Financial Accounting – Neels Hattingh https://www.neelshattingh.com Knowledge Base Tue, 19 May 2026 17:32:27 +0000 en-US hourly 1 https://wordpress.org/?v=7.0 Lesson 17 – Analysis & Interpretation https://www.neelshattingh.com/financialaccounting/lesson-17-analysis-interpretation/ Tue, 19 May 2026 17:32:25 +0000 https://www.neelshattingh.com/?p=406 FAC1502 · Study Unit 17 · Financial Analysis | Lexicon
Lexicon
FAC1502 / Study Unit 17 / Financial Analysis

FAC1502 · Financial Accounting · Study Unit 17

Final Study Unit

Analysis & Interpretation

Reading the Numbers — Ratios, Trends & What They Mean

SU 17 UNISA BCom IAS / IFRS ~5 hr study
FAC1502 Course ProgressSU 17 of 17 — Final
SU 1–6 SU 7–9 SU 10–12 SU 13 SU 14 SU 15 SU 16 SU 17 ★

Contents

01

Purpose of Financial Analysis

Financial statements present the raw numbers. Financial analysis gives those numbers meaning by expressing relationships between figures — as ratios, percentages, or days — and comparing them against benchmarks, prior periods, or competitors.

A single figure tells you almost nothing. Revenue of R5 million is impressive for a corner café but underwhelming for a listed retailer. A ratio provides context — it normalises scale and allows meaningful comparison.

Three Bases for Comparison

Trend analysis — comparing the same entity’s ratios over multiple periods. Are things improving or deteriorating?

Cross-sectional analysis — comparing ratios to industry averages or direct competitors. Is this business performing above or below its peers?

Benchmark comparison — comparing to widely accepted thresholds (e.g. current ratio ≥ 2:1 as a general rule of thumb). Use benchmarks cautiously — they are starting points, not absolute standards.

Users Investors (return and risk), creditors (ability to repay), management (operational performance), employees (job security), SARS (tax compliance), and analysts (valuation). Limitations Ratios are backward-looking, based on historical cost, affected by accounting policies, and can be manipulated. Always read qualitative notes alongside the numbers.

02

The Five Ratio Categories

FAC1502 organises financial ratios into five groups, each answering a distinct question about the business:

  • LIQLiquidity — Can the business meet its short-term obligations as they fall due? Does it have enough current assets to cover current liabilities?
  • PROFProfitability — How efficiently is the business generating profit from its sales and its assets? Is it creating value for owners?
  • SOLYSolvency & Gearing — Can the business meet its long-term obligations? How much of its funding comes from debt versus equity? What is the financial risk?
  • EFFEfficiency (Activity) — How well is the business managing its assets — inventory, debtors, creditors — to generate sales and cash?
  • INVInvestment — What return are shareholders receiving? How does the market value the business relative to its earnings and book value?
    • // TIP

    In FAC1502 exam questions, you will usually be asked to calculate a ratio and comment on what it means. Always structure your answer as: (1) state the ratio value, (2) interpret it in context, (3) note what it suggests about financial health. A bare number with no interpretation earns half marks at best.

    03

    Liquidity Ratios

    Liquidity ratios measure the ability to pay short-term debts from short-term assets. They draw on the current assets and current liabilities sections of the balance sheet.

    Liquidity
    Current Ratio
    Current Assets ÷ Current Liabilities
    Expressed as x : 1. General benchmark ≥ 2 : 1. A ratio below 1 means current liabilities exceed current assets — a serious short-term risk. Too high may indicate idle assets.
    Acid-Test (Quick) Ratio
    (Current Assets − Inventory) ÷ Current Liabilities
    Expressed as x : 1. Benchmark ≥ 1 : 1. Excludes inventory because it is the least liquid current asset — it must first be sold and collected before it becomes cash.
    // NOTE

    The difference between the current ratio and the acid-test ratio highlights the weight of inventory in current assets. A business with a current ratio of 3:1 but an acid-test of 0.8:1 is heavily inventory-dependent — its liquidity is only strong if it can sell that stock quickly.

    04

    Profitability Ratios

    Profitability ratios measure how effectively the business converts revenue and assets into profit. They are expressed as percentages or as a return on a base.

    Profitability
    Gross Profit Margin
    (Gross Profit ÷ Revenue) × 100
    Expressed as a %. Measures the mark-up retained after direct production costs. A declining GPM signals rising input costs or price pressure.
    Net Profit Margin
    (Net Profit Before Tax ÷ Revenue) × 100
    Expressed as a %. Measures overall profitability after all operating expenses. Compare trend year-on-year; a widening gap vs GPM signals rising operating costs.
    Return on Equity (ROE)
    (Net Profit After Tax ÷ Total Equity) × 100
    Expressed as a %. Answers: “How many rands of profit per rand invested by owners?” Higher is better. Compare to cost of equity or deposit rates.
    Return on Assets (ROA)
    (Net Profit Before Interest & Tax ÷ Total Assets) × 100
    Expressed as a %. Measures how well management deploys all assets regardless of funding structure. Also called Return on Investment (ROI).
    // EXAM

    Watch whether the question asks for net profit before or after tax. ROE typically uses after-tax profit; ROA typically uses profit before interest and tax (EBIT) to remove the effect of financing decisions. State your assumption if the question is ambiguous.

    05

    Solvency & Gearing Ratios

    Solvency ratios examine the long-term financial structure. Gearing (also called leverage) measures how much of the business is funded by debt versus equity. High gearing amplifies returns in good times but increases risk — and interest obligations — in downturns.

    Solvency & Gearing
    Debt-to-Equity Ratio
    Total Debt ÷ Total Equity
    Expressed as x : 1 or a decimal. Shows how many rands of debt exist per rand of equity. A ratio above 1 means the business owes more than owners have invested.
    Debt Ratio
    Total Liabilities ÷ Total Assets
    Expressed as a decimal or %. Shows what proportion of assets is financed by creditors. Below 0.5 (50%) is generally considered conservative.
    Equity Ratio
    Total Equity ÷ Total Assets
    Expressed as a decimal or %. The complement of the debt ratio. Debt Ratio + Equity Ratio = 1.0 (100%). Higher equity ratio = lower financial risk.
    Interest Cover
    EBIT ÷ Interest Expense
    Expressed as x times. How many times operating profit covers interest charges. Below 2× is a warning sign; below 1× means the business cannot service its debt from operations.
    // NOTE

    Total Debt can mean different things. In FAC1502, it typically refers to total interest-bearing borrowings (long-term loans + short-term portion of loans + bank overdraft), not total liabilities. Read the question carefully — if it says “total liabilities” use that; if it says “total debt” use only borrowings.

    06

    Efficiency (Activity) Ratios

    Efficiency ratios measure how effectively the business manages its working capital — the cycle of converting inventory into sales, collecting cash from debtors, and paying creditors. They are expressed in days or as turnover multiples.

    Efficiency
    Inventory Days (Holding Period)
    (Average Inventory ÷ Cost of Sales) × 365
    Days stock is held before being sold. Lower is generally better — but too low risks stock-outs. Industry context matters enormously (fresh produce vs. heavy machinery).
    Inventory Turnover
    Cost of Sales ÷ Average Inventory
    Times stock is “turned over” per year. High turnover = efficient stock management. Low turnover may signal obsolete or excess inventory. Inverse of Inventory Days × 365.
    Debtors Days (Collection Period)
    (Trade Debtors ÷ Credit Sales) × 365
    Average days to collect from credit customers. Compare to credit terms offered. If credit terms are 30 days but debtors days = 55, collection is slow — cash flow risk.
    Creditors Days (Payment Period)
    (Trade Creditors ÷ Credit Purchases) × 365
    Average days to pay suppliers. Longer is better for cash flow, but excessively long may damage supplier relationships or trigger penalties.

    The Cash Conversion Cycle

    The Cash Conversion Cycle (CCC) links all three working capital ratios into a single measure of how long cash is tied up in the operating cycle:

    CCC = Inventory Days + Debtors Days − Creditors Days

    A lower CCC means cash cycles through the business faster. A negative CCC (common in large retailers) means the business collects cash before it pays suppliers — essentially funded by its creditors.

    // EXAM

    Use average inventory = (Opening + Closing) ÷ 2 when both figures are available. If only one figure is given, use it directly. The same averaging rule applies to average debtors and average creditors if the question provides opening and closing balances.

    07

    Investment Ratios

    Investment ratios assess the returns and value delivered to shareholders. They are most relevant to listed companies but appear in FAC1502 in the context of companies with issued share capital.

    Investment
    Earnings Per Share (EPS)
    Net Profit After Tax ÷ Number of Ordinary Shares
    Expressed in cents per share. Shows how much profit is attributable to each share. Rising EPS is a positive signal for shareholders.
    Dividends Per Share (DPS)
    Total Dividends Declared ÷ Number of Ordinary Shares
    Expressed in cents per share. The portion of earnings actually distributed. DPS ≤ EPS (you cannot pay out more than you earn sustainably).
    Dividend Payout Ratio
    (DPS ÷ EPS) × 100 OR (Total Dividends ÷ Net Profit AT) × 100
    Expressed as a %. What fraction of earnings is paid out as dividends. Growth companies retain more (low payout); mature companies distribute more.
    Dividend Yield
    (DPS ÷ Market Price Per Share) × 100
    Expressed as a %. The cash return on the current market price. Requires market price data — usually given in the question.
    Price-Earnings (P/E) Ratio
    Market Price Per Share ÷ EPS
    Expressed as x times. How many years of current earnings investors pay for. A high P/E implies high growth expectations; a low P/E may signal undervaluation or poor prospects.
    Net Asset Value Per Share (NAV)
    Total Equity ÷ Number of Ordinary Shares
    Expressed in cents or rands per share. The book value of equity per share. If market price > NAV, the market values the business above its balance sheet worth.

    08

    Full Worked Example

    Calculate and interpret selected ratios for Meridian Retail Ltd using the financial data below. The company has 2 000 000 ordinary shares in issue. Market price per share: R4.50.

    Meridian Retail Ltd — Financial Data
    ItemCurrent Year (R)Prior Year (R)
    INCOME STATEMENT
    Revenue (all credit sales)3 600 0003 200 000
    Cost of sales2 160 0001 984 000
    Gross profit1 440 0001 216 000
    Operating expenses720 000640 000
    EBIT720 000576 000
    Interest expense120 00080 000
    Net profit before tax600 000496 000
    Tax (28%)168 000138 880
    Net profit after tax432 000357 120
    Dividends declared200 000160 000
    BALANCE SHEET
    Inventory480 000420 000
    Trade debtors360 000310 000
    Cash & equivalents90 00060 000
    Total current assets930 000790 000
    Total assets2 800 0002 500 000
    Total current liabilities460 000395 000
    Trade creditors (in current liabilities)280 000240 000
    Long-term loans800 000600 000
    Total equity1 540 0001 505 000

    Ratio Calculations & Interpretation

    Meridian Retail Ltd — Ratio Analysis
    Ratio Calculation Result Interpretation
    LIQUIDITY
    Current Ratio 930 000 ÷ 460 000 2.02 : 1 Just above the 2:1 benchmark. Adequate short-term cover but little buffer — worth monitoring.
    Acid-Test Ratio (930k − 480k) ÷ 460k 0.98 : 1 Below the 1:1 benchmark. Excluding inventory, current liabilities are barely covered — liquidity depends heavily on selling stock.
    PROFITABILITY
    Gross Profit Margin (1 440 000 ÷ 3 600 000) × 100 40.0% Strong and consistent (prior year: 38.0%). Mark-up is improving, suggesting better purchasing or pricing power.
    Net Profit Margin (600 000 ÷ 3 600 000) × 100 16.7% Solid operating efficiency. The gap vs. GPM (40% vs 16.7%) reflects operating expenses and growing interest costs.
    Return on Equity (432 000 ÷ 1 540 000) × 100 28.1% Excellent return for shareholders — well above typical deposit rates. Rising from ~23.7% prior year.
    Return on Assets (720 000 ÷ 2 800 000) × 100 25.7% Assets are generating strong pre-financing returns. ROA > cost of debt signals positive financial leverage.
    SOLVENCY & GEARING
    Debt Ratio 1 260 000 ÷ 2 800 000 0.45 45% of assets financed by creditors. Below 50% — acceptable, but loans grew from R600k to R800k this year.
    Interest Cover 720 000 ÷ 120 000 6.0× EBIT covers interest 6 times — comfortable cushion. Prior year was 7.2× — slight deterioration as debt grew faster than EBIT.
    EFFICIENCY
    Inventory Days ((480k+420k)÷2) ÷ 2 160k × 365 76 days Stock sits for ~76 days before sale. For a retailer this is moderately high — investigate whether slow-moving lines exist.
    Debtors Days 360 000 ÷ 3 600 000 × 365 36.5 days Collections averaging ~37 days. If credit terms are 30 days, collection is slightly slow — monitor debtor quality.
    Creditors Days 280 000 ÷ 2 160 000 × 365 47.3 days Taking ~47 days to pay suppliers. Longer than debtors days — suppliers are effectively financing the business.
    INVESTMENT
    EPS 432 000 ÷ 2 000 000 21.6 cents Each share earned 21.6c. Up from 17.9c — growing earnings per share is a positive signal.
    DPS 200 000 ÷ 2 000 000 10.0 cents 10c dividend declared per share.
    Payout Ratio (10.0 ÷ 21.6) × 100 46.3% Just under half of earnings paid out. Retaining 53.7% for reinvestment — a balanced growth/income policy.
    P/E Ratio 450c ÷ 21.6c 20.8× Market prices the share at ~21× earnings. Reflects growth expectations. Context-dependent — compare to sector peers.
    NAV Per Share 1 540 000 ÷ 2 000 000 77.0 cents Market price (450c) is 5.8× the book value — the market assigns significant value to intangibles and future earnings.

