

expected in the near future. The unit cost of manufacturing the dash boards internally,

including fixed costs, is expected to be as follows:

Exhibit 6-10

Direct materials

Direct labour

Variable factory overhead costs

Fixed factory overhead costs

R160

R160

R104

R136

Total cost per unit R560



If the buy price of R480 is compared to the make price of R560, the decision would favour

buying the dash boards. However, if the unused capacity could be used to make the dash

boards then the fixed factory costs will not be considered to be a relevant cost. The relevant

costs would thus be the direct materials, direct labour and variable factory overhead costs.

The cost per unit is illustrated below:

Exhibit 6-11

Direct materials

Direct labour

Variable factory overhead costs

R160

R160

R104


It now appears that there would be a cost saving of R56 (R480 – R424) if the dashboards

were manufactured internally. However, other factors must also be considered. The

capacity committed to the dashboards may not be available for more production

opportunities in the future. Business relations with the supplier of the dashboards, who may

supply other essential parts, may be affected.

3.2

Long-term decisions

Capital budgeting plays an important role in making long-term decisions. Capital

budgeting is a process of analysing capital expenditures e.g. investing in plant, equipment

etc to determine whether the investment will generate a satisfactory return on investment

over time.

A sum of money today has a greater value than the same amount at any time in the future.

This may be due to the effects of inflation, risk and loss of interest. The present value of

money is very important in capital investment appraisal. In order to eliminate the number

of steps to calculate the present value of any amount, present value tables are available.

The present value of R1 can be read from the tables.



3.2.1

Capital investment appraisal using techniques that ignore the time value of money

When appraising investment decisions, net cash flows need to be calculated. Net cash flow

is the difference between the cash inflow arising from an investment and the cash outflow

that it requires. However, the minimum rate of return of an investment should be greater

than the interest rate on borrowed funds or rate of return of the enterprise (depending on the

source of financing – borrowed or own). The following techniques that ignore the time

value of money may be used to evaluate capital investment projects:

Payback period

Accounting rate of return

3.2.1.1

Payback period

Payback period measures the amount of time required to recover the initial cost of the

investment from the net cash inflows from the project. The general decision rule to follow

is to choose the project with a shorter payback period. The reason for this is that the

shorter the payback period, the less risky the project and the greater the liquidity.

Payback period is calculated as follows if the net cash inflow is the same each year:

Cost of project

Net cash inflow (p.a.)

3.2.1.2

Accounting rate of return (ARR)

The accounting rate of return (ARR) measures profitability by relating the average

investment to the future annual net profit. In other words, ARR uses the average profit an

investment will generate and expresses it as a percentage of the average investment over

the life of the project. The project that is expected to realise a higher rate of return is

chosen.

The accounting rate of return of an investment is calculated as follows:

ARR =

Average annual profit

Average investment

X 100

1

The average investment in respect of a machine is calculated as follows:

Average investment =

Cost of machine + Disposal value or scrap value or residual value

2



3.2.2

Capital investment appraisal using discounted cash flow methods

Since the two methods described above do not take into account the time value of money,

the following methods are widely used to evaluate investment opportunities:

Net present value (NPV)

Internal rate of return (IRR)

3.2.2.1

Net present value (NPV)

By applying the present value method, the present values of future cash flows are

calculated using the enterprise’s minimum rate of return. The net present value is the

difference between the present value of the projected cash inflows and the present value of

the cash outflows. If the NPV is positive, then the project is considered for acceptance. If

the NPV is negative, the project is rejected since it would not be profitable.

3.2.2.2

Internal rate of return (IRR)

This is the discount rate that will discount the cash flows to a net present value of zero. In

other words the present value of cash flows minus the initial investment equals a zero

NPV. The IRR therefore indicates what a particular project is expected to earn. A project

must only be considered if the IRR exceeds the cost of capital. The advantage of the IRR

method is that it considers the time value of money and is therefore more realistic than the

accounting rate of return (ARR). However, the calculation can be difficult especially when

the cash flows are not even.

4.

4.1


What is the relationship among sales, production and purchases budgets?

4.2

Your friend, who works for a company selling household appliances, recently told you that

she finds it amazing that the company seems to forecast sales each year so well. She cannot

explain how it is able to do it. Outline to your friend some factors that the management of

her company may have taken into account to forecast sales.

4.3

It is said that the forecast of operating activities is the key to the entire budget.

Explain why this is so.



4.4

Study the debtors collection schedule, cash budget and additional information for MVN

Enterprises for the period 01 April 20.6 to 30 June 20.6 and answer the questions that

follow.

Debtors collection schedule

Month

Credit

sales

R

April

R

May

R

June

R

February

March

April

May

208 000

320 000

336 000

304 000

41 600

256 000

-

-

-

64 000

268 800

-

-

-

67 200

?

297 600 332 800 ?

Cash budget for the period 01 April to 30 June 20.6

April May June

Cash receipts ? ? ?

Cash sales

Receipts from debtors

Loan

84 000

?

-

?

?

-

72 000

?

60 000

Cash payments (309 400) (300 200) (284 500)

Cash purchases of merchandise

Payments to creditors for merchandise

Rent

Selling and administrative costs

Other expenses

Interest on loan

50 400

112 000

20 000

105 000

22 000

-

45 600

117 600

20 000

95 000

22 000

-

43 200

106 400

22 000

90 000

22 000

900

Cash surplus (shortfall) ? ? ?

Opening cash balance 4 000 ? ?

Closing cash balance ? ? ?

Additional information

Cash sales account for 20% of total sales.

Thirty percent (30%) of all purchases are for cash

Creditors are paid in full in the month after the purchase of merchandise.



QUESTIONS

4.4.1 Calculate the expected cash sales for May 20.6.

4.4.2 Fill in the other missing amounts (indicated by?) in the debtor’s collection schedule and

cash budget.

4.4.3

4.4.3.1

4.4.3.2

Calculate the amount of credit sales that is expected to be collected after:

one month.

two months.

4.4.4 Debtors are granted credit terms of 30 days. Comment on the collections from debtors.

4.4.5 A cheque for the loan is expected to be received on 01 June 20.6. Calculate the interest

rate on the loan if interest is paid monthly.