    Overall Assessment

    Summary Verdict — Meridian Retail Ltd

    Strengths: Strong and improving profitability (GPM 40%, ROE 28%). Good interest cover (6×). Growing EPS. Market premium over NAV reflects investor confidence.

    Watch points: Acid-test ratio below 1:1 — liquidity depends on inventory conversion. Inventory days of 76 is moderately high for retail. Loan balances growing faster than equity — gearing creeping up. Debtors days slightly exceeding implied credit terms.

    Overall: A financially healthy, growing business but with liquidity and working capital efficiency areas worth management attention in the coming period.

    09

    Practice Exercises

    Exercise 01
    Liquidity & Solvency — Quick Calculations
    [expand]

    From the balance sheet of Langa Trading: Current assets R540 000 (including inventory R200 000); Current liabilities R270 000; Total assets R1 800 000; Total liabilities R900 000; Total equity R900 000; EBIT R180 000; Interest expense R45 000.

    Calculate: (a) Current Ratio, (b) Acid-Test Ratio, (c) Debt Ratio, (d) Equity Ratio, (e) Interest Cover. Comment briefly on each.

    (a) Current Ratio 540 000 ÷ 270 000 = 2.0 : 1 → Exactly at the 2:1 benchmark. Adequate but no surplus buffer. (b) Acid-Test Ratio (540 000 − 200 000) ÷ 270 000 = 340 000 ÷ 270 000 = 1.26 : 1 → Above 1:1 — even without inventory, current liabilities are covered. Good. (c) Debt Ratio 900 000 ÷ 1 800 000 = 0.50 (50%) → Exactly half the assets are creditor-funded. At the boundary — not alarming but leaves no room to take on more debt comfortably. (d) Equity Ratio 900 000 ÷ 1 800 000 = 0.50 (50%) → Confirms the above: debt ratio + equity ratio = 1.0. ✓ (e) Interest Cover 180 000 ÷ 45 000 = 4.0 × → EBIT covers interest 4 times — adequate, though not exceptional.
    Exercise 02
    Efficiency Ratios & Cash Conversion Cycle
    [expand]

    Mhle Distributors reports the following for the year ended 28 Feb 2025: Credit sales R2 400 000; Cost of sales R1 680 000; Opening inventory R310 000; Closing inventory R290 000; Trade debtors (closing) R220 000; Trade creditors (closing) R195 000; Credit purchases R1 700 000.

    Calculate: (a) Inventory Days, (b) Inventory Turnover, (c) Debtors Days, (d) Creditors Days, (e) Cash Conversion Cycle. Interpret the CCC.

    (a) Inventory Days Average inventory = (310 000 + 290 000) ÷ 2 = 300 000 300 000 ÷ 1 680 000 × 365 = 65.2 days (b) Inventory Turnover 1 680 000 ÷ 300 000 = 5.6 times per year (c) Debtors Days 220 000 ÷ 2 400 000 × 365 = 33.5 days (d) Creditors Days 195 000 ÷ 1 700 000 × 365 = 41.9 days (e) Cash Conversion Cycle CCC = Inventory Days + Debtors Days − Creditors Days = 65.2 + 33.5 − 41.9 = 56.8 days → Cash is tied up in the operating cycle for ~57 days. The business collects from customers before paying suppliers (33.5 days to collect vs 41.9 days to pay), but the inventory holding period (65 days) is the dominant drag. Reducing stock holding would be the most impactful lever to improve cash flow.
    Exercise 03
    Investment Ratios — Listed Company
    [expand]

    Stellarion Ltd has 5 000 000 ordinary shares in issue at a market price of R12.60. Net profit after tax: R1 800 000. Dividends declared: R900 000. Total equity: R9 000 000.

    Calculate: (a) EPS, (b) DPS, (c) Dividend Payout Ratio, (d) Dividend Yield, (e) P/E Ratio, (f) NAV per share. State whether the market prices the share at a premium or discount to book value.

    (a) EPS 1 800 000 ÷ 5 000 000 = 36 cents per share (b) DPS 900 000 ÷ 5 000 000 = 18 cents per share (c) Dividend Payout Ratio (18 ÷ 36) × 100 = 50% → Half of earnings paid out; half retained. (d) Dividend Yield (18c ÷ 1 260c) × 100 = 1.43% → Low yield — typical of a growth-oriented company where investors expect capital gains rather than income. (e) P/E Ratio 1 260c ÷ 36c = 35.0 × → Investors are paying 35× current earnings. High — implies significant growth expectations priced in. (f) NAV Per Share 9 000 000 ÷ 5 000 000 = 180c = R1.80 per share Market price R12.60 vs NAV R1.80 → market prices the share at a PREMIUM of 7.0× book value. The excess reflects the market’s valuation of brand, growth prospects, and intangible value not captured on the balance sheet.

    Reference

    Master Ratio Reference — All 18 Ratios

    FAC1502 Complete Ratio Reference Card
    RatioFormulaUnitGood Signal
    LIQUIDITY
    Current RatioCurrent Assets ÷ Current Liabilitiesx : 1≥ 2 : 1
    Acid-Test Ratio(CA − Inventory) ÷ CLx : 1≥ 1 : 1
    PROFITABILITY
    Gross Profit MarginGP ÷ Revenue × 100%Stable or rising
    Net Profit MarginNPBT ÷ Revenue × 100%Stable or rising
    Return on EquityNPAT ÷ Total Equity × 100%Above cost of equity
    Return on AssetsEBIT ÷ Total Assets × 100%Above cost of debt
    SOLVENCY & GEARING
    Debt RatioTotal Liabilities ÷ Total Assetsdecimal< 0.50
    Equity RatioTotal Equity ÷ Total Assetsdecimal> 0.50
    Debt-to-EquityTotal Debt ÷ Total Equityx : 1< 1 : 1
    Interest CoverEBIT ÷ Interest Expense× times≥ 3×
    EFFICIENCY
    Inventory DaysAvg Inventory ÷ COS × 365daysLower = faster turnover
    Inventory TurnoverCOS ÷ Avg Inventory× timesHigher = more efficient
    Debtors DaysTrade Debtors ÷ Credit Sales × 365days≤ credit terms offered
    Creditors DaysTrade Creditors ÷ Credit Purchases × 365days≥ debtors days
    INVESTMENT
    EPSNPAT ÷ Shares in issuecentsRising year-on-year
    DPSTotal Dividends ÷ Shares in issuecentsSustainable (DPS ≤ EPS)
    Payout RatioDPS ÷ EPS × 100%Consistent with strategy
    P/E RatioMarket Price ÷ EPS× timesContext-dependent
    NAV Per ShareTotal Equity ÷ Shares in issuecents/RMarket price > NAV = premium

    Study Unit 17 — Key Takeaways

    1. Ratios require context — a number alone is meaningless. Always compare to prior periods, benchmarks, or industry norms, and state your interpretation.

    2. Five categories: Liquidity (short-term survival), Profitability (earnings quality), Solvency (long-term structure), Efficiency (working capital management), Investment (shareholder returns).

    3. Liquidity benchmarks: Current ≥ 2:1; Acid-test ≥ 1:1. The gap between them reveals inventory dependency.

    4. Cash Conversion Cycle = Inventory Days + Debtors Days − Creditors Days. A lower CCC means faster cash flow.

    5. ROA uses EBIT; ROE uses NPAT. When ROA > cost of debt, financial leverage is creating value for shareholders.

    6. Market price vs NAV: A premium signals the market values intangibles and growth beyond book value. A discount can signal undervaluation or distress.

    ✦
    FAC1502 Complete

    All seventeen study units covered — from the accounting equation to full financial statement analysis. The foundation is set.

    SU 1 — Accounting Equation SU 2 — Journals SU 3 — Ledgers SU 4 — Trial Balance SU 5 — Adjustments SU 6 — Financial Statements SU 7 — Debtors SU 8 — Creditors SU 9 — Bank Recon SU 10 — Fixed Assets SU 11 — Inventory SU 12 — Companies SU 13 — Partnerships SU 14 — Cash Flow SU 15 — Budgeting SU 16 — Manufacturing SU 17 — Analysis ★
    ]]>         Lesson 16 – The Manufacturing Account https://www.neelshattingh.com/financialaccounting/lesson-16-the-manufacturing-account/ Tue, 19 May 2026 17:31:16 +0000 https://www.neelshattingh.com/?p=404 FAC1502 · Study Unit 16 · Manufacturing Accounts | Lexicon
    Lexicon
    FAC1502 / Study Unit 16 / Manufacturing

    FAC1502 · Financial Accounting · Study Unit 16

    The Manufacturing Account

    From Raw Material to Finished Good — Costing the Factory Floor

    SU 16 UNISA BCom Topic 5 ~4 hr study
    FAC1502 Course ProgressSU 16 of 17
    SU 1–6 SU 7–9 SU 10–12 SU 13 SU 14 SU 15 SU 16 SU 17

    Contents

    01

    Trading vs Manufacturing Entities

    A trading entity buys goods in a finished state and resells them. A manufacturing entity converts raw materials into finished goods before selling them. This fundamental difference means a manufacturer needs an additional financial statement — the Manufacturing Account — to determine the cost of goods it produced during the period.

    Trading Entity

    Buys finished goods from suppliers. Cost of goods sold = Opening stock + Purchases − Closing stock. One inventory account: Merchandise Inventory.

    Financial statements needed: Trading Account → Income Statement.

    Manufacturing Entity

    Transforms raw materials using labour and machinery. Must calculate the cost of production before it can calculate COGS. Three inventory accounts in play simultaneously.

    Financial statements needed: Manufacturing Account → Trading Account → Income Statement.

    // NOTE

    The Manufacturing Account produces a single output figure: Cost of Production (also called Cost of Goods Manufactured). This figure flows directly into the Trading Account as the equivalent of “Purchases” in a trading entity.

    02

    Cost Classification

    Manufacturing costs are classified in two ways: by nature (what was spent on) and by behaviour (how the cost changes with output). Both classifications are tested in FAC1502.

    Classification by Nature

    Direct Materials — Raw materials that become physically part of the finished product and can be traced to it economically (e.g. steel in a car, fabric in a shirt).

    Direct Labour — Wages of workers who physically convert raw materials into finished goods (e.g. machine operators, assembly line workers). Directly traceable to units produced.

    Manufacturing Overhead — All other factory costs that cannot be directly traced to individual units: factory rent, depreciation of machinery, factory supervisor salaries, indirect materials, factory electricity.

    Variable Cost Changes in direct proportion to production volume. If output doubles, total variable cost doubles. Direct materials and direct labour are typically variable. Variable cost per unit stays constant. Fixed Cost Remains constant in total regardless of output level (within a relevant range). Factory rent, depreciation, and supervisors’ salaries are typically fixed. Fixed cost per unit decreases as output rises. Semi-variable Has both a fixed component and a variable component. Factory electricity (fixed connection fee + variable consumption) is a classic example. Also called a mixed cost.
    // EXAM

    Only factory / manufacturing costs appear in the Manufacturing Account. Selling expenses, distribution costs, and administrative expenses are period costs — they go directly to the Income Statement, never into the Manufacturing Account.

    03

    The Three Inventory Accounts

    A manufacturing entity maintains three separate inventory accounts, each representing a different stage in the production process. Understanding what sits in each account is fundamental to building the Manufacturing Account correctly.

    Raw Materials Inventory Materials purchased but not yet put into production
    Stage 1 — Unprocessed
    Work-in-Progress (WIP) Inventory Partially completed units still on the factory floor
    Stage 2 — In Process
    Finished Goods Inventory Completed units awaiting sale
    Stage 3 — Complete
    Total Inventories on the Balance Sheet All three balances combined under Current Assets
    Balance Sheet Item

    The Flow of Costs

    Raw Materials → (issued to factory) → Work-in-Progress → (completed) → Finished Goods → (sold) → Cost of Sales.

    At each stage, costs accumulate. The Manufacturing Account captures the movement from Raw Materials and WIP through to Finished Goods — calculating the Cost of Production that emerges from the factory each period.

    04

    Prime Cost & Conversion Cost

    Two composite cost concepts appear throughout manufacturing accounting. You must know both by heart.

    Prime Cost Direct Materials Used + Direct Labour = the most basic cost of making something
    DM + DL
    Conversion Cost Direct Labour + Manufacturing Overhead = cost of converting raw material into finished product
    DL + MOH
    Total Manufacturing Cost Direct Materials + Direct Labour + Manufacturing Overhead
    DM + DL + MOH
    PRIME COST = Direct Materials Used + Direct Labour where: Direct Materials Used = Opening RM + Purchases − Closing RM CONVERSION COST = Direct Labour + Manufacturing Overhead TOTAL MANUFACTURING COST = Prime Cost + Manufacturing Overhead = Direct Materials Used + Direct Labour + Manufacturing Overhead
    // MEMORY AID

    Prime = the primary, most direct costs (DM + DL). Conversion = what it costs to convert materials into product (DL + MOH). Direct Labour appears in both — it is the bridge between the two concepts.

    05

    The Manufacturing Account

    The Manufacturing Account is a nominal account — it is closed off each period. Its purpose is to calculate the Cost of Production (also called Cost of Goods Manufactured) for the period. This single figure is then passed to the Trading Account.

    MANUFACTURING ACCOUNT — Structure SECTION 1 — PRIME COST Direct materials: Opening raw materials stock ××× Add: Purchases of raw materials ××× Add: Carriage on raw materials ××× ────── Raw materials available ××× Less: Closing raw materials stock (×××) ────── Direct materials used ××× Direct labour (factory wages) ××× ────── PRIME COST ××× SECTION 2 — MANUFACTURING OVERHEAD Factory rent ××× Depreciation — machinery ××× Factory supervisor salary ××× Indirect materials ××× Factory electricity ××× Other factory overheads ××× ────── TOTAL MANUFACTURING OVERHEAD ××× ────── TOTAL MANUFACTURING COST ××× Add: Opening work-in-progress (WIP) ××× Less: Closing work-in-progress (WIP) (×××) ────── COST OF PRODUCTION (→ Trading Account) ×××
    // EXAM

    WIP adjustments are made after Total Manufacturing Cost — not before. The logic: Total Manufacturing Cost is what the factory spent this period. WIP opening adds costs that were started last period; WIP closing removes costs relating to units not yet finished. The result is the cost of goods completed and transferred out this period.