4.4.6 Calculate the expected total purchases of merchandise for May 20.6.

4.4.7 By what percentage is the rent expected to increase by in June?

4.4.8 What could be the reason for the loan?

4.4.9 Comment on the cash position of the entity for the budget period.

4.5

PC Solutions makes and sells computers. On 31 March 20.6, the entity had 60 computers in

inventory. The company’s policy is to maintain a computer inventory of 5% of the

following month’s sales. The sales forecast of the entity for second quarter of the year is:

April 1 200 computers

May 1 000 computers

June 900 computers

Required

What is the projected production for May?

4.6

The standard cost of material of product C for the third quarter of 20.6 was:

4 kg per unit at R3 per kg

45 000 kg of material was purchased at R2,80 for the third quarter.

The actual production of product C for the third quarter of 20.6 was:

9 000 units which took 37 000 kg of material

Required

Calculate the following variances:

4.6.1 Raw material price variance

4.6.2 Raw material usage variance

4.6.3 What are the most likely reasons for the price and usage variances? Who should be held

responsible?



4.7 Details relating to labour in the production department of AMI Ltd are as follows:

Standard labour cost

Actual hours worked and rate

Number of units manufactured

1,25 hours per unit at R5,50 per hour

600 hours @ R5,25 per hour

450

Required

4.7.1 Calculate the direct labour rate variance

4.7.2 Calculate the direct labour efficiency variance

4.7.3 What are the most likely reasons for the direct labour rate and efficiency variances?

Who should be held responsible?

4.8 The budgeted figures of GHI Manufacturers for August 20.6 are as follows:

Variable overheads

Fixed overheads

Number of labour hours

Standard time to manufacture one product

R49 000

R60 025

24 500

12

hours

The actual results are as follows:

Variable overheads

Fixed overheads

Number of labour hours worked

Units manufactured

R50 652

R60 300

24 120

2 000

4.8.1

Required

Calculate the following variances:


4.8.2 Variable overhead spending variance

4.8.3 Fixed overhead spending variance

4.8.4 Fixed overhead volume variance

4.9

What are some factors you would consider when accepting a special sales offer at a price

below cost?



4.10

Compu Limited has been purchasing carrying cases for its laptop computers at a delivered

cost of R102 each. The company, which is presently operating below full capacity, charges

factory overhead to production at the rate of 40% of direct labour cost. The fully absorbed

unit costs to produce similar carrying cases are expected to be:

Direct materials

Direct labour

Factory overhead (40% of direct labour)

R40

R48

R19,20

Total cost per unit R107,20

If Compu Limited manufactures the carrying cases, fixed factory overheads will not

increase and variable overhead costs associated with the cases are expected to be 25% of

the direct labour costs.

Required

Would it be advisable to make the carry cases or to continue buying them?

Support your answer by doing the necessary calculations.

4.11

Pegasus Limited expects to operate at 85% of productive capacity during June. The total

manufacturing costs for May for the production of 20 000 calculators are budgeted as

follows:

Direct materials

Direct labour

Variable factory overhead

Fixed factory overhead

R220 000

R90 000

R30 000

R70 000

Total manufacturing costs R410 000

The company has the opportunity to bid for 1 000 calculators to be delivered by 30 June to

a government agency. If the contract is obtained, selling and administrative expenses will

not increase. What is the unit cost below which Pegasus Limited should not go in bidding

on the government contract?



4.12

MG Motors intend investing in a new wheel alignment machine. The following details

relating to the machine apply:

Cost of machine

Expected useful life

Scrap value

Method of depreciation

Cost of capital

R60 000

5 years

R15 000

Straight-line

12%

Year

1

2

3

4

5

Cash flow

R10 000

R12 000

R28 000

R20 000

R45 000

Profit

R 1 000

R3 000

R19 000

R11 000

R21 000

Discount factor (12%)

0,8929

0,7972

0,7118

0,6355

0,5674

4.12.1

4.12.2

4.12.3

Required:

Calculate the payback period

Calculate the net present value (NPV). Should MG Motors invest in the new machine?

Calculate the accounting rate of return (ARR). Is this return favourable to MG Motors?

SOLUTIONS

? THINK POINT 1

* If the budgeting process did not encourage participation, managers on a lower level and

staff may feel disinclined to work to budget.

* Setting unrealistic targets may demotivate staff.

* Some managers may spend every cent of the budget allowance even though the spending

might be unnecessary.

* Those involved in the budgeting process may set low targets for achievement for

themselves.



? THINK POINT 2

* Managers usually don’t have the time to investigate every deviation from budget.

* They should rather focus on significant differences.

* This allows managers to focus their energies on where they are needed and where they

are likely to make a difference.

4.1

Taken together, the sales, production and material purchases budgets represent the

operation component of the master budget. From the sales budget, managers develop the

production budget and in turn the material purchases budget. In this way, information and

estimates flow through the three schedules that all link together.

4.2

* The starting point is usually the current year’s level of sales.

Other factors include:

* Historical data e.g. sales trends of the company, competitors and industry.

* Economic trends e.g. inflation rates, interest rates.

* Anticipated changes in both purchasing costs and sales prices.

* Future marketing plans.

* Impact of new products on the product line.

4.3

The level of planned operating activity determines the quantity the products needed to fulfil

the plan, and this in turn has an influence on the level of operating expenses and other costs

that will be incurred as well as the level of cash and other resources that will be needed to

support the fulfilment of the plan.



4.4.1

Cash sales = 20% of total sales.

Credit sales for May = R304 000 (80% of total sales)

Cash sales = R304 000 X 20 = R76 000

80

OR

Credit sales = R304 000

Therefore: Total sales = R304 000 X 100

80

= R380 000

Therefore: Cash sales = R380 000 – R304 000

= R76 000

4.4.2 Debtors collection schedule

Month

Credit

sales

R

April

R

May

R

June

R

February

March

April

May

208 000

320 000

336 000

304 000

41 600

256 000

-

-

-

64 000

268 800

-

-

-

67 200

243 200

297 600 332 800 310 400

Cash budget for the period 01 April to 30 June 20.6

April May June

Cash receipts 381 600 408 800 442 400

Cash sales

Receipts from debtors

Loan

84 000

297 600

-

76 000

332 800

-

72 000

310 400

60 000

Cash payments (309 400) (300 200) (284 500)

Cash purchases of merchandise

Payments to creditors for merchandise

Rent

Selling and administrative costs

Other expenses

Interest on loan

50 400

112 000

20 000

105 000

22 000

-

45 600

117 600

20 000

95 000

22 000

-

43 200

106 400

22 000

90 000

22 000

900

Cash surplus (shortfall) 72 200 108 600 157 900

Opening cash balance 4 000 76 200 184 800

Closing cash balance 76 200 184 800 342 700



4.4.3.1

4.4.3.2

Using the credit sales for March (R320 000):

R256 000 ÷ R320 000 X 100 = 80% (collected after one month)

R64 000 ÷ R320 000 X 100 = 20% (collected after two months)

4.4.4

80% of debtors settle their accounts on time. The remaining 20% exceed their credit terms

by paying one month later than they supposed to. The business does not expect any bad

debts.

4.4.5 R900 X 12 X 100 = 18%

R60 000

4.4.6

Cash purchases for May

Credit purchases for May

R45 600

R106 400

R152 000

4.4.7 R2 000 ÷ R20 000 X 100 = 10%

4.4.8

The entity probably intends expanding and may therefore need the funds (together with the

cash generated from operations) for purchase of assets such as machinery and equipment.

4.4.9

The entity expects to generate enough cash each month to meet its payments. A cash

surplus is thus expected each month. Since the bank balance is expected to be favourable

each month, it does not need overdraft facilities during the budget period. The cash position

is good.

4.5 Apr May

Sales forecast (in units)

Desired closing inventory of finished goods

1 200

50

1 000

45

Total budgeted production needs

Opening inventory of finished goods

1250

(60)

1 045

(50)

Required production 1 190 995

Projected production for August is 995 computers.



4.6.1

Raw material price variance

= (Actual price – Standard price) X Actual quantity issued

= (R2,80 – R3,00) X 37 000

= R7 400 (favourable)

4.6.2

Raw material usage variance

= (Actual quantity – Standard quantity) X Standard price

= (37 000 – 36 000) X R3

= R3 000 (unfavourable)

Note: Standard quantity = 9 000 X 4 kg = 36 000 kg

4.6.3

The purchasing department is responsible for any raw material price variance that may

arise. It may be due to incorrect calculation of discounts and delivery costs. However,

material price variances may be the result of mistakes made when the standard price was set

and unexpected price changes.

The production department is also responsible for any raw material usage variances that

might occur. It may be due to poor control over materials. However, variances may be due

to faulty standards and changes in the quality of the material supplied.

4.7.1

Direct labour rate variance

= (Actual rate – Standard rate) X Actual hours worked

= (R5,25 – R5,50) X 600

= R150 (favourable)

4.7.2

Direct labour efficiency variance

= (Actual time worked – Standard time allowed) X Standard rate

= (600 – 562,5) X R5,50

= R206,25 (unfavourable)

Note:

Standard time allowed = 450 units X 1,25 hours per unit

= 562,5 hours



4.7.3

The personnel manager will usually be responsible for this variance. However the

variance could be ascribed to change to wage rates, unscheduled overtime, use of lower

skilled workers with lower pay etc.

The manager responsible for the supervision of labour is usually responsible for this

variance. However this variance may be due to the quality of supervision, skill of

employees, interruptions in production etc.

4.8.1


= (Actual hours – Standard hours allowed) X Standard rate

= (24 120 – [2 000 X 12]) X (49 000 ÷ 24 500)

= (24 120 – 24 000) X R2,00

= 120 X R2,00

= R240 (unfavourable)

4.8.2

Variable overhead spending variance

= (Actual rate – Standard rate) X Actual hours

= ([50 652 ÷ 24 120] – R2,00) X 24 120

= (R2,10 – R2,00) X 24 120


4.8.3 Fixed overhead spending variance

= Actual fixed overheads – Budgeted fixed overheads

= R60 300 – R60 025

= R275 (unfavourable)

4.8.4 Fixed overhead volume variance

= Budgeted fixed overheads – Standard fixed overheads

= R60 025 – (2 000 X 12 X R2,45)

= R60 025 – R58 800


Note:

Standard fixed overheads = Number of units produced X Standard time to make 1 product

X Standard rate per hour

Standard rate per hour = Standard fixed overheads ÷ standard number of labour hours

= R60 025 ÷ 24 500

= R2,45



4.9

* Production capacity must be available.

* Fixed costs must remain unchanged.

* The price offered must be more than the relevant costs that would be incurred if the offer

is accepted.

*The current selling prices per unit must not be affected by the acceptance of the special

offer.

4.10 Direct materials

Direct labour

Variable factory overhead costs (25% of direct labour)

R40

R48

R12


If there are no unfavourable factors affecting the decision, Compu Limited would be

advised to manufacture the cases as there would be a saving of R2 per case.

4.11

The relevant costs are the variable costs. It should not sell below the variable costs per unit

of R17 which is calculated below. Any selling price above this amount will result in a

positive contribution margin.

20 000 units

Total (R) Per unit (R)

Direct materials

Direct labour

Variable overhead costs

220 000

90 000

30 000

Total variable costs 340 000 R17

4.12.1 Investment (R60 000)

Year 1 Cash flow R10 000

(R50 000)


(R38 000)


(R10 000)


Payback period is 3 years 6 months

Note:

R10 000 X 12 mths

R20 000

= 6 months



4.12.2

Year Cash inflow Discount

Factor

Present

value

1

2

3

4

5

5 (scrap value)

Total PV

Investment

NPV (positive)

R10 000

R12 000

R28 000

R20 000

R30 000

R15 000

0,8929

0.7972

0,7118

0,6355

0.5674

0.5674

R8 929

R9 566

R19 930

R12 710

*R17 022

* R8 511

R76 668

(R60 000)

R16 668

* Alternative: Year 5 45 000 X 0,5674 = R25 533

Since the net present value is positive, the machine should be purchased.

4.12.3 Accounting rate of return:

Average annual profit X 100 =

Average investment 1

Machine X

R11 000 X 100

R37 500 1

= 29,33%

Note:

Average annual profit =

R1 000 + R3 000 + R19 000 + R11 000 + R21 000

5 years

= R11 000 p.a.

Average investment = Cost of machine + Disposal value

2

= R60 000 + R15 000

2

= R37 500

Since the accounting rate of return (29,33%) is greater than the cost of capital (12%), the

return is favourable and the machine should be purchased.