    06

    The Trading Account

    Once the Manufacturing Account produces the Cost of Production figure, it flows into the Trading Account — which operates identically to a trading entity’s account, except that Cost of Production replaces Purchases.

    TRADING ACCOUNT — Manufacturing Entity Sales revenue ××× Less: Cost of goods sold Opening finished goods stock ××× Add: Cost of Production (from Mfg A/c) ××× ────── Goods available for sale ××× Less: Closing finished goods stock (×××) ────── Cost of goods sold ××× ────── GROSS PROFIT ×××
    // NOTE

    In a manufacturing entity, the Finished Goods Inventory on the balance sheet is valued at Cost of Production per unit — not at raw material cost. This means closing finished goods stock carries the full manufacturing cost (DM + DL + MOH) of the unsold units.

    07

    Full Income Statement Structure

    The complete income statement for a manufacturing entity has three tiers, each feeding the next:

    • 01Manufacturing Account → produces Cost of Production. Contains all factory costs plus WIP adjustments.
    • 02Trading Account → takes Cost of Production, adjusts for finished goods opening/closing stock, calculates Gross Profit.
    • 03Income Statement → deducts selling, distribution, and administrative expenses from Gross Profit to arrive at Net Profit before Tax.
    Income Statement — Manufacturing Entity (Skeleton)
    ItemRR
    MANUFACTURING ACCOUNT
    Direct materials used×××
    Direct labour×××
    Prime cost×××
    Manufacturing overhead×××
    Total manufacturing cost×××
    Add: Opening WIP×××
    Less: Closing WIP(×××)
    Cost of Production×××
    TRADING ACCOUNT
    Sales revenue×××
    Opening finished goods×××
    Add: Cost of Production×××
    Less: Closing finished goods(×××)
    Cost of goods sold(×××)
    Gross profit×××
    INCOME STATEMENT
    Selling & distribution expenses(×××)
    Administrative expenses(×××)
    Net profit before tax×××

    08

    Full Worked Example

    Prepare the Manufacturing Account and the Trading and Income Statement for Vulcan Industries for the year ended 28 February 2025.

    Given Data

    Trial Balance Extracts — 28 February 2025
    ItemR
    INVENTORY — OPENING BALANCES
    Raw materials (1 Mar 2024)42 000
    Work-in-progress (1 Mar 2024)18 500
    Finished goods (1 Mar 2024)65 000
    MANUFACTURING COSTS
    Purchases of raw materials310 000
    Carriage on raw materials8 200
    Direct labour (factory wages)185 000
    Factory rent48 000
    Depreciation — machinery22 000
    Factory supervisor salary55 000
    Indirect materials12 400
    Factory electricity19 600
    SALES & PERIOD COSTS
    Sales revenue1 250 000
    Selling & distribution expenses78 000
    Administrative expenses95 000
    CLOSING INVENTORIES (per stocktake)
    Raw materials (28 Feb 2025)38 000
    Work-in-progress (28 Feb 2025)22 000
    Finished goods (28 Feb 2025)71 000

    Manufacturing Account

    Vulcan Industries — Manufacturing Account for the year ended 28 February 2025
    ItemRR
    DIRECT MATERIALS
    Opening raw materials stock42 000
    Add: Purchases310 000
    Add: Carriage on raw materials8 200
    Raw materials available360 200
    Less: Closing raw materials stock(38 000)
    Direct materials used322 200
    Direct labour185 000
    Prime Cost507 200
    MANUFACTURING OVERHEAD
    Factory rent48 000
    Depreciation — machinery22 000
    Factory supervisor salary55 000
    Indirect materials12 400
    Factory electricity19 600
    Total Manufacturing Overhead157 000
    Total Manufacturing Cost664 200
    Add: Opening WIP18 500
    Less: Closing WIP(22 000)
    Cost of Production660 700

    Trading and Income Statement

    Vulcan Industries — Trading and Income Statement for the year ended 28 February 2025
    ItemRR
    Sales revenue1 250 000
    COST OF GOODS SOLD
    Opening finished goods stock65 000
    Add: Cost of Production660 700
    Goods available for sale725 700
    Less: Closing finished goods stock(71 000)
    Cost of goods sold(654 700)
    Gross Profit595 300
    OPERATING EXPENSES
    Selling & distribution expenses(78 000)
    Administrative expenses(95 000)
    Net Profit Before Tax422 300
    // CHECK

    Quick sanity check: Gross Profit Margin = R595 300 ÷ R1 250 000 = 47.6%. Net Profit Margin = R422 300 ÷ R1 250 000 = 33.8%. These are high margins — typical for a value-added manufacturer. If your margins come out negative or implausibly large, trace back through the WIP adjustment and overhead classification first.

    09

    Practice Exercises

    Exercise 01
    Classify the Cost
    [expand]

    Classify each item below as: Direct Material (DM), Direct Labour (DL), Manufacturing Overhead (MOH), or Period Cost (P):

    1. Steel sheets used in making car bodies
    2. Salary of the factory floor supervisor
    3. Wages of assembly line workers (traceable to units)
    4. Depreciation on delivery vans
    5. Factory building insurance
    6. Lubricating oil for production machinery
    7. Commission paid to sales representatives
    8. Depreciation on production machinery
    9. CEO’s salary
    10. Packaging materials that become part of the finished product
    1. DM — directly traceable raw material
    2. MOH — indirect factory labour (supervisor, not production worker)
    3. DL — directly traceable factory labour
    4. P — delivery is a selling/distribution cost, not factory
    5. MOH — factory overhead (fixed)
    6. MOH — indirect material (supports production but not part of product)
    7. P — selling expense
    8. MOH — factory overhead (fixed)
    9. P — administrative expense
    10. DM — becomes physically part of the saleable product
    Exercise 02
    Prime Cost & Conversion Cost
    [expand]

    Titan Plastics has the following cost data for March 2025:

    • Opening raw materials: R25 000
    • Raw material purchases: R140 000
    • Closing raw materials: R30 000
    • Direct labour: R95 000
    • Factory rent: R20 000
    • Machine depreciation: R15 000
    • Indirect labour: R18 000

    Calculate: (a) Direct materials used, (b) Prime Cost, (c) Conversion Cost, (d) Total Manufacturing Cost.

    (a) Direct Materials Used Opening RM + Purchases − Closing RM = 25 000 + 140 000 − 30 000 = R135 000 (b) Prime Cost = Direct Materials Used + Direct Labour = 135 000 + 95 000 = R230 000 (c) Conversion Cost = Direct Labour + Manufacturing Overhead MOH = Factory rent + Depreciation + Indirect labour = 20 000 + 15 000 + 18 000 = R53 000 Conversion Cost = 95 000 + 53 000 = R148 000 (d) Total Manufacturing Cost = Prime Cost + MOH = 230 000 + 53 000 = R283 000
    Exercise 03
    Manufacturing Account — Abridged
    [expand]

    Using the data from Exercise 02, plus the following additional information, prepare the Manufacturing Account and calculate the Cost of Production:

    • Opening WIP: R14 000
    • Closing WIP: R9 500
    Titan Plastics — Manufacturing Account, March 2025
    ItemRR
    Direct materials used135 000
    Direct labour95 000
    Prime Cost230 000
    Factory rent20 000
    Machine depreciation15 000
    Indirect labour18 000
    Total Manufacturing Overhead53 000
    Total Manufacturing Cost283 000
    Add: Opening WIP14 000
    Less: Closing WIP(9 500)
    Cost of Production287 500

    Note: Opening WIP > Closing WIP, so the adjustment adds net R4 500 to Cost of Production — more goods were completed this period than started (some from prior period WIP were finished).

    Study Unit 16 — Key Takeaways

    1. Manufacturing entities need three inventory accounts: Raw Materials, Work-in-Progress, and Finished Goods — each representing a different stage of production.

    2. The Manufacturing Account calculates Cost of Production: Direct Materials Used + Direct Labour + Manufacturing Overhead ± WIP adjustment.

    3. Prime Cost = DM + DL. Conversion Cost = DL + MOH. Direct Labour appears in both — it bridges materials and overhead.

    4. Only factory costs go into the Manufacturing Account. Selling, distribution, and admin costs are period costs — straight to the Income Statement.

    5. Cost of Production replaces “Purchases” in the Trading Account. The rest of the Trading Account logic is identical to a trading entity.

    6. WIP adjustment sequence: Total Manufacturing Cost + Opening WIP − Closing WIP = Cost of Production. Opening WIP adds; closing WIP deducts.

    ]]>         Lesson 15 – The Art of the Budget https://www.neelshattingh.com/financialaccounting/lesson-15-the-art-of-the-budget/ Tue, 19 May 2026 17:30:10 +0000 https://www.neelshattingh.com/?p=402 FAC1502 · Study Unit 15 · Budgeting | Lexicon
    Lexicon
    FAC1502 / Study Unit 15 / Budgeting

    FAC1502 · Financial Accounting · Study Unit 15

    The Art of the Budget

    Planning, Control & Variance Analysis

    SU 15 UNISA BCom Topic 5 ~4 hr study
    FAC1502 Course ProgressSU 15 of 17
    SU 1–6 SU 7–9 SU 10–12 SU 13 SU 14 SU 15 SU 16–17

    Contents

    01

    What is a Budget?

    A budget is a formal, quantified plan expressed in monetary terms, covering a defined future period — typically one financial year, broken into monthly intervals. It translates strategy into numbers, setting targets for revenue, expenditure, production, and cash before the period begins.

    Budgeting is not merely a forecasting exercise. Its real value lies in control: once the period ends, actual results are compared to the budget, variances are investigated, and management can correct course for the next period.

    The Four Functions of a Budget

    Planning — forces management to think systematically about the future and commit to quantified targets before they spend a cent.

    Coordination — aligns the sales, production, and finance functions so that each department’s plans are consistent with the others.

    Motivation — clearly defined targets give employees and managers something concrete to work towards.

    Control — actual results are compared to budget, variances are identified and investigated, and corrective action is taken.

    Fixed Budget Prepared for a single activity level and remains unchanged regardless of actual output. Simple to prepare but less useful for control when volumes differ from plan. Flexible Budget Adjusted to the actual level of activity achieved. Separates volume differences from efficiency differences, making variance analysis far more meaningful. Zero-Based Budget Every line item starts from zero each period — no automatic carry-forward of prior year figures. Forces justification of all spending but is time-intensive. Rolling Budget Continuously updated by adding a new future period as the most recent period passes. Always maintains a 12-month forward view.
    // NOTE

    FAC1502 focuses on fixed budgets and their associated variance analysis. The flexible budget concept is introduced conceptually but the exam calculations centre on static budget comparisons.

    02

    The Master Budget

    The master budget is the consolidated, comprehensive plan for the entire organisation, combining all departmental sub-budgets into a unified whole. It culminates in three financial statements: a budgeted income statement, a budgeted balance sheet, and a cash budget.

    The individual sub-budgets feed into one another in a specific sequence — each one depends on the outputs of the one before it. This chain is called the budget cascade.

    Sales Budget
    The starting point — all other budgets flow from this
    ↓
    Production Budget
    Units to produce = Sales + Closing stock − Opening stock
    Direct Materials Budget
    Raw materials to purchase, in units and cost
    Direct Labour Budget
    Hours and cost of labour for planned production
    Manufacturing Overhead Budget
    Fixed and variable factory overheads
    Selling & Admin Budget
    Operating expenses below the gross profit line
    ↓
    Budgeted Income Statement
    Revenue − COGS − Expenses = Net Profit
    Cash Budget
    Receipts − Payments = Net cash movement
    Budgeted Balance Sheet
    Financial position at end of budget period
    // TIP

    The limiting factor (also called the principal budget factor) determines where the cascade begins. In most businesses it is sales — but if a factory is at full capacity, production capacity becomes the limiting factor and the production budget must come first, constraining what sales can promise.

    03

    The Sales Budget

    The sales budget is the foundation of the entire master budget. It states the expected units to be sold and the expected selling price per unit for each period, producing a total budgeted revenue figure.

    Sales Budget Format

    Sales budget = Units budgeted × Budgeted selling price per unit

    It is typically broken down by product, region, and month. For FAC1502 purposes, a single product or small product mix over three months is standard.

    Worked Illustration

    Zara Manufacturing expects to sell 800 units in January, 1 000 in February, and 900 in March at R250 per unit.

    Sales Budget — January to March
    ItemJanuaryFebruaryMarchTotal
    Budgeted units8001 0009002 700
    Selling price per unitR250R250R250—
    Budgeted sales revenue200 000250 000225 000675 000
    // EXAM

    In questions involving cash collections, the sales budget gives revenue on an accrual basis. The cash budget then requires you to apply a collection pattern (e.g. 60% collected in month of sale, 40% in the following month) to convert revenue into actual cash receipts. Keep these two clearly separate.

    04

    Production & Purchases Budget

    Once sales volumes are known, the production (or purchases, for a trading entity) budget calculates how many units must be made or bought to satisfy both sales demand and desired closing stock levels.

    PRODUCTION BUDGET — Units Budgeted sales (units) ××× Add: Desired closing finished goods stock ××× ────── Total units required ××× Less: Opening finished goods stock (×××) ────── Units to produce ××× PURCHASES BUDGET — for a trading entity (units or R) Budgeted sales (units or cost) ××× Add: Desired closing inventory ××× ────── Total units / cost required ××× Less: Opening inventory (×××) ────── Units / cost to purchase ×××

    Raw Materials Purchases Budget

    For a manufacturing entity, after calculating units to produce, you then calculate raw material requirements:

    RAW MATERIALS BUDGET Units to produce × material per unit = Material required for production Add: Desired closing raw material stock ××× ────── Total raw material needed ××× Less: Opening raw material stock (×××) ────── Raw materials to purchase ××× × Purchase price per unit ××× ────── Total purchases cost (R) ×××
    // NOTE

    Closing stock targets are typically expressed as a percentage of the next month’s sales or production. For example, “closing stock should equal 20% of next month’s sales” — so March’s closing stock is based on April’s budgeted sales. If April data is not given, the question will usually state the closing stock figure directly.