TOPIC 8

TRANSFER PRICING FOR DECENTRALISED ENTERPRISES

LEARNING OUTCOMES


► be familiar with the purposes of transfer pricing.

► describe the various transfer pricing methods.

► explain the tax implication when setting transfer prices for multinational transactions.



CONTENTS

1. What is transfer pricing?

2. Purposes of transfer pricing

3. Transfer pricing methods

4. International transfer pricing


READING

Recommended

Atrill P and Mc Laney E (2002) Management Accounting for Non-specialists, Third edition,

Pearson Education Limited: Essex. (Chapter 10)

Drury C. (2005) Management Accounting for Business, Third edition, Thomson Learning: London

(Chapter 14)


Decisions, Third edition, Thomson South-Western: Canada. (Chapter M10)


Management Accounting, Fifth edition, LexisNexis Butterworths: Durban. (Chapter 14)


(Chapter 14)



1.

WHAT IS TRANSFER PRICING?

Transfer pricing involves determining appropriate selling prices for goods or services when

both the buyer and the seller are within the same entity. Transfer pricing thus arise within

decentralised enterprises. When an enterprise has many divisions, it often happens that one

division buys products from another division. Since internal transfer prices will affect

revenues (for the selling division) and costs (for the buying division), an enterprise’s

transfer pricing policies will influence each division’s return on investment. Since

divisional managers are often assessed by the profits generated by their divisions, setting

transfer prices may be a sensitive issue to divisional managers.

? THINK POINT 1

What would be some implications of divisional competition and performance evaluation on

the setting of transfer prices?

2.

PURPOSES OF TRANSFER PRICING

Transfer pricing seeks to attain the following:

Optimise the profits for the enterprise as a whole.

Encourage the autonomy of individual divisions.

Provide information to evaluate the performance of divisions.

Move profits between divisions or locations.

3.

TRANSFER PRICING METHODS

The general methods for determining transfer prices are as follows:

Market-based transfer prices

Variable cost transfer prices

Full cost transfer prices

Cost-plus a mark-up transfer price

Negotiated transfer price



3.1

Market-based transfer prices

These are the actual prices that the supplying division sells the product to external clients

for or they may the prices a competitor is offering. If a perfectly competitive market exists,

the current market price is the most suitable basis for setting the transfer price. A perfectly

competitive market is one where the product is homogeneous and no single buyer or seller

can affect market prices. In this kind of market, there is little interdependence between

divisions. The supply of transfer goods at market prices usually results in optimal profits

for the entire enterprise.

In a perfectly competitive market, the supplying division should supply as much as is

required by the receiving division at the current market price. If the receiving division’s

demand is greater then the supplying division can meet, additional supplies must be

obtained from an outside supplier at market price.

If the supplying division cannot sustain a profit in the long term at the current outside

market price, then the enterprise will be better off not producing the product internally. It

should rather purchase from outside suppliers

? THINK POINT 2

If the receiving division cannot make a profit in the long term when transfers are made at

the current market price, what should the enterprise do?

One of the major problems of using market prices is that it is unlikely that the market will

be perfectly competitive. Also, the product being transferred may have certain

characteristics that differentiate it from other varieties of the same product. Sometimes it

may be possible that external suppliers may be selling at a temporary discounted price that

is below the total cost but above the variable cost. If the supplying division has excess

capacity, incorrect decisions may be taken if the market price rule is strictly adhered to.

For example, suppose the supplying division has spare capacity to produce the (transfer)

product at a variable cost of R500 and the transfer price is set at the external market price of

R800. If an external supplier is selling at a temporary discounted price of R750, the

manager of the receiving division will be tempted to purchase from the external supplier at



R750 instead of R800 (transfer price). However, since the supplying division has spare

capacity and the relevant cost of making the product is R500, adhering strictly to the market

price rule can cause managers to make decisions that are not in the best interests of the

enterprise.

3.2

Variable cost transfer prices

When the supplying division is operating below capacity, variable cost transfer prices can

motivate both the supplying and receiving divisions to operate at levels of output that will

maximize the profit of the enterprise as a whole. In this case the opportunity cost to the

supplying division is not the market price since it does not have to give up selling in the

market to enable it to supply its fellow division. There is capacity to do both. In these

circumstances the opportunity cost is equal to the variable cost of producing the product.

Using variable cost as a basis for determining transfer prices is an acceptable approach in

the short term.

The biggest problem with this method is that the receiving division will generate a profit at

the expense of the supplying division. Quite often supplying divisions are reluctant to

transfer their products at variable costs. Another problem is that variable cost per unit may

not be constant over the entire range of output as increases may occur. Where the division

is operating at full capacity, variable cost transfers will mean that inter-divisional sales will

be less profitable than sales to external customers.

3.3

Full cost transfer prices

This method is widely used. Full costs include all production and costs of other business

functions including marketing, distribution, administrative, research and development. This

method is preferable to variable cost transfers for evaluation purposes since the supplying

division can recover the full cost of production.

The main problem with this method is that the supplying division will gain no profit from

the transfer and thus does not provide an incentive to the supplying division to transfer

goods internally. If internal transfers comprise a significant part of the supplying division’s

business, its profits will be understated.



3.4

Cost-plus a mark-up transfer price

This method attempts to enable supplying divisions to obtain a profit on the goods

transferred. This places the division on a good footing for performance evaluation. A mark-

up may be added to the full cost to provide a profit margin for the supplying division. In

other cases the mark-up is added to the variable cost and is intended to cover both fixed

costs and profit contribution.

Problems arise when the method is applied to transfers beyond two divisions. If the first

division transfers goods to the second division at cost plus 15%, and the goods received

from the second division are further processed and transferred at cost plus 15% to the next

division, and so on, then the percentage margin becomes very great by the time the mark-up

is added by the last division in the process.

3.5

Negotiated transfer price

As a result of the difficulties experienced with the methods described above, negotiated

transfers have been suggested. Negotiated transfer prices are appropriate when there are

market imperfections for the product. In these cases, divisional managers must have the

freedom to buy and sell outside the enterprise to enable them to engage in the bargaining

process.

If divisions are free to bargain with each other, they will usually make decisions that will

maximize the profits of the enterprise. It is important for managers to have equal bargaining

power for negotiations to be effective. Where there is a perfect market situation for the

product, the external market price is still preferable to negotiated transfer prices.