    05

    The Cash Budget

    The cash budget is arguably the most important planning tool in the master budget. A business can be profitable yet face a cash crisis if collections are slow or payments bunch up. The cash budget forecasts actual cash inflows and outflows for each month, revealing when shortfalls might occur so management can arrange overdraft facilities or defer expenditure in advance.

    Structure of the Cash Budget

    Section A — Receipts: Cash collected from customers (applying the collection pattern to credit sales), cash sales, proceeds from asset disposals, loans received.

    Section B — Payments: Cash paid to suppliers (applying payment terms), wages and salaries paid, overheads paid, capital expenditure, loan repayments, tax and dividends paid.

    Section C — Net movement: Total receipts − Total payments = Net cash inflow or (outflow).

    Section D — Closing balance: Opening balance + Net movement = Closing balance. A negative closing balance signals a funding requirement.

    CASH BUDGET LAYOUT Jan Feb Mar RECEIPTS Collections from debtors ××× ××× ××× Cash sales ××× ××× ××× Other receipts ××× ××× ××× ────── ────── ────── Total receipts ××× ××× ××× PAYMENTS Payments to creditors ××× ××× ××× Salaries & wages ××× ××× ××× Overheads (cash) ××× ××× ××× Capital expenditure ××× — — Loan repayments — ××× ××× Tax / dividends ××× — — ────── ────── ────── Total payments ××× ××× ××× ────── ────── ────── Net cash inflow / (outflow) ××× ××× (×××) Opening balance ××× ××× ××× ────── ────── ────── Closing balance ××× ××× (×××)

    Debtors Collection Pattern

    Most businesses sell on credit and collect cash with a lag. The question will state the collection pattern. Apply it carefully, month by month:

    Example Collection Pattern

    60% of sales collected in the month of sale; 35% in the following month; 5% estimated bad debts (never collected).

    If January sales = R200 000 and February sales = R250 000, then February cash receipts from debtors = (250 000 × 60%) + (200 000 × 35%) = R150 000 + R70 000 = R220 000.

    Creditors Payment Pattern

    Similarly, purchases on credit create a payment lag. Apply the payment pattern to the purchases budget to determine cash paid each month:

    Example Payment Pattern

    50% of purchases paid in month of purchase; 50% paid in the following month.

    If January purchases = R80 000 and February purchases = R95 000, then February cash payments to creditors = (95 000 × 50%) + (80 000 × 50%) = R47 500 + R40 000 = R87 500.

    // EXAM

    Depreciation, amortisation, and other non-cash charges never appear in the cash budget — they do not involve cash. If an overhead total includes depreciation, you must subtract it before including the amount in the cash budget. Always read the question notes carefully for this trap.

    06

    Budgeted Income Statement

    The budgeted income statement assembles the outputs of the sales, production cost, and operating expense budgets to show the expected profitability for the period. It is prepared on an accrual basis — unlike the cash budget.

    Budgeted Income Statement — Three months ended 31 March
    ItemRR
    Sales revenue (from sales budget)675 000
    Less: Cost of goods sold
    Opening finished goods inventory(×××)
    Production costs for period(×××)
    Less: Closing finished goods inventory×××
    Gross profit×××
    Less: Operating expenses
    Selling expenses(×××)
    Administrative expenses(×××)
    Depreciation(×××)
    Budgeted net profit before tax×××
    // NOTE

    The budgeted income statement and the cash budget will not show the same profit/cash figure. Profit is accrual-based; cash reflects timing of actual payments. Understanding this difference is a core FAC1502 competency — it loops back directly to Study Unit 14’s cash flow statement logic.

    07

    Variance Analysis

    Once the period ends, actual results are compared to budgeted figures. The difference is a variance. Variance analysis is the control mechanism that makes budgeting worthwhile — without it, the budget is just a document that gathers dust.

    Favourable (F) The actual result is better than budget — actual revenue higher than budgeted, or actual cost lower than budgeted. Increases profit relative to plan. Adverse (A) The actual result is worse than budget — actual revenue lower than budgeted, or actual cost higher than budgeted. Reduces profit relative to plan. Variance Variance = Actual − Budget (for income items) or Budget − Actual (for cost items). State whether Favourable or Adverse.

    Always Label Your Variances

    A bare number means nothing. Always write F or A next to every variance figure. An examiner who sees “R12 000” without a label will mark it wrong, even if the number is correct.

    Key Variance Calculations

    SALES VARIANCE Sales variance = Actual revenue − Budgeted revenue → Actual > Budget : Favourable (F) → Actual < Budget : Adverse (A) COST VARIANCE (any expense line) Cost variance = Budgeted cost − Actual cost → Budgeted > Actual : Favourable (F) — spent less than planned → Budgeted < Actual : Adverse (A) — overspent GROSS PROFIT VARIANCE GP variance = Actual GP − Budgeted GP → Positive difference : Favourable (F) → Negative difference : Adverse (A) PROFIT VARIANCE (Net) = Sum of all individual variances (revenue + cost lines) Favourable variances increase profit → positive Adverse variances reduce profit → negative
    // TIP

    Build your variance statement as a table with four columns: Actual | Budget | Variance | F or A. Calculate each line, then sum the variances at the bottom to reconcile actual net profit to budgeted net profit. The totals must cross-check — the sum of individual variances equals the total profit variance.

    Possible Causes of Variances

    • 01Sales volume variance — more or fewer units sold than planned. Driven by market conditions, competitor activity, or poor demand forecasting.
    • 02Selling price variance — actual price differed from budget. Price reductions to meet competition cause adverse variances; price increases cause favourable ones.
    • 03Material cost variance — input prices changed (price variance) or more/less material was used per unit than planned (usage/efficiency variance).
    • 04Labour variance — wage rate differed from budget (rate variance) or more/fewer hours worked per unit than planned (efficiency variance).
    • 05Overhead variance — fixed overhead overruns are common when activity is lower than planned (under-absorption); efficiency gains at high volumes create favourable variances.

    08

    Full Worked Example

    Kalahari Traders sells a single product. Prepare (a) a three-month cash budget, and (b) a variance statement for March, using the data below.

    Given Data

    Budgeted & Actual Sales Data
    MonthBudget UnitsActual UnitsSelling Price
    January1 000950R200
    February1 2001 300R200
    March1 1001 050R200

    Additional information:

    • 60% of sales collected in month of sale; 40% in following month. No bad debts.
    • Cost of goods sold: R120 per unit (variable). No opening/closing stock difference for cash purposes.
    • Purchases paid: 50% in month of purchase, 50% next month.
    • Fixed overheads: R30 000 per month (includes R5 000 depreciation — not a cash item).
    • Opening bank balance 1 January: R15 000.
    • Actual March costs: COGS R128 per unit; fixed overheads R33 000 (cash: R28 000).

    Step 1 — Budgeted Sales Revenue

    January
    1 000 units × R200200 000
    February
    1 200 units × R200240 000
    March
    1 100 units × R200220 000

    Step 2 — Budgeted Purchases (Cash COGS basis)

    January
    1 000 × R120120 000
    February
    1 200 × R120144 000
    March
    1 100 × R120132 000

    Step 3 — Cash Budget

    Cash Budget — January to March (Budgeted)
    ItemJanuary (R)February (R)March (R)
    RECEIPTS
    Collections — current month (60%) 120 000 144 000 132 000
    Collections — prior month (40%) — 80 000 96 000
    Total receipts120 000224 000228 000
    PAYMENTS
    Purchases — current month (50%) 60 000 72 000 66 000
    Purchases — prior month (50%) — 60 000 72 000
    Fixed overheads (cash: R30k − R5k depn) 25 000 25 000 25 000
    Total payments85 000157 000163 000
    NET POSITION
    Net cash inflow / (outflow)35 00067 00065 000
    Opening balance15 00050 000117 000
    Closing balance50 000117 000182 000
    // NOTE

    January has no prior-month collections because we assume no outstanding debtors at 31 December. In a real exam, if an opening debtors balance is given, that amount becomes January’s “prior month” receipt. Always check for this.

    Step 4 — March Variance Statement

    Variance Statement — March
    Item Budget (R) Actual (R) Variance (R) F / A
    INCOME
    Sales revenue 220 000 210 000 10 000 A
    COSTS
    Cost of goods sold 132 000 134 400 2 400 A
    Gross profit 88 000 75 600 12 400 A
    Fixed overheads 30 000 33 000 3 000 A
    Net profit 58 000 42 600 15 400 A

    Actual sales: 1 050 × R200 = R210 000  |  Actual COGS: 1 050 × R128 = R134 400  |  Total adverse variance on net profit: R15 400 (A) — driven by lower volumes (R10 000 A), higher unit cost (R2 400 A), and overhead overrun (R3 000 A).

    09

    Practice Exercises

    Exercise 01
    Production Budget — Units
    [expand]

    Naledi Industries budgets the following sales for the first quarter: April 2 000 units, May 2 500 units, June 2 200 units. Closing finished goods stock should equal 15% of the following month’s sales. Opening stock on 1 April is 250 units. June’s closing stock target should be based on July’s estimated sales of 2 400 units.

    Prepare the production budget in units for April, May, and June.

    Closing stock targets:
    April closing = 15% × 2 500 = 375  |  May closing = 15% × 2 200 = 330  |  June closing = 15% × 2 400 = 360

    ItemAprilMayJune
    Budgeted sales (units)2 0002 5002 200
    Add: Desired closing stock375330360
    Total required2 3752 8302 560
    Less: Opening stock(250)(375)(330)
    Units to produce2 1252 4552 230

    Note: Each month’s closing stock becomes the next month’s opening stock.

    Exercise 02
    Cash Collections Calculation
    [expand]

    Msimbi Trading has the following budgeted credit sales: February R180 000, March R210 000, April R195 000. The collection pattern is: 70% in month of sale, 25% in following month, 5% bad debts. There are no opening debtors.

    Calculate the cash collected from debtors in March and April.

    SourceMarch CollectionsApril Collections
    Current month sales (70%)147 000136 500
    Prior month sales (25%)45 00052 500
    Total cash collected192 000189 000

    March: (R210 000 × 70%) + (R180 000 × 25%) = R147 000 + R45 000 = R192 000
    April: (R195 000 × 70%) + (R210 000 × 25%) = R136 500 + R52 500 = R189 000
    The 5% bad debts are simply never collected — they do not appear anywhere in the cash budget.

    Exercise 03
    Variance Analysis — Classify and Calculate
    [expand]

    The following results were recorded for June:

    ItemBudget (R)Actual (R)
    Sales revenue320 000340 000
    Cost of sales190 000205 000
    Salaries45 00045 000
    Rent18 00018 000
    Other overheads22 00019 500

    Prepare a variance statement for June, labelling each variance as Favourable (F) or Adverse (A). Reconcile budgeted net profit to actual net profit.

    ItemBudget (R)Actual (R)Variance (R)F / A
    Sales revenue320 000340 00020 000F
    Cost of sales190 000205 00015 000A
    Gross profit130 000135 0005 000F
    Salaries45 00045 000——
    Rent18 00018 000——
    Other overheads22 00019 5002 500F
    Net profit45 00052 5007 500F

    Reconciliation:
    Budgeted net profit                 R45 000
    Add: Favourable sales variance   R20 000 (F)
    Less: Adverse COGS variance     (R15 000) (A)
    Add: Favourable overheads       R2 500 (F)
                                               ──────
    Actual net profit                     R52 500 ✓

    Study Unit 15 — Key Takeaways

    1. The budget cascade flows from Sales → Production → Materials/Labour/Overhead → Budgeted IS, Cash Budget, Budgeted BS. Each step feeds the next.

    2. Production budget formula: Sales + Closing stock − Opening stock = Units to produce.

    3. The cash budget uses actual cash timing — apply collection and payment patterns to convert accrual revenue and purchases into cash flows. Exclude depreciation.

    4. The budgeted income statement is accrual-based; the cash budget is cash-based. They will show different figures — this is expected and correct.

    5. Variance = Actual − Budget for income; Budget − Actual for costs. Always label Favourable (F) or Adverse (A).

    6. A reconciliation of budgeted profit to actual profit using variances is a high-mark exam question — practise it until it is automatic.

    ]]>         Lesson 14 – The Cash Flow Statement https://www.neelshattingh.com/financialaccounting/lesson-14-the-cash-flow-statement/ Tue, 19 May 2026 17:27:26 +0000 https://www.neelshattingh.com/?p=400 FAC1502 · Study Unit 14 · Cash Flow Statement | Lexicon
    Lexicon
    FAC1502 / Study Unit 14 / Cash Flow

    FAC1502 · Financial Accounting · Study Unit 14

    The Cash Flow Statement

    Where money actually moved — and why it matters

    SU 14 UNISA BCom IAS 7 ~4 hr study
    FAC1502 Course Progress SU 14 of 17
    SU 1–6 SU 7–9 SU 10–12 SU 13 SU 14 SU 15 SU 16–17

    Contents

    01

    Purpose & Overview

    The Statement of Cash Flows (IAS 7) explains the change in a business’s cash and cash equivalents over a reporting period. While the income statement records profit on an accrual basis, the cash flow statement asks a simpler question: did cash actually move?

    A business can be profitable on paper yet still run out of cash — think of a retailer with strong credit sales but slow-paying debtors. Conversely, a loss-making entity might generate strong operating cash flows. The cash flow statement bridges this gap between profit and liquidity.

    Why IAS 7 Requires It

    IAS 7 mandates the cash flow statement as a primary financial statement for all entities that prepare financial statements in accordance with IFRS. It must accompany the balance sheet, income statement, and statement of changes in equity.