Negotiated transfer pricing has some disadvantages. The agreed transfer price depends on

the negotiating skills and bargaining power of the managers involved. Also, conflicts may

arise between divisions. The process can also be time-consuming for the managers involved

especially when a large number of transactions are involved.



4.

INTERNATIONAL TRANSFER PRICING

The concern here is with prices that an enterprise uses to transfer products between

divisions in different countries. The rise of multinational enterprises brings about a further

issue to be considered when setting transfer prices viz. the effect of taxation.

If tax rates differ significantly between countries, setting a transfer price that allows the

enterprise to allocate most of its profit in the county with the lowest tax rate would be wise.

Suppose an enterprise manufactures products in country X that has a marginal tax rate of

30% and it sell those products to its division in country Y that has a marginal tax rate of

42%. The enterprise will benefit more if it locates most of its profit in country X that has

the lower tax rate. The enterprise will therefore want to use the highest possible transfer

price so that the receiving division in country Y will have higher costs and report lower

profits. On the other hand the supplying division in country X will earn higher revenues and

earn higher profits.

With multinational enterprises the main issue with setting transfer prices is minimization of

global taxes. However taxation authorities in most countries are aware of intentions of

many multinational enterprises to manipulate profits declared in various countries. They

investigate transfer pricing methods to combat tax avoidance. For this reason many

multinational enterprises use the same transfer pricing method for both domestic and

international transfers.

5.

5.1


If there is a perfectly competitive market, explain why the correct transfer price should be

the external market price.

5.2 Explain some problems that may arise from using market price as the transfer price

between divisions.

5.3

Where a perfectly competitive market exists, the effect of selling expenses will be different

on the enterprise’s profits if the product is acquired internally compared to externally.

Explain why.

5.4

Describe the use of and problems associated with transfer prices based on variable cost and

full cost.



5.5

The head office of the division you are working for prescribes that the full cost transfer

price method be used for transfers between its divisions. Recommend to head office and

motivate for an alternative to using the actual cost for transfers between divisions (whilst

still using the full cost transfer method).

5.6

When using the negotiated transfer price approach, within what range would you

recommend the transfer price be established? Explain why.

5.7

Verda Limted has an operating division that produces toasters. The toasters are normally

sold to customers at R75 each. The division is presently producing 4 000 toasters per month

(which is about 60% capacity) and has the following cost structure:

Variable cost

Fixed cost apportionment

Unit cost

R35

R15

Another division of the company has offered to buy 1 500 toasters at R45 each. How would

you respond to the offer if you were the manager of the supplying division?

SOLUTIONS

? THINK POINT 1

The use of performance indicators like return on investment may encourage managers to

make decisions that benefit their divisions but at the same time adversely affect the overall

enterprise. In order to increase return on investment for their respective divisions, the

selling division will try to receive the highest possible price while the buying division will

try to pay the lowest possible price.

? THINK POINT 2

It should stop making the product, and the supplying division should sell its output to the

external market.



5.1

If the supplying division did not exist, the product will have to be purchased at the current

market price from external suppliers. Other the other hand, if the receiving division did not

exist, the product will have to be sold at current market price to the outside market.

Divisional profits will thus be similar if the divisions were separate organisations.

5.2

*The market price may not be the best option if the supplying division is operating below

capacity (a price between the variable cost per unit and market price can be negotiated).

* The supplying division may make savings since selling and distribution costs may be

lower. These savings could be passed on to the receiving division in the form of lower

prices.

* There may not be a potential external customer for the product as it may be specific to the

needs of the division it manufactures for.

5.3

The supplying division will incur selling expenses when selling to the outside market but

these selling expenses may not be incurred in inter-divisional transfers (resulting in a saving

for the enterprise). If the receiving division purchases the product externally, the enterprise

will be worse off to the extent of the selling expenses incurred by the supplying division in

selling to the outside market.

5.4

The variable cost method is useful when the supplying division is operating below

capacity. However, when the supplying division is operating at full capacity and external

customers are prepared to pay more than the variable cost of the goods, a variable cost

internal transfer price will result in inter-divisional sales being less profitable than sales to

the external market. There is thus no incentive to managers of the supplying division to

agree to a variable cost transfer price.

The full cost method is preferable to variable cost transfers for evaluation purposes since

the supplying division can recover the full cost of production. However this approach does

not provide any real incentive to the divisional managers to keep costs down, since they can

pass the costs on to the receiving division. The result is that operating inefficiencies of the

supplying division will be transferred to the receiving division.

5.5

Standard costs (an estimate of what products should cost) may be used instead of actual

costs. In this way differences between actual costs and standard costs remain with the

supplying division for cost control purposes.



5.6

The negotiated price should be no less than the variable cost per unit and no greater than the

market price per unit. In a perfectly competitive market, there is little interdependence

between divisions. The supply of transfer goods at market prices usually results in optimal

profits for the entire enterprise.

When the supplying division has excess capacity, the opportunity cost to the supplying

division is not the market price since it does not have to give up selling in the market to

enable it to supply its fellow division. There is capacity to do both. In these circumstances

the opportunity cost is equal to the variable cost of producing the product.

5.7

Since the division is operating below capacity, the market-based transfer price may be

inappropriate as it would lead to lost sales. The other division may buy from external

sources and the loss in sales will not be made good by sales to outside customers. It would

be better to base the transfer price on the variable cost of the goods as this would represent

the relevant cost of increased production when there is excess capacity. The transfer price

could therefore be somewhere between R35 and R75.



TOPIC 9

CORPORATE GOVERNANCE

LEARNING OUTCOMES


► explain the reasons for establishment of corporate governance systems.

► describe why corporate governance is important.

► outline the role of audit and independent auditors.

► explain the responsibility of directors to the shareholders and the public in general.

► recognise the implications for directors of fraudulent and wrongful trading.



CONTENTS

1. Background to the emergence of corporate governance

2. Definition of corporate governance

3. Corporate governance code of practice

4. Audit and the role of auditors

5. Responsibilities of directors

6. Directors remuneration

7. Insolvency

8. Wrongful trading and fraudulent trading


READING

Recommended


(Chapter 7)

Hand L., Isaaks C. and Sanderson P (2005) Introduction to Accounting for Non-Specialists, First

edition, Thomson Learning: London. (Chapter 11)


Press Southern Africa: Cape Town. (Chapter 1)


(Chapter 32)



1.