    The statement is structured around three activities: operating, investing, and financing. Together they must reconcile to the movement in cash and cash equivalents for the period.

    Cash Notes and coins on hand, plus demand deposits held at banks. Cash Equivalents Short-term, highly liquid investments readily convertible to known cash amounts, with insignificant risk of value change. Typically, investments with original maturities of three months or less. Bank Overdraft Included as a component of cash and cash equivalents when it is repayable on demand and forms an integral part of the entity’s cash management.

    02

    The Three Activities

    Every cash transaction in the business must be classified under one of three headings. Getting the classification right is the first skill to master.

    Operating

    Cash flows from the principal revenue-producing activities of the entity — the day-to-day core business.

    + Cash received from customers
    + Interest received (sometimes)
    + Dividends received (sometimes)
    − Cash paid to suppliers
    − Cash paid to employees
    − Income tax paid
    − Interest paid (sometimes)
    Investing

    Cash flows from the acquisition and disposal of long-term assets and other investments not included in cash equivalents.

    − Purchase of PPE
    − Purchase of investments
    − Loans advanced
    + Proceeds from sale of PPE
    + Proceeds from investments
    + Loan repayments received
    Financing

    Cash flows that result in changes in the size and composition of the entity’s equity and borrowings.

    + Issue of shares
    + Proceeds from borrowings
    − Repayment of borrowings
    − Dividends paid to owners
    − Lease liability repayments
    // EXAM

    Interest and dividends can be classified in different sections depending on the entity’s accounting policy. For FAC1502, the typical treatment is: interest paid → operating or financing; interest received → operating or investing; dividends paid → financing; dividends received → operating or investing. Always follow the question’s instruction — or if silent, use the most common convention (interest paid and received = operating; dividends paid = financing; dividends received = operating).

    // NOTE

    Tax paid is generally classified as operating unless it can be specifically identified with financing or investing activities.

    03

    Direct vs Indirect Method

    IAS 7 permits two approaches for presenting the operating activities section. The investing and financing sections are always presented the same way regardless of the method chosen.

    Direct Method

    Shows actual cash receipts and payments line by line: “Cash received from customers: R×××”, “Cash paid to suppliers: R×××”, etc. More transparent and intuitive — but requires detailed transaction records. IAS 7 encourages this method.

    Indirect Method

    Starts with net profit (or net loss) and works backwards — adjusting for non-cash items and working capital changes — to arrive at cash generated from operations. More commonly used in practice because it derives from existing financial statements without needing raw transaction data.

    FAC1502 focuses almost exclusively on the indirect method.

    // TIP

    Both methods produce the same total for cash generated from operating activities. The difference is only in presentation. Once you reach the operating subtotal, the rest of the statement (investing and financing) is identical under both methods.

    04

    The Indirect Method — Step by Step

    The indirect method reconciles profit before tax to cash generated from operations. Think of it as un-doing the accrual adjustments the accountant made when preparing the income statement.

    Step 1 — Start with Profit Before Tax

    Take the net profit figure from the income statement, before income tax. This is your starting point.

    Step 2 — Add Back Non-Cash Charges

    Depreciation, amortisation, and impairment losses reduced profit but involved no cash outflow. Add them back.

    Step 3 — Adjust for Non-Operating Items

    Remove interest expense (will appear later, if paid), interest income, and profit/loss on disposal of assets (the cash proceeds appear in investing activities).

    Step 4 — Working Capital Adjustments

    Adjust for changes in debtors, inventory, creditors, and other current items. These convert accrual-based operating profit into actual cash flows.

    Step 5 — Cash Generated from Operations

    The subtotal after working capital adjustments. This is a key performance metric in its own right.

    Step 6 — Deduct Interest & Tax Paid

    Subtract interest paid and income tax actually paid in cash during the period to arrive at net cash from operating activities.

    OPERATING SECTION (Indirect Method) Profit before tax R ××× Add: Depreciation & amortisation ××× Add: Impairment losses ××× Add: Loss on disposal of PPE ××× Less: Gain on disposal of PPE (×××) Add: Interest expense (if to be shown separately) ××× Less: Interest income (if to be shown separately) (×××) ────── Operating profit before working capital changes R ××× Add: Decrease in trade debtors / receivables ××× Less: Increase in trade debtors / receivables (×××) Add: Decrease in inventory ××× Less: Increase in inventory (×××) Add: Increase in trade creditors / payables ××× Less: Decrease in trade creditors / payables (×××) ────── Cash generated from operations R ××× Less: Interest paid (×××) Less: Income tax paid (×××) ────── Net cash from / (used in) operating activities R ×××

    05

    Working Capital Adjustments — The Logic

    Working capital adjustments are the trickiest part of the indirect method. The rule is simple once you understand the underlying logic: if cash came in, add; if cash went out, deduct.

    The Underlying Principle

    Accrual accounting records revenue when earned and expenses when incurred — regardless of when cash moves. Working capital adjustments convert these accrual figures back into their cash equivalents.

    An increase in debtors means the business recognised revenue but has not yet received the cash — so subtract it. A decrease in debtors means cash was collected from sales recorded previously — so add it back.

    Balance Sheet Item Movement Cash Flow Effect Adjustment
    CURRENT ASSETS (Debtors, Inventory, Prepayments)
    Trade debtors / Inventory Increase ↑ Cash tied up — less cash received than revenue/COGS suggests (Deduct)
    Trade debtors / Inventory Decrease ↓ Cash freed up — more cash received/saved than accrual shows Add
    CURRENT LIABILITIES (Creditors, Accruals)
    Trade creditors / Accruals Increase ↑ Less cash paid than expenses suggest — creditors absorbing costs Add
    Trade creditors / Accruals Decrease ↓ More cash paid than expenses suggest — settling old payables (Deduct)
    // MEMORY AID

    Assets and liabilities move in opposite directions: an asset increase = deduct; a liability increase = add. Think of it this way — when an asset grows, your business used cash to fund it (bad for cash); when a liability grows, your business deferred cash payment (good for cash).

    Calculating Tax Paid

    The income statement shows tax expense, not tax paid. To find actual cash paid:

    TAX PAID CALCULATION Opening tax payable (liability) ××× Add: Tax charge for the year (I/S) ××× ────── ××× Less: Closing tax payable (liability) (×××) ────── Tax paid during the year ×××

    The same logic applies to calculating interest paid when only the expense and an accrued interest balance are given.

    06

    Investing Activities

    The investing section records actual cash movements relating to the purchase and disposal of long-term assets. This section is prepared by analysing the relevant asset accounts in the ledger.

    PPE Ledger Analysis

    For each class of fixed asset, reconstruct the ledger account to find the cash paid for new assets and the cash received from disposals:

    PPE ACCOUNT (at carrying amount / cost) Opening balance (beg of year) ××× Add: Purchases (cash outflow — investing) ××× ────── ××× Less: Disposals (at carrying amount) (×××) Less: Depreciation for the year (×××) ────── Closing balance (end of year) ××× → Rearrange to solve for “Purchases”: Purchases = Closing + Disposals (CV) + Depreciation − Opening
    // NOTE

    In the investing section, record the actual cash proceeds received on disposal, not the book value. The difference between cash proceeds and carrying amount is the profit/loss on disposal — which was already removed in the operating section reconciliation.

    • 01Cash paid for PPE → always a cash outflow in investing activities.
    • 02Cash received on disposal of PPE → always a cash inflow in investing activities.
    • 03If PPE was acquired on credit or hire purchase, only the cash portion appears in investing. The finance element appears in financing.
    • 04Loans granted to third parties → outflow; Loan repayments received → inflow.

    07

    Financing Activities

    Financing activities reflect changes in the entity’s capital structure — how it raised and repaid funds from owners and lenders. These are typically the easiest to identify because they involve share capital, long-term borrowings, and dividends.

    Share Issue Cash received from issuing new shares = inflow. Compare opening and closing share capital and share premium accounts, adjusting for any bonus issues (non-cash). Loans Raised New borrowings during the period = inflow. Reconstruct the long-term loan account: Opening + New loans − Repayments = Closing. Loan Repayments Capital repayments on borrowings = outflow. Note: interest paid is classified as operating (or financing per policy). Dividends Paid Calculate via: Opening dividends payable + Dividends declared − Closing dividends payable = Dividends paid.

    Calculating Dividends Paid

    DIVIDENDS PAID CALCULATION Opening dividends payable ××× Add: Dividends declared during year ××× ────── ××× Less: Closing dividends payable (×××) ────── Dividends paid (cash outflow) ×××
    // EXAM

    A bonus share issue (capitalisation issue) is not a cash flow — it increases share capital and decreases retained earnings but involves no money changing hands. Exclude it from the cash flow statement entirely. Only cash received from new share issues appears in financing activities.

    08

    Full Worked Example

    The following information relates to Mara Traders (Pty) Ltd for the year ended 28 February 2025. Prepare the Statement of Cash Flows using the indirect method.

    Given Information

    Selected Balance Sheet Items
    Item28 Feb 202528 Feb 2024
    PPE (carrying amount)480 000360 000
    Inventory95 00080 000
    Trade debtors62 00075 000
    Cash & bank28 00015 000
    Trade creditors48 00040 000
    Income tax payable18 00014 000
    Long-term loan200 000150 000
    Share capital300 000250 000
    Retained earnings99 00046 000
    Income Statement Extracts
    ItemAmount (R)
    Net profit before tax120 000
    Depreciation45 000
    Interest expense22 000
    Profit on disposal of PPE8 000
    Income tax expense36 000
    Dividends declared31 000

    Additional: PPE with a carrying amount of R20 000 was sold during the year. New PPE was purchased for cash. Interest payable: nil opening and closing (assume all paid). No dividends payable at year end (nil opening).

    Preliminary Calculations

    PPE PURCHASES Opening CV 360 000 + Purchases ??? − Disposal CV (20 000) − Depreciation (45 000) = Closing CV 480 000 → Purchases = 480 000 + 20 000 + 45 000 − 360 000 = R185 000 DISPOSAL PROCEEDS CV of disposed asset: 20 000 + Profit on disposal: 8 000 = Cash proceeds: R28 000 TAX PAID Opening tax payable: 14 000 + Tax expense: 36 000 − Closing tax payable: (18 000) = Tax paid: R32 000 LOAN RAISED Opening: 150 000 + New borrowings: ??? − Repayments: nil (assume) = Closing: 200 000 → New loan: R50 000 SHARE ISSUE Opening: 250 000 → Closing: 300 000 → Cash received: R50 000 DIVIDENDS PAID Opening payable: 0 + Declared: 31 000 − Closing payable: 0 = R31 000

    Statement of Cash Flows

    Mara Traders (Pty) Ltd — Statement of Cash Flows for the year ended 28 February 2025
    DescriptionRR
    OPERATING ACTIVITIES
    Profit before tax120 000
    Adjustments for non-cash items:
    Depreciation45 000
    Profit on disposal of PPE(8 000)
    Interest expense22 000
    Working capital changes:
    Decrease in trade debtors (75k → 62k)13 000
    Increase in inventory (80k → 95k)(15 000)
    Increase in trade creditors (40k → 48k)8 000
    Cash generated from operations185 000
    Interest paid(22 000)
    Income tax paid(32 000)
    Net cash from operating activities131 000
    INVESTING ACTIVITIES
    Purchase of PPE(185 000)
    Proceeds from disposal of PPE28 000
    Net cash used in investing activities(157 000)
    FINANCING ACTIVITIES
    Proceeds from issue of shares50 000
    Proceeds from long-term loan50 000
    Dividends paid(31 000)
    Net cash from financing activities69 000
    NET MOVEMENT IN CASH
    Net increase in cash and cash equivalents43 000
    Cash at beginning of year15 000
    Cash at end of year28 000 ✓
    // VERIFY

    The closing cash of R28 000 matches the balance sheet. Always verify this — it is your built-in proof that the statement is complete and balanced.

    09

    Practice Exercises

    Exercise 01
    Working Capital Adjustments — Classification
    [expand]

    For each of the following changes, state whether the adjustment to profit under the indirect method is an addition or a deduction:

    1. Trade debtors increased from R40 000 to R55 000
    2. Inventory decreased from R90 000 to R70 000
    3. Trade creditors decreased from R30 000 to R22 000
    4. Accrued expenses increased from R5 000 to R9 000
    5. Prepaid expenses decreased from R12 000 to R8 000
    1. Debtors ↑ R15 000 → Deduct R15 000 — cash not yet received
    2. Inventory ↓ R20 000 → Add R20 000 — goods sold, cash saved on purchases
    3. Creditors ↓ R8 000 → Deduct R8 000 — more cash paid than expenses suggest
    4. Accruals ↑ R4 000 → Add R4 000 — expense recognised but not yet paid in cash
    5. Prepayments ↓ R4 000 → Add R4 000 — prior cash payment now expensed, restoring cash position
    Exercise 02
    Classify the Cash Flow
    [expand]

    Classify each item as Operating (O), Investing (I), or Financing (F), and state whether it is an inflow (+) or outflow (−):

    1. Cash received from credit customers
    2. Purchase of a new delivery truck for cash
    3. Dividends paid to shareholders
    4. Proceeds from selling a piece of land
    5. Repayment of a long-term bank loan
    6. Cash paid to employees (salaries)
    7. New shares issued for cash
    8. Income tax paid to SARS
    1. O (+) — Cash collected from customers is core operating revenue
    2. I (−) — Acquisition of a long-term asset
    3. F (−) — Return of capital to equity holders
    4. I (+) — Disposal of a long-term asset
    5. F (−) — Capital repayment on borrowing
    6. O (−) — Core business cash payment
    7. F (+) — Raising equity capital
    8. O (−) — Tax is classified as operating (general rule)
    Exercise 03
    PPE Purchases from Ledger Data
    [expand]

    The PPE account (at cost) had a balance of R620 000 at the start of the year and R780 000 at year end. During the year, an asset that originally cost R60 000 was sold. Depreciation for the year was R95 000 (use accumulated depreciation below).