BACKGROUND TO THE EMERGENCE OF CORPORATE GOVERNANCE

In recent times a number of financial scandals have been reported in the media e.g. Enron,

Global Crossing, SA Post Office. It is not uncommon for executives and directors to misuse

company assets for their own use. Although it is the shareholders who own the company, it

is difficult for them to monitor the actions of directors and call them to account.

Following the financial scandals and company failures in the 1980s and 1990s there was a

lack in confidence in financial reporting. Furthermore shareholders and other stakeholders

could not depend on auditors to provide the necessary safeguards to rely on company

annual reports.

? THINK POINT 1

What do you think were the main factors that contributed to the lack of confidence in

financial reporting?

John Sullivan, the executive director of the Centre for Private Enterprise, said the following

in his keynote speech (2006) to the US Chamber of Commerce which was attended by the

Institute of Directors:

“The dilemma in corruption is that though it’s bad for business, individual companies that

engage in the practice receive a short-term advantage. Therefore, it is important to establish

a system that makes it hard for companies to be corrupt. Corporate governance is one of the

antidotes. If governance is effective, it is hard for companies to offer bribes or other

company resources to government officials.”

Committees were set up in different countries to address the concerns of financial

corruption and company failure and to make recommendations on good practice. In South

Africa, the Institute of Directors assigned this task to the King Commission that published

two reports (called King Reports) on corporate governance in 1994 and 2002. In the UK, it

was the Cadbury Committee that was given the task.



2.

DEFINITION OF CORPORATE GOVERNANCE

Corporate governance is concerned with how a company should be controlled and managed

in the best interests of all its stakeholders. The concern is also with whether a company

attains its objectives in a socially responsible manner.

3.

3.1

CORPORATE GOVERNANCE CODE OF PRACTICE

The King Reports

The King Reports spells out the controls and disclosures that a company should comply

with to protect the various stakeholders. The governance controls included in the report are:

directors are to be appointed by a committee and their contracts should not extend to more

than three years.

directors remuneration should be based on performance and decided on by a remuneration

committee (that excludes executive directors who are involved in the management of the

company).

there should be an internal audit function that reports directly to the Board of Directors.

The King Reports also sets out disclosure requirements i.e. information that is required in a

company’s annual report. These disclosure requirements include:

disclosure of the company’s economic empowerment policies and practices.

disclosure of the company’s HIV/Aids strategy, policies and practices.

disclosure of the social and environmental impact of the company, including policies and

practices to address these concerns.

All private and public companies are encouraged to comply with the King reports. Listed

companies are required to disclose the extent of their compliance to the second King report,

providing reasons for any failures to comply. These companies face penalties if they fail to

provide this information.



3.2

Combined Code of Practice

The Combined Code of Practice (UK) provides a framework for corporate governance and

accountability and it was a result of work done by the Cadbury Committee and Greenbury

Committee.

The main elements of the code are:

3.2.1 The board of directors: Boards should be properly constituted and there should be

adequate separation of duties. The board should have at least one-third of its membership as

independent non-executive directors who can give impartial advice. Directors should re-

submit themselves for re-election every three years. Directors should not be involved in

determining their own remuneration and terms of service.

3.2.2 Relationship with shareholders: The code lays down good practice for communication

between the board and shareholders. Shareholders must be given the chance to question

directors on the conduct of the company’s business at the annual general meeting of the

company.

3.2.3 Accountability and audit: Directors and auditors are required to provide a written

explanation of their responsibilities in producing the financial reports. The directors must

confirm that the business is a going concern, giving any qualification they think is

appropriate.

3.2.4 Internal control: Directors are required to regularly check that they have effective systems

of internal control that cover financial, operational and risk management of the business.

3.2.5 Audit committees: Besides the necessity of having external auditors, the code recommends

the establishment of a company audit committee that includes three non-executive directors

to oversee the audit and to ensure that the auditors are independent and objective in

carrying out their functions.

Since corporate governance has a lot to do with audit and directors, a greater discussion

about these follow.



4.

AUDIT AND THE ROLE OF AUDITORS

The external auditors are not part of the company but their responsibility is to the

shareholders. Their main duty is to objectively report to shareholders and others as to

whether, in their opinion, the financial statements can be relied upon and whether they

comply with statutory, regulatory and accounting standard requirements.

Sometimes financial statements may be affected by an inherent, and fundamental

uncertainty. If there is inadequate disclosure about the fundamental uncertainty then the

auditors may give what is called a qualified opinion and the audit report is described as a

qualified audit report.

? THINK POINT 2

What could be possible consequences of a qualified audit report to a company?

The role of auditors has been subject to criticism over the years because their

responsibilities do not include providing guarantees that the financial statements are

correct, that the company will not fail and that there has been no fraud. An area of risk that

is of great concern to companies is fraud. Since this is not currently required from an

external audit, it is something that the internal audit committee should be responsible for.

The internal audit must aim to detect fraud and try to minimise or eliminate it.

5.

RESPONSIBILITIES OF DIRECTORS

Directors are expected to use their common sense, be careful in what they do and look after

shareholders, employees and creditors. They must always act in the best interests of the

company without acting for their personal benefit. They must carry out their duties with the

skill and care that someone with the necessary knowledge and experience would exercise if

they were acting on their own behalf. Directors must act honestly and in good faith.



6.

DIRECTORS REMUNERATION

Executive directors should not play any part in decisions about their own remuneration.

Boards should appoint remuneration committees consisting of mainly or all independent

non-executive directors. The remuneration committee will determine the company’s policy

on executive remuneration including pension rights and any compensation payments. The

members of the committee should be listed in the committee’s report to shareholders each

year. The chairperson of this committee must attend the company’s annual general meeting

(AGM) to answer questions about directors’ remuneration. A resolution is then voted on at

the AGM to approve the remuneration package proposed to directors.

7.

INSOLVENCY

A company becomes insolvent when it is unable to pay creditors’ debts in full if all the

assets of the company are realised. Directors who allow a company to trade while insolvent

may be disqualified and may also incur personal liability. If a company becomes insolvent

courts assess the directors’ responsibility for:

the cause of the insolvency;

any failure to supply goods that have been paid for; and

entering into any fraudulent transactions.

8.

WRONGFUL TRADING AND FRAUDULENT TRADING

Wrongful trading arises when a director knows or ought to have known before the

commencement of winding up that there was no reasonable chance of the company

avoiding insolvency and that he/she did not take steps to minimise losses to creditors. Such

a person may be ordered by the court to contribute to the assets of the company and the

person would also be disqualified from any further involvement in corporate management

for a specified period of time.

Fraudulent trading occurs when a person is knowingly party to the company incurring

more debts at a time when it is known that these debts will not be honoured, or for any

other fraudulent purposes (which could take place at any time). Persons acting in this

manner may be held liable, without limitation, for the debts of the company. This kind of

offence usually carries criminal penalties.



9.

9.1


In a study of outstandingly successful businesses and companies that failed, it was found

that strategic factors were considered to be more important than good corporate

governance. What are your views on this?

9.2

At the Global Economic Governance Forum (2006), one of the speakers said that directors

should be trusted to act with integrity. What do you think?

9.3

Name some of the basic problems that shareholders with small shareholdings encounter as

they enter a new relationship with the company that they effectively partly own.

9.4 Name some factors that you think has increased the incidence of fraud in recent times.

9.5 To whom are auditors responsible and for what?

9.6 Why do you think it may become necessary to bar a person from becoming a director of a

company?

9.7

Use the following information from the annual company report of Thompsons Limited (a

multi-national company) as a basis for discussing the users of financial information’s need

for information on directors’ remuneration.

T. Blair (Executive director)

Basic salary

R1 500 000

Bonuses

R450 000

Benefits in kind

R50 000

C. Ramaphosa (Non- Executive director) R90 000 Nil Nil

G. Bush (Non- Executive director) None of the above but has a US $ R200 000

consultancy agreement.

9.8 Why should there be openness regarding directors’ benefits and perks?

9.9

The King Report states directors contracts should not extend to more than three years and

that they should no longer be open-ended. Why do you think that the investigation came up

with this recommendation?



SOLUTIONS

? THINK POINT 1

* Loose accounting standards that allow a lot of latitude e.g. the treatment of extraordinary

items in financial reporting.

* Directors did not operate within a clear framework to regularly review business controls.

* Inability of auditors to maintain independence from boards of directors.

* Lack of accountability with regard to directors’ remuneration.

? THINK POINT 2

A qualified audit report can destroy the credibility of a company. It can also create

uncertainty. It will impact negatively on market share price. A qualified report is definitely

something that should be avoided.

9.1

It must be remembered that poor corporate governance can ruin a company. On the other

hand, good corporate governance, on its own, cannot ensure success. This implies that a

combination of strategic factors and good corporate governance are requirements for

success.

9.2

Numerous incidents of fraud and negligence on the part of directors require some form of

control and this can be achieve through the application of effective corporate governance.

Many directors have been found to be:

* guilty of breaches of company legislation.

* unfit to run a company.

* negligent in carrying out their duties.

* engaged in fraudulent or wrongful trading.

* convicted of some indictable offence.



9.3

Within a short time of acquiring their shares, most new small shareholders realise that they

have neither the influence nor power to make a difference. As the company expands, the

directors become more distanced from the shareholders. During the period towards

expansion questions about accountability often start to develop.

9.4

* Increasing pace of change

* Unavoidable use of computer systems.

* Ease and speed of the electronic transfer of funds.

* Use of the internet.

* Increasing dependence on specific knowledge e.g. information technology (IT).

9.5

Auditors are responsible to the shareholders.

Their main duty is to report objectively to shareholders and others as to whether, in their

opinion, the financial statements show a true and fair view and whether they comply with

statutory, regulatory and accounting standard requirements.

9.6

* Unscrupulous persons may cause innocent people to lose their money.

* Many creditors may be left out of pocket through their actions.

9.7

Shareholders are the owners of the company and their dividends depend on the profit

earned by the company. These profits are affected by the for directors’ remuneration

expense. The remuneration of directors should take into account the difficulty in managing

a major multi-national company.

The executive director earns a salary of R1 500 000, an amount that shareholders will like

to see disclosed in the accounts and discussed at the AGM. The bonus of R450 000 will

also generate some interest amongst shareholders and institutions. Pressure will be exerted

on directors if they feel that the award is excessive. The consultancy agreement for a non-

executive director may also be of interest to the various users.

9.8

These benefits and perks affect the annual profit. Shareholders receive dividends from the

annual profit. Shareholders are required to approve of the accounts including the

remuneration of directors at the AGM. If directors conceal information regarding their

benefits and perks from the shareholders, then that part of the accounts may not show a true

and fair view of the situation.



9.9

Prior to the King Reports being accepted and the governance code introduced, directors had

powers that were increasing especially regarding length of contract. Newspapers report

regularly on compensation paid to directors, where the company performance was

acknowledged to be poor. There is usually a reference to the length of the outstanding

directors’ contract. Furthermore, shareholders can decide to buy or sell or hold shares if

they know in advance information on the type of contracts being awarded to directors of the

company.



TABLE 1

Table 1: Present value of R1: PVFA (k,n) =

Number

of

Periods

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

25%

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333 0.8000

2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.7305 0.7182 0.7062 0.6944 0.6400

3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575 0.6407 0.6244 0.6086 0.5934 0.5787 0.5120

4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.5337 0.5158 0.4987 0.4823 0.4096

5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4561 0.4371 0.4190 0.4019 0.3277

6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.4104 0.3898 0.3704 0.3521 0.3349 0.2621

7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.3538 0.3332 0.3139 0.2959 0.2791 0.2097

8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.3050 0.2848 0.2660 0.2487 0.2326 0.1678

9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843 0.2630 0.2434 0.2255 0.2090 0.1938 0.1342

10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946 0.2697 0.2472 0.2267 0.2080 0.1911 0.1756 0.1615 0.1074

11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149 0.1954 0.1778 0.1619 0.1476 0.1346 0.0859

12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869 0.1685 0.1520 0.1372 0.1240 0.1122 0.0687

13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625 0.1452 0.1299 0.1163 0.1042 0.0935 0.0550

14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807 0.1597 0.1413 0.1252 0.1110 0.0985 0.0876 0.0779 0.0440