    Accumulated depreciation: opening R180 000; closing R220 000. The sold asset had accumulated depreciation of R35 000 at the date of sale.

    Calculate: (a) the carrying amount of the disposed asset, (b) the cash paid to purchase new PPE.

    (a) Carrying amount of disposed asset:
    Cost R60 000 − Accumulated depreciation R35 000 = R25 000

    (b) PPE purchases (cost account):

    Opening cost: 620 000 + Purchases: ??? − Cost of disposed asset: (60 000) = Closing cost: 780 000 Purchases = 780 000 + 60 000 − 620 000 = R220 000

    Verify accumulated depreciation account:
    Opening R180 000 + Charge R95 000 − Disposed R35 000 = Closing R240 000… but closing given is R220 000.
    Check: 180 + 95 − 35 = 240 ≠ 220 → the depreciation charge must be R75 000 (not R95 000) for the numbers to balance, or there is a rounding/typo in the question. In exam conditions, always check your accumulated depreciation account as a cross-check — if it doesn’t balance, revisit the depreciation figure.

    Study Unit 14 — Key Takeaways

    1. Three sections: Operating, Investing, Financing. Every cash transaction belongs in exactly one.

    2. Indirect method starts with profit before tax and works backwards by removing non-cash and non-operating items, then adjusting for working capital changes.

    3. Working capital rule: current asset ↑ = deduct; current asset ↓ = add; current liability ↑ = add; current liability ↓ = deduct.

    4. PPE purchases are calculated by reconstructing the asset account: Opening + Purchases − Disposals (cost) − Depreciation = Closing.

    5. Tax paid, dividends paid, and interest paid are all calculated via their respective ledger/payable accounts using the same Opening + Charge − Closing = Paid formula.

    6. Verify by confirming that opening cash + net movement = closing cash per the balance sheet. If it doesn’t balance, find the error before submitting.

    ]]>         Lesson 13 – The Partnership https://www.neelshattingh.com/financialaccounting/lesson-13-the-partnership/ Tue, 19 May 2026 17:24:08 +0000 https://www.neelshattingh.com/?p=398 FAC1502 · Study Unit 13 · Partnerships | Lexicon
    Lexicon
    FAC1502 / Study Unit 13 / Partnerships

    FAC1502 · Financial Accounting · Study Unit 13

    The Partnership

    Formation, Capital, Profit Distribution & Dissolution

    SU 13 UNISA BCom Topic 5 ~4 hr study
    FAC1502 Course Progress SU 13 of 17
    SU 1–6 SU 7–9 SU 10–12 SU 13 SU 14 SU 15 SU 16–17

    Contents

    01

    What is a Partnership?

    A partnership is an association of two or more persons who carry on a business together with the shared goal of making a profit. Unlike a company, a partnership is not a separate legal entity — the partners themselves are the business in the eyes of the law, and they bear unlimited personal liability for the firm’s debts.

    Legal Definition

    In South African law, a partnership is defined by the Partnerships Act and common law. Key characteristics: (1) two or more persons, (2) carrying on a business, (3) in common, (4) for the joint benefit of all partners, and (5) each partner contributes something of value.

    General Partner Has unlimited liability. Actively manages the business and is jointly and severally liable for all partnership debts. Silent Partner Contributes capital but takes no active role in management. Still subject to unlimited liability unless structured otherwise. Limited Partner Liability limited to the amount contributed. Must not participate in management. Requires formal registration.
    // NOTE

    For FAC1502 purposes, we deal almost exclusively with general partnerships where partners share profits/losses and bear unlimited liability. The accounting principles below apply to this form.

    02

    The Partnership Agreement

    While a partnership agreement can be oral, it is strongly recommended that it be reduced to writing. The agreement governs the financial relationship between partners and determines how profit is divided, how capital contributions are handled, and what happens upon dissolution.

    If no agreement exists (or the agreement is silent on a matter), South African partnership law implies certain default rules, mirroring the Partnerships Act provisions.

    Typical Clauses in a Partnership Agreement

    Capital contributions — the amount each partner brings in, and whether it is fixed or variable.

    Profit & loss sharing ratio — how net profit (or loss) is divided after appropriations.

    Partner salaries — fixed amounts payable to partners for services rendered, treated as an appropriation of profit.

    Interest on capital — a percentage return on capital balances, also an appropriation before the residual split.

    Interest on drawings — a charge against partners who withdraw funds during the year, increasing the net profit available for distribution.

    Goodwill provisions — how goodwill is valued and shared on admission or dissolution.

    // EXAM

    If the agreement is silent on profit sharing, profits and losses are divided equally among all partners — regardless of capital contributions or workload. This is a frequently tested default rule.

    03

    Capital & Current Accounts

    Each partner’s equity is tracked through two separate accounts. Keeping them separate provides clarity: the capital account reflects the long-term investment while the current account captures ongoing transactions with the business.

    Capital Account Records the original and permanent capital contribution by each partner. Changes only when additional capital is introduced or capital is formally reduced. Fixed in nature. Current Account A running account that accumulates: profit shares, salary allocations, interest on capital (credits) and drawings, interest on drawings (debits). Fluctuates each period.

    The total equity of a partner = Capital Account balance + Current Account balance.

    // TIP

    A debit balance on the current account means the partner has taken out more than was allocated — they owe the partnership. A credit balance means the partnership owes the partner.

    04

    Profit & Loss Distribution — The Process

    Distributing profit in a partnership follows a structured step-by-step appropriation process. Think of it as working through a waterfall — each step reduces the pool before the remainder is split in the agreed ratio.

    The Appropriation Waterfall

    Step 1 — Start with Net Profit (per the income statement).

    Step 2 — Add back Interest on Drawings (these are debited to partners, increasing distributable profit).

    Step 3 — Deduct Partner Salaries (fixed amounts per agreement).

    Step 4 — Deduct Interest on Capital (applied to opening or average capital balances as specified).

    Step 5 — Deduct any Bonus entitlements.

    Step 6 — The residual amount is split in the agreed profit-sharing ratio.

    Net Profit (per income statement) + Interest on Drawings (all partners) ───────────────────────────────────── = Distributable Profit − Partner Salaries − Interest on Capital − Bonuses ───────────────────────────────────── = Residual Profit (or Loss) ↓ Allocated in agreed P:L ratio
    // EXAM

    If the residual amount is negative after salaries and interest allocations, the loss is still shared in the profit-sharing ratio (as a debit to each partner’s current account). Partners can still receive their salary and interest allocations even if the residual is a loss — unless the agreement says otherwise.

    05

    Salaries, Interest on Capital & Interest on Drawings

    Partner Salaries are not expenses on the income statement — they are appropriations of profit. They appear in the Profit & Loss Appropriation Account, not as an operating cost.

    Interest on Capital

    Compensates partners for different levels of capital invested. Calculated as:

    Interest = Capital Balance × Rate × Time

    The base is usually the opening capital balance for the year, unless mid-year capital changes occurred, in which case a time-weighted average is used.

    Interest on Drawings

    Discourages partners from withdrawing funds early in the year. It is a charge to partners (debited to their current accounts) and increases the profit available for distribution. Calculated on each drawing from the date of withdrawal to year-end:

    Interest = Drawing × Rate × (Months remaining / 12)

    If the agreement specifies a simplified method (e.g., assume drawings are evenly spread), an average period of 6 months is often used.

    // NOTE

    Partner salaries and interest on capital are credits in the partner’s current account. Interest on drawings is a debit. Drawings themselves are also debited to the current account when they are made.

    Worked Example — Interest on Drawings

    Partner B drew the following amounts during the year ended 28 Feb 2025. The agreement stipulates 12% p.a. interest on drawings.

    Interest on Drawings — Partner B
    Date Drawing Amount (R) Months to Y/E Interest (R)
    1 Mar 2024 Monthly allowance 5 000 12 600
    1 Jun 2024 Cash withdrawal 20 000 9 1 800
    1 Sep 2024 Cash withdrawal 15 000 6 900
    1 Dec 2024 Cash withdrawal 10 000 3 300
    TOTAL INTEREST ON DRAWINGS 3 600

    Each monthly drawing of R5 000 runs the full 12 months only if drawn on 1 March. In practice, if drawings are made monthly on the 1st, they are treated individually, or simplified using the 6-month average rule if the agreement allows it.

    06

    The Profit & Loss Appropriation Account

    The Appropriation Account is a nominal account that distributes the net profit (transferred from the P&L Account) to the individual partners. It sits between the income statement and the partners’ current accounts.

    // NOTE

    The Appropriation Account is unique to partnerships (and companies). Sole traders have no need for it — profit simply transfers to the owner’s capital account.

    Comprehensive Example

    Partnership of Absa and Biko. Year ended 28 Feb 2025. Net profit per income statement: R240 000. Agreement: Absa salary R48 000; Biko salary R36 000. Interest on capital at 10% p.a. Capital balances: Absa R200 000, Biko R150 000. Interest on drawings: Absa R3 600; Biko R2 400. Residual profit ratio: 3:2 (Absa:Biko).

    Profit & Loss Appropriation Account — year ended 28 February 2025
    Description Absa (R) Biko (R) Total (R)
    CREDITS — Sources of distributable profit
    Net profit (from P&L) — — 240 000
    Interest on drawings 3 600 2 400 6 000
    Distributable profit — — 246 000
    DEBITS — Appropriations
    Partner salaries 48 000 36 000 (84 000)
    Interest on capital 20 000 15 000 (35 000)
    Residual profit (3:2) — — 127 000
    Absa (3/5 × 127 000) 76 200 — —
    Biko (2/5 × 127 000) — 50 800 —
    NET ALLOCATION TO CURRENT ACCOUNTS
    Total credited to current account 144 200 101 800 246 000

    Note: Interest on capital = Absa R200 000 × 10% = R20 000; Biko R150 000 × 10% = R15 000. The interest on drawings (R6 000) added to net profit is exactly offset by the debits to each partner’s current account, so the Appropriation Account always balances.

    Journal Entries — Closing the Appropriation Account

    Date Account Debit (R) Credit (R)
    28 Feb 2025 Profit & Loss Account 240 000 —
    Profit & Loss Appropriation Account — 240 000
    Transfer net profit to Appropriation Account
    28 Feb 2025 Current Account — Absa 3 600 —
    Current Account — Biko 2 400 —
    Profit & Loss Appropriation Account — 6 000
    Interest on drawings charged to partners
    28 Feb 2025 Profit & Loss Appropriation Account 246 000 —
    Current Account — Absa — 144 200
    Current Account — Biko — 101 800
    Allocate salary, interest on capital & residual profit to partners

    07

    Admission of a New Partner

    When a new partner joins a partnership, the existing partners must agree to the terms of admission. The key accounting challenge is the treatment of goodwill — the premium the new partner pays over and above the net asset value of the business.

    Goodwill on Admission

    Goodwill arises because the existing partners have built up customer relationships, reputation, and earning power. The new partner must compensate them for their share of this intangible value.

    Two methods are typically used: (a) Raise and Write-Off the goodwill, or (b) Premium method where the new partner pays extra into the existing partners’ accounts directly.

    Method A — Raise and Write-Off Goodwill

    • 01 Raise goodwill in the books: Dr Goodwill / Cr Capital accounts of OLD partners (in old profit-sharing ratio). This recognises the existing partners’ contribution.
    • 02 New partner joins and contributes capital (which may implicitly include a goodwill premium).
    • 03 Write off goodwill immediately: Dr Capital accounts of ALL partners (new ratio) / Cr Goodwill. This recognises that goodwill is not carried on the books going forward.
    // TIP

    The net effect of raising and writing off goodwill is a transfer of value from the new partner to the old ones — without actually recording a goodwill asset permanently. This is the most commonly tested method in FAC1502.

    Revaluation of Assets on Admission

    Before admitting a new partner, assets should be revalued to fair value so that the new partner does not benefit from — or be prejudiced by — unrealised gains or losses accrued before their arrival.

    Dr Asset Account (if increase) ××× Cr Revaluation Reserve / Capital Accounts (old ratio) ××× Dr Revaluation Reserve / Capital Accounts (old ratio) ××× Cr Asset Account (if decrease) ×××

    08

    Dissolution & Realisation

    A partnership dissolves when it ceases to exist — through agreement, death of a partner, insolvency, or court order. On dissolution, all assets are realised (sold), liabilities settled, and any remaining cash distributed to partners.

    The Realisation Account

    The Realisation Account is a temporary account opened specifically for the dissolution process. All assets are transferred into it at book value, and the proceeds from their sale are credited. The balance represents the profit or loss on realisation, which is shared among partners in their profit-sharing ratio.

    Step-by-Step Dissolution Process

    • 01 Transfer all assets to the Realisation Account at book value: Dr Realisation / Cr each Asset Account.
    • 02 Record proceeds from asset sales: Dr Bank / Cr Realisation (for amounts received).
    • 03 Settle liabilities: Dr Creditors/Loans / Cr Bank.
    • 04 Close the Realisation Account: balance = profit or loss on realisation. Share among partners in P:L ratio via their current/capital accounts.
    • 05 Close partners’ loan accounts (if any) and current accounts — transfer balances into capital accounts.
    • 06 Pay partners final capital balances from the Bank account: Dr Capital Accounts / Cr Bank.
    // EXAM

    If a partner’s capital account shows a debit balance after absorbing the realisation loss, that partner owes the partnership money. They must pay cash to make good the deficiency before the remaining partners can be paid. If they cannot pay, the deficiency is borne by the solvent partners in their profit-sharing ratio (Garner v Murray rule applies in some jurisdictions — check the question facts).

    Dissolution — Worked Skeleton Journal

    Account Debit Credit Narration
    Realisation Account BV of assets — Transfer assets
    Asset Accounts (each) — BV of assets
    Bank Proceeds — Sale of assets
    Realisation Account — Proceeds
    Liabilities (Creditors etc.) Carrying amount — Settle liabilities
    Bank — Amount paid
    Realisation Account Profit (if any) — Share realisation profit
    Capital / Current — each partner — Each share
    Capital Accounts (each) Final balance — Pay out partners
    Bank — Final balance

    09

    Practice Exercises

    Exercise 01
    Appropriation Account with Interest & Salaries
    [expand]

    Partners Nkosi and Peters share profits in the ratio 3:1. The following information is available for the year ended 31 August 2025:

    • Net profit per income statement: R180 000
    • Capital balances (1 Sep 2024): Nkosi R120 000; Peters R80 000
    • Partner salaries: Nkosi R30 000; Peters R24 000
    • Interest on capital: 8% p.a.
    • Drawings during the year: Nkosi R40 000; Peters R20 000
    • Interest on drawings: 10% p.a. — assume drawings were made evenly throughout the year (use 6-month average)

    Prepare the Profit & Loss Appropriation Account for the year ended 31 August 2025, showing the allocation to each partner’s current account.

    Step 1: Calculate interest on drawings
    Nkosi: R40 000 × 10% × 6/12 = R2 000  |  Peters: R20 000 × 10% × 6/12 = R1 000

    Step 2: Calculate interest on capital
    Nkosi: R120 000 × 8% = R9 600  |  Peters: R80 000 × 8% = R6 400

    Step 3: Distributable profit = R180 000 + R3 000 (interest on drawings) = R183 000

    Step 4: Residual = R183 000 − R54 000 (salaries) − R16 000 (interest on capital) = R113 000
    Nkosi 3/4: R84 750  |  Peters 1/4: R28 250

    Description Nkosi (R) Peters (R) Total (R)
    Net profit——180 000
    Interest on drawings2 0001 0003 000
    Distributable profit——183 000
    Salaries(30 000)(24 000)(54 000)
    Interest on capital(9 600)(6 400)(16 000)
    Residual (3:1)——113 000
    Share of residual84 75028 250—
    Total to current account124 35058 650183 000
    Exercise 02
    Loss Scenario — Residual Deficit
    [expand]

    Partners Stein and Oba share profits 2:3. Net profit for the year: R45 000. No interest provisions exist. Stein’s salary is R40 000 and Oba’s salary is R35 000. There is no interest on capital or drawings.

    Prepare the appropriation account and show the allocation. What is the residual result, and how is it treated?

    Residual = R45 000 − R75 000 (salaries) = (R30 000) — a deficit.
    This R30 000 loss is shared 2:3. Stein bears R12 000; Oba bears R18 000.

    Description Stein (R) Oba (R) Total (R)
    Net profit——45 000
    Salaries(40 000)(35 000)(75 000)
    Residual deficit (2:3)——(30 000)
    Share of deficit(12 000)(18 000)—
    Net to current account28 00017 00045 000

    Both partners still receive net positive allocations despite the residual deficit, because their salaries exceed their share of the loss. Their current accounts are credited with R28 000 and R17 000 respectively.

    Exercise 03
    Simple Dissolution
    [expand]

    The partnership of Dlamini and Jacobs (ratio 1:1) dissolves on 30 June 2025. Balance sheet extracts on that date:

    • Inventory: R60 000 (sold for R45 000)
    • Equipment: R80 000 (sold for R95 000)
    • Debtors: R30 000 (collected in full)
    • Bank: R5 000
    • Creditors: R40 000 (paid in full)
    • Capital: Dlamini R100 000; Jacobs R130 000

    Prepare the Realisation Account and show the final cash distributed to each partner.

    Total assets transferred to Realisation = R60 000 + R80 000 + R30 000 = R170 000
    Total proceeds = R45 000 + R95 000 + R30 000 = R170 000 (note: debtors collected at face value)
    Loss on Inventory = R15 000; Gain on Equipment = R15 000; Net = nil.
    Realisation profit/loss = R0

    Realisation Account
    DrRCrR
    Inventory60 000Bank (inventory)45 000
    Equipment80 000Bank (equipment)95 000
    Debtors30 000Bank (debtors)30 000
    170 000170 000

    Bank Account movements:

    Opening balance: R5 000 + Proceeds: R170 000 − Creditors paid: (R40 000) ───────────────────────────── Available: R135 000 − Dlamini capital: (R100 000) − Jacobs capital: (R 35 000) ← wait: Jacobs = R130k? Jacobs capital = R130 000 → but only R35 000 left after Dlamini?

    Total available = R135 000. Capital totals = R100 000 + R130 000 = R230 000. But cash available is only R135 000. The shortfall = R95 000. Shared equally: each bears R47 500.

    Revised capital balances after sharing shortfall:
    Dlamini: R100 000 − R47 500 = R52 500 (paid out)
    Jacobs: R130 000 − R47 500 = R82 500 (paid out)
    Total: R135 000 ✓

    // NOTE

    The shortfall arises because total asset book values (R170 000 + R5 000 = R175 000) minus liabilities (R40 000) = R135 000 in net assets, which is less than R230 000 capital. This difference (R95 000) represents accumulated losses or drawings already absorbed in prior periods — it is not a realisation loss here since proceeds matched book values perfectly. The partners simply have more capital recorded than there is cash to pay.

    Study Unit 13 — Key Takeaways

    1. Partnerships are not separate legal entities — partners bear unlimited personal liability.

    2. Capital accounts are fixed; current accounts absorb ongoing transactions (salary, interest, drawings, profit share).

    3. The appropriation waterfall: net profit → add interest on drawings → deduct salaries → deduct interest on capital → deduct bonuses → split residual in P:L ratio.

    4. A residual loss is still shared in the P:L ratio, even if partners receive salary and interest allocations that exceed the net profit.

    5. On admission, goodwill is raised in the old ratio and written off in the new ratio, transferring value to existing partners without permanently recognising goodwill.

    6. Dissolution: transfer all assets to Realisation Account, record proceeds, settle liabilities, share realisation profit/loss, pay partners their final capital balances.

    ]]>         Lesson 12 – Other Non-current Assets https://www.neelshattingh.com/financialaccounting/lesson-12-other-non-current-assets/ Tue, 28 Apr 2026 04:44:37 +0000 https://www.neelshattingh.com/?p=330 FAC1502 — Study Unit 12: Other Non-current Assets
    FAC1502 — Study Unit 12

    Other Non-current Assets

    Study Unit 11 covered the tangible non-current assets — property, plant and equipment that you can see and touch. This study unit covers the other two categories: intangible assets (no physical substance) and other financial assets (cash investments and investments in shares).

    In this study unit
    1. Non-current asset categories
    2. Intangible assets
    3. Financial instruments
    4. Cash investments
    5. Investments in shares
    6. Cash investments vs shares — comparison
    7. Journal entries
    8. SFP presentation
    9. Investment income calculator
    10. Worked exercises
    11. Quick quiz

    1. Non-current asset categories

    Non-current assets are assets with an expected useful life of more than one year. They are divided into three broad categories:

    🏭
    Property, Plant & Equipment
    Tangible assets — physical, touchable. Land, buildings, machinery, vehicles, furniture. Covered in Study Unit 11.
    💡
    Intangible Assets
    Non-monetary assets without physical substance. Patents, trademarks, goodwill, copyrights, computer software.
    📈
    Other Financial Assets
    Cash investments (savings, fixed deposits) and investments in shares. Earn interest or dividends.

    2. Intangible assets

    According to IAS 38, an intangible asset is an identifiable, non-monetary asset without physical substance, held for use in the production or supply of goods or services, for rental to others, or for administrative purposes. It must be controlled by the entity as a result of past events, and future economic benefits must be expected to flow from it.

    Examples of intangible assets:
    ▸ Patents — exclusive right to manufacture or use an invention
    ▸ Trademarks / brand names — exclusive right to use a name or logo
    ▸ Goodwill — excess amount paid for a business above the fair value of its net assets
    ▸ Copyrights — exclusive right to reproduce creative works
    ▸ Computer software licences
    ▸ Franchises — right to operate under another entity’s brand

    Intangible assets that have a finite useful life are subject to amortisation — the systematic allocation of their cost over that life. Amortisation is the intangible asset equivalent of depreciation for PPE.

    Amortisation vs Depreciation:
    Both spread the cost of an asset over its useful life. Depreciation applies to tangible PPE. Amortisation applies to intangible assets. The accounting treatment is identical — an amortisation expense is charged each year and accumulated in an Accumulated amortisation account (contra-asset). Land is not depreciated. Some intangibles (e.g. goodwill with indefinite life) are not amortised but tested annually for impairment instead.

    3. Financial instruments

    A financial instrument is any contract that gives rise to a financial asset in one entity and a financial liability or equity instrument in another entity. In FAC1502, the focus is on financial assets — specifically cash investments and investments in shares.

    Key principle: When a financial asset is acquired, the relevant financial asset account is debited and the bank account is credited.

    Dr Cash investment / Investment in shares
    Cr Bank

    4. Cash investments

    Entities invest available cash to earn the best possible return. Cash investments include savings accounts, call deposits and fixed deposits. They earn interest at a fixed rate or one that doesn’t change often.

    Why entities make cash investments

    • To earn the highest possible yield on temporarily available cash
    • To park cash that is needed only on a specific future date
    • Fixed deposits typically earn higher interest than a cheque account
    • Safer and more certain return than equity investments

    Interest income calculation

    Formula: Interest = Principal × Rate% / 100 × Time (months / 12)

    Example: R50 000 invested at 8% per annum for 6 months
    Interest = R50 000 × 8/100 × 6/12 = R2 000
    Journal entries — cash investment lifecycle
    1. Making the investment
    Cash investment (Fixed deposit)50 000
    Bank50 000
    Investment placed in fixed deposit at 8% p.a.
    2. Recognising interest income (accrued or received)
    Bank / Accrued income2 000
    Interest income2 000
    Interest earned: R50 000 × 8% × 6/12
    3. Withdrawing the investment at maturity
    Bank52 000
    Cash investment50 000
    Interest income (if not yet accrued)2 000
    Fixed deposit matured — principal + interest received

    5. Investments in shares

    An entity may invest in the ordinary shares of another company. The return on a share investment is called a dividend. Unlike interest, dividends are only paid if the company declares a dividend — they are not guaranteed.

    How dividends are calculated

    Dividends are declared in one of two ways:

    • As a percentage of the nominal value of the shares — e.g. a 15% dividend on shares with a nominal value of R2 each = R0,30 per share
    • As cents per share — e.g. 25 cents per share on 10 000 shares = R2 500
    Journal entries — investment in shares lifecycle
    1. Purchasing the shares
    Investment in shares (ABC Ltd)30 000
    Bank30 000
    Purchased 10 000 ordinary shares in ABC Ltd at R3,00 each
    2. Receiving dividends
    Bank2 500
    Investment income (Dividends received)2 500
    Dividend received: 10 000 shares × 25 cents per share
    Dividends vs Interest: Interest is earned at a fixed rate and is virtually certain. Dividends depend on the company’s profitability and the board’s decision to declare a dividend. Both are recorded as Investment income (or Interest income / Dividend income) in the Statement of Profit or Loss.

    6. Cash investments vs shares — comparison

    Feature Cash investments
    NatureFixed deposits, savings accounts, call depositsOrdinary shares in a company
    ReturnInterest — at a fixed or semi-fixed rate
    CertaintyHigh — rate is agreed upfrontVariable — depends on profitability and board decision
    RiskLower — capital and return generally guaranteedHigher — share value can fall; dividends not guaranteed
    Typical return basis% p.a. on principal × time% of nominal share value OR cents per share
    Income accountInterest incomeInvestment income / Dividends received
    SFP classificationOther financial assets (non-current) or cash equivalents (current)Other financial assets (non-current)

    7. Further journal entry examples

    Accrued interest at year-end

    If interest has been earned but not yet received at year-end, it must be accrued (as a year-end adjustment from Study Unit 6):

    Year-end adjustment — accrued interest on investment
    Accrued incomeX
    Interest incomeX
    Interest earned but not yet received at year-end

    Dividend declared but not yet received

    When a dividend is declared (announced) but the cash has not yet arrived, a receivable is created:

    Dividend declared but not yet received
    Dividends receivable / Accrued incomeX
    Investment income (Dividends received)X
    Dividend declared by ABC Ltd — X cents per share × number of shares

    8. SFP presentation

    Other non-current assets are shown under non-current assets on the Statement of Financial Position. If an investment matures within 12 months, it is reclassified as a current asset.

    SFP extract — Non-current assets
    Non-current assets
    Property, plant and equipment (Note 3)XXX
    Intangible assetsXXX
    Other financial assetsXXX
    Cash investments (fixed deposits)X
    Investment in sharesX
    Total non-current assetsXXX
    Classification note: A fixed deposit that matures within 12 months of the SFP date is a current asset (cash equivalent), not a non-current asset. Only deposits maturing after more than 12 months are non-current. Similarly, accrued interest receivable is a current asset.

    9. Investment income calculator

    Calculate interest on cash investments or dividends on share investments.

    Investment income calculator

    10. Worked exercises

    Other non-current assets questions in the FAC1502 exam style.

    Apply the concepts
    Scenario 1 of 6

    11. Quick quiz

    Twelve questions on other non-current assets.

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    ]]>         Lesson 11 – Property, Plant and Equipment https://www.neelshattingh.com/financialaccounting/lesson-11-property-plant-and-equipment/ Mon, 27 Apr 2026 18:40:14 +0000 https://www.neelshattingh.com/?p=328 FAC1502 — Study Unit 11: Property, Plant and Equipment
    FAC1502 — Study Unit 11

    Property, Plant and Equipment

    Non-current assets are the long-lived tools of the business. They wear out, lose value and eventually need replacement. This study unit covers how to cost them correctly, calculate depreciation using three methods, and account for disposals — including scrapping, selling and trading in.