15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599 0.1401 0.1229 0.1079 0.0949 0.0835 0.0736 0.0649 0.0352

16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176 0.1883 0.1631 0.1415 0.1229 0.1069 0.0930 0.0811 0.0708 0.0618 0.0541 0.0281

17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978 0.1696 0.1456 0.1252 0.1078 0.0929 0.0802 0.0693 0.0600 0.0520 0.0451 0.0225

18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.2120 0.1799 0.1528 0.1300 0.1108 0.0946 0.0808 0.0691 0.0592 0.0508 0.0437 0.0376 0.0180

19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635 0.1377 0.1161 0.0981 0.0829 0.0703 0.0596 0.0506 0.0431 0.0367 0.0313 0.0144

20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486 0.1240 0.1037 0.0868 0.0728 0.0611 0.0514 0.0433 0.0365 0.0308 0.0261 0.0115

25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1842 0.1460 0.1160 0.0923 0.0736 0.0588 0.0471 0.0378 0.0304 0.0245 0.0197 0.0160 0.0129 0.0105 0.0038

30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573 0.0437 0.0334 0.0256 0.0196 0.0151 0.0116 0.0090 0.0070 0.0054 0.0042 0.0012

40 0.6717 0.4529 0.3066 0.2083 0.1420 0.0972 0.0668 0.0460 0.0318 0.0221 0.0154 0.0107 0.0075 0.0053 0.0037 0.0026 0.0019 0.0013 0.0010 0.0007 0.0001

50 0.6080 0.3715 0.2281 0.1407 0.0872 0.0543 0.0339 0.0213 0.0134 0.0085 0.0054 0.0035 0.0022 0.0014 0.0009 0.0006 0.0004 0.0003 0.0002 0.0001 *

60 0.5504 0.3048 0.1697 0.0951 0.0535 0.0303 0.0173 0.0099 0.0057 0.0033 0.0019 0.0011 0.0007 0.0004 0.0002 0.0001 0.0001 * * * *



TABLE 2

Table 2 : Present value of a regular annuity of R1 per period for n periods : PVFA (k,n) =

Number

of

Periods

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333

2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355 1.7125 1.6901 1.6681 1.6467 1.6257 1.6052 1.5852 1.5656 1.5465 1.5278

3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018 2.3612 2.3216 2.2832 2.2459 2.2096 2.1743 2.1399 2.1065

4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373 2.9745 2.9137 2.8550 2.7982 2.7432 2.6901 2.6386 2.5887

5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048 3.5172 3.4331 3.3522 3.2743 3.1993 3.1272 3.0576 2.9906

6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114 3.9975 3.8887 3.7845 3.6847 3.5892 3.4976 3.4098 3.3255

7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684 4.7122 4.5638 4.4226 4.2883 4.1604 4.0386 3.9224 3.8115 3.7057 3.6046

8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676 4.7988 4.6389 4.4873 4.3436 4.2072 4.0776 3.9544 3.8372

9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590 5.5370 5.3282 5.1317 4.9464 4.7716 4.6065 4.4506 4.3038 4.1633 4.0310

10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502 5.4262 5.2161 5.0188 4.8332 4.6586 4.4941 4.3389 4.1925

11 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951 6.2065 5.9377 5.6869 5.4527 5.2337 5.0286 4.8364 4.6560 4.4865 4.3271

12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137 6.4924 6.1944 5.9176 5.6603 5.4206 5.1971 4.9884 4.7932 4.6105 4.4392

13 12.1337 11.3484 10.6350 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235 6.1218 5.8424 5.5831 5.3423 5.1183 4.9095 4.7147 4.5327

14 13.0037 12.1062 11.2961 10.5631 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282 6.3025 6.0021 5.7245 5.4675 5.2293 5.0081 4.8023 4.6106

15 13.8651 12.8493 11.9379 11.1184 10.3797 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109 6.4624 6.1422 5.8474 5.5755 5.3242 5.0916 4.8759 4.6755

16 14.7179 13.5777 12.5611 11.6523 10.8378 10.1059 9.4466 8.8514 8.3126 7.8237 7.3792 6.9740 6.6039 6.2651 5.9542 5.6685 5.4053 5.1624 4.9377 4.7296

17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196 6.7291 6.3729 6.0472 5.7487 5.4746 5.2223 4.9897 4.7746

18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 10.0591 9.3719 8.7556 8.2014 7.7016 7.2497 6.8399 6.4674 6.1280 5.8178 5.5339 5.2732 5.0333 4.8122

19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 10.3356 9.6036 8.9501 8.3649 7.8393 7.3658 6.9380 6.5504 6.1982 5.8775 5.5845 5.3162 5.0700 4.8435

20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136 7.9633 7.4694 7.0248 6.6231 6.2593 5.9288 5.6278 5.3527 5.1009 4.8696

25 22.0232 19.5235 17.4131 15.6221 14.0939 12.7834 11.6536 10.6748 9.8226 9.0770 8.4217 7.8431 7.3300 6.8729 6.4641 6.0971 5.7662 5.4669 5.1951 4.9476

30 25.8077 22.3965 19.6004 17.2920 15.3725 13.7648 12.4090 11.2578 10.2737 9.4269 8.6938 8.0552 7.4957 7.0027 6.5660 6.1772 5.8294 5.5168 5.2347 4.9789

40 32.8347 27.3555 23.1148 19.7928 17.1591 15.0463 13.3317 11.9246 10.7574 9.7791 8.9511 8.2438 7.6344 7.1050 6.6418 6.2335 5.8713 5.5482 5.2582 4.9966

50 39.1961 31.4236 25.7298 21.4822 18.2559 15.7619 13.8007 12.2335 10.9617 9.9148 9.0417 8.3045 7.6752 7.1327 6.6605 6.2463 5.8801 5.5541 5.2623 4.9995

60 44.9550 34.7609 27.6756 22.6235 18.9293 16.1614 14.0392 12.3766 11.0480 9.9672 9.0736 8.3240 7.6873 7.1401 6.6651 6.2402 5.8819 5.5553 5.2630 4.9999

∑ n i=1

=



MBA 2 Accounting for Decision Making Jan 2014

Documents

accounting information

business accounting

financial accounting

china accounting

survey of accounting

accounting concepts

contrast management

thomson learning