    In this study unit
    1. What is property, plant and equipment
    2. Determining the cost price
    3. Assets register and control
    4. The concept of depreciation
    5. Recording depreciation
    6. The three depreciation methods
    7. Straight-line method
    8. Diminishing balance method
    9. Production unit method
    10. Acquisitions during the year
    11. Disposal of PPE — the 6-step procedure
    12. Disposal scenarios
    13. SFP presentation and PPE note
    14. Depreciation calculator
    15. Worked exercises
    16. Quick quiz

    1. What is property, plant and equipment

    Property, plant and equipment (PPE) are tangible non-current assets held for use in the production of goods or services, for rental, or for administrative purposes, and expected to be used for more than one financial period. Examples include land and buildings, machinery, vehicles, furniture and equipment.

    Substance over form: Legal ownership is not required for an asset to be recognised. Assets acquired on credit, by instalment, or via a lease can be recognised as PPE — provided the corresponding liability is also recorded. Economic reality matters, not legal title.
    PPE vs inventory: An item is PPE if it is kept for use in the business (not for resale). The same item can be inventory in one entity and PPE in another. A vehicle for sale at a dealership is inventory; the same vehicle used for deliveries is PPE.

    2. Determining the cost price

    The historical cost price of PPE includes everything spent to get the asset ready for use:

    • Purchase price less trade discount
    • Transport and delivery costs to get the asset to the premises
    • Installation costs, including wages of own technical personnel
    • Any other cost incurred in getting the asset operational
    Not included in cost:
    ▸ Financing costs (interest on loans to buy the asset)
    ▸ Ongoing maintenance and repair costs
    ▸ Operating costs once the asset is in use

    Bilgredon — cost calculation example

    Machine purchased for R500 000 with a discount of R60 000. Transport R15 000. Installation R5 000.

    Purchase price                 R500 000
    Less: Trade discount          (R60 000)
    Add: Transport                 R15 000
    Add: Installation              R5 000
    Historical cost price        R460 000

    3. Assets register and control

    An assets register is maintained for all PPE. It records per asset: location, serial number, cost price, date of acquisition, expected lifespan, carrying amount, current year’s depreciation, and accumulated depreciation.

    Control rule: The total cost prices in the assets register for any specific asset category must always equal the balance of that asset account in the general ledger.

    4. The concept of depreciation

    PPE loses value as it is used. Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. It is an expense charged to the income statement every year — matching the cost of using the asset against the income it helps generate.

    Key terms:
    ▸ Depreciable amount = Cost price − Residual (scrap) value
    ▸ Residual value = Estimated value of the asset at end of its useful life (trade-in/scrap value)
    ▸ Carrying amount = Cost price − Accumulated depreciation (= net book value)
    ▸ Useful life = The period over which the asset is expected to be used by the entity

    5. Recording depreciation

    Depreciation is an annual year-end adjustment recorded in the general journal. The asset account itself is never reduced — instead, the accumulated depreciation account (a contra-asset with a credit balance) accumulates the total depreciation charged to date.

    Annual depreciation entry (year-end)
    Depreciation: [asset type]X
    Accumulated depreciation: [asset type]X
    Provision for depreciation on [asset] for the year
    Closing entry (transfer depreciation to profit or loss)
    Profit or lossX
    Depreciation: [asset type]X
    Closing depreciation to profit or loss account

    6. The three depreciation methods

    Fixed instalment
    Straight-line method
    Same amount every year.

    Annual depreciation =
    Cost ÷ Lifespan
    or Cost × Rate%

    Carrying amount decreases by equal amounts until it reaches NIL (or residual value).
    Reducing balance
    Diminishing balance method
    Fixed % of carrying amount — higher in early years, lower later.

    Annual depreciation =
    Carrying amount × Rate%

    Carrying amount will mathematically never reach NIL.
    Usage-based
    Production unit method
    Based on actual units produced.

    Annual depreciation =
    (Units this year ÷ Total expected units) × Cost

    Depreciation varies with actual output each year.

    7. Straight-line method — Bilgredon example

    Machine cost R460 000 (after discount, transport, installation). Estimated lifespan: 5 years. No residual value. Financial year ends 31 May.

    Year (May 31) Cost (R) Annual Depreciation (R) Accumulated Dep. (R) Carrying Amount (R)
    20.1 (Year 1)460 00092 00092 000368 000
    20.2 (Year 2)460 00092 000184 000276 000
    20.3 (Year 3)460 00092 000276 000184 000
    20.4 (Year 4)460 00092 000368 00092 000
    20.5 (Year 5)460 00092 000460 000NIL
    Total460 000
    Formula: Annual depreciation = R460 000 ÷ 5 = R92 000 per year (or 20% × R460 000). The carrying amount reaches NIL exactly at the end of the asset’s life. Total depreciation = Cost price.

    8. Diminishing balance method — Bilgredon example

    Same machine (R460 000 cost, 5 years). Rate: 20% per year on the carrying amount.

    Year (May 31) Cost (R) Annual Depreciation (R) Accumulated Dep. (R) Carrying Amount (R)
    20.1 (Year 1)460 00092 00092 000368 000
    20.2 (Year 2)460 00073 600165 600294 400
    20.3 (Year 3)460 00058 880224 480235 520
    20.4 (Year 4)460 00047 104271 584188 416
    20.5 (Year 5)460 00037 683309 267150 733
    Total309 267
    Key difference from straight-line: The carrying amount of R150 733 at year 5 is the effective scrap value — the carrying amount never mathematically reaches NIL under this method. The total depreciation is less than the cost price. Each year’s charge is calculated on the carrying amount from the previous year.

    9. Production unit method — Bilgredon example

    Same machine. Total expected production over 5 years: 2 000 units. Actual units: Year 1=500, Year 2=550, Year 3=300, Year 4=200, Year 5=450.

    Formula: Annual depreciation = (Units produced this year ÷ Total expected units) × Cost price

    Year (May 31) Units Annual Depreciation (R) Accumulated Dep. (R) Carrying Amount (R)
    20.1 (Year 1)500115 000115 000345 000
    20.2 (Year 2)550126 500241 500218 500
    20.3 (Year 3)30069 000310 500149 500
    20.4 (Year 4)20046 000356 500103 500
    20.5 (Year 5)450103 500460 000NIL
    Total2 000460 000
    Year 1 check: 500/2000 × R460 000 = R115 000. Depreciation varies with output — high production years have higher charges. Total depreciation equals cost exactly when all expected units are produced.

    10. Acquisitions during the financial year

    When an asset is purchased during the financial year (not on the first day), depreciation for the first year must be calculated pro rata — only for the portion of the year the asset was in use.

    Pro rata formula:
    First year depreciation = Cost × Rate% × (Months used ÷ 12)

    Example: Machine costs R460 000. Rate 20% p.a. Purchased 6 months before year-end.
    Depreciation = R460 000 × 20% × 6/12 = R46 000

    The same applies when an asset is disposed of mid-year — depreciate only up to the date of disposal.

    11. Disposal of PPE — the 6-step procedure

    When PPE is disposed of (scrapped, sold or traded in), it must be removed from the books entirely. A Realisation account is used to capture all the entries relating to the disposal and determine the profit or loss on disposal.

    1
    Record pro rata depreciation up to date of disposal (if disposed mid-year)
    Dr Depreciation: [asset]  |  Cr Accumulated depreciation: [asset]
    2
    Transfer accumulated depreciation to the Realisation account
    Dr Accumulated depreciation: [asset]  |  Cr Realisation of [asset]
    3
    Transfer cost price of asset to the Realisation account
    Dr Realisation of [asset]  |  Cr [Asset] at cost
    4
    Record proceeds received (credit Realisation in all cases)
    Cash sale: Dr Bank  |  Cr Realisation of [asset]
    Credit sale: Dr Debtors  |  Cr Realisation of [asset]
    Trade-in: Dr New asset account  |  Cr Realisation of [asset]
    5
    Determine profit or loss on disposal
    If Cr side > Dr side of Realisation account → Profit
    If Dr side > Cr side of Realisation account → Loss
    6
    Transfer profit or loss to the Profit or loss account
    Profit: Dr Realisation of [asset]  |  Cr Profit on disposal of [asset]
    Loss: Dr Loss on disposal of [asset]  |  Cr Realisation of [asset]
    Golden rule: Profits and losses on disposal must be disclosed separately in the Statement of Profit or Loss and Other Comprehensive Income — not netted against each other or against depreciation.

    12. Disposal scenarios — Bilgredon examples

    Scenario A: Scrapping (no proceeds)

    Machine scrapped at end of useful life under straight-line method. Accumulated depreciation = R460 000 (fully depreciated). Carrying amount = NIL.

    General journal — 31 May 20.5 (scrap fully depreciated asset)
    Accumulated depreciation: Machinery460 000
    Machinery (at cost)460 000
    Scrapped machine written off — fully depreciated, no proceeds

    Scenario B: Scrapping with a loss (asset not fully depreciated)

    Machine scrapped at end of year 5 under production unit method. Cost R460 000, accumulated depreciation R402 500. Carrying amount R57 500. No proceeds.

    General journal — 31 May 20.5
    Realisation of Machinery460 000
    Machinery (at cost)460 000
    Transfer machinery at cost to realisation account
    Accumulated depreciation: Machinery402 500
    Realisation of Machinery402 500
    Transfer accumulated depreciation to realisation account
    Loss on disposal of Machinery57 500
    Realisation of Machinery57 500
    Loss on scrapping = carrying amount R57 500 (Dr side R460 000 − Cr side R402 500)

    Scenario C: Selling for cash at a profit

    Same machine (cost R460 000, acc. dep. R402 500, carrying amount R57 500). Sold for R60 000 cash.

    General journal — 31 May 20.5
    Realisation of Machinery460 000
    Machinery (at cost)460 000
    Accumulated depreciation: Machinery402 500
    Realisation of Machinery402 500
    Bank (cash proceeds)60 000
    Realisation of Machinery60 000
    Cash received — recorded in CRJ
    Realisation of Machinery2 500
    Profit on disposal of Machinery2 500
    Profit = Proceeds R60 000 − Carrying amount R57 500 = R2 500
    Realisation account check: Dr side = Cost R460 000 + Profit R2 500 = R462 500. Cr side = Acc. dep. R402 500 + Bank R60 000 = R462 500. ✓

    13. SFP presentation and PPE note

    Only the carrying amount is shown on the face of the SFP. The detailed breakdown (cost, accumulated depreciation, depreciation for the year, disposals) is shown in Note 3.

    Bilgredon
    Note 3: Property, plant and equipment — for the year ended 31 May 20.2 (Straight-line method)
    Property, plant and equipmentMachinery (R)Total (R)
    Carrying amount: Beginning of year
      Cost460 000460 000
      Accumulated depreciation(92 000)(92 000)
      Carrying amount b/y368 000368 000
      Additions——
      Disposals——
      Depreciation(92 000)(92 000)
    Carrying amount: End of year
      Cost460 000460 000
      Accumulated depreciation(184 000)(184 000)
      Carrying amount e/y276 000276 000

    14. Depreciation calculator

    Calculate annual depreciation and generate a full schedule for any of the three methods.

    Depreciation calculator

    15. Worked exercises

    PPE questions in the FAC1502 exam style.

    Apply the PPE concepts
    Scenario 1 of 6

    16. Quick quiz

    Twelve questions on PPE.

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    ]]>         Lesson 10 – Inventory https://www.neelshattingh.com/financialaccounting/lesson-10-inventory/ https://www.neelshattingh.com/financialaccounting/lesson-10-inventory/#respond Mon, 27 Apr 2026 08:30:12 +0000 https://www.neelshattingh.com/?p=325 FAC1502 — Study Unit 10: Inventory

    Inventory

    Inventory is typically the largest single asset on a trading entity’s balance sheet. Getting the valuation wrong has a ripple effect — it distorts cost of sales, gross profit, net profit, total assets and equity, and carries forward into the next year as the opening inventory.

    In this study unit
    1. What inventory includes
    2. Why correct valuation matters
    3. Valuation at historical cost
    4. Net realisable value (NRV)
    5. What is included in the cost of inventory
    6. The gross profit method
    7. Consistency
    8. Disclosure on the SFP
    9. Inventory & GP calculator
    10. Worked exercises
    11. Quick quiz

    1. What inventory includes

    Inventory is any of the following goods held by an entity:

    🛒
    Trading inventory (merchandise)
    Goods kept for sale in the normal course of business. The primary inventory type for a trading entity.
    🔧
    Work-in-progress
    Goods in the process of being manufactured — partly complete at year-end.
    📦
    Raw materials
    Materials used in the manufacture of inventory for sale (e.g. steel, fabric, chemicals).
    📎
    Consumable inventory
    Goods consumed in normal business activities (e.g. stationery, packaging). Shown separately on the SFP.
    Consumable inventory ≠ Trading inventory. Packaging material, stationery and cleaning materials are consumables — they are NOT included in the trading inventory figure. They are shown separately under inventories on the SFP. Any consumables used during the year are an expense in the income statement.

    2. Why correct valuation matters

    An incorrect inventory figure at year-end has a compounding effect that spans two financial years. The closing inventory of year 1 becomes the opening inventory of year 2, so an error is never confined to a single period.

    If closing inventory is understated Effect in Year 1 Effect in Year 2
    Cost of salesOverstated ↑Understated ↓
    Gross profitUnderstated ↓Overstated ↑
    Net profitUnderstated ↓Overstated ↑
    Total assets (SFP)Understated ↓Correct (error cancels)
    Equity (Capital)Understated ↓Correct (error cancels)
    The two-year self-correction: An inventory error always cancels itself out over two years — because what is understated in year 1 becomes understated as the opening inventory in year 2, which then overstates year 2 profit by exactly the same amount. The cumulative profit over both years is correct, but each individual year is wrong.

    What to include in closing inventory

    • All goods physically on the premises that belong to the entity
    • Goods in transit that have been shipped FOB (Free on Board) from the seller — ownership has passed
    • Do NOT include goods received on consignment (they belong to the supplier)
    • Do NOT include goods already sold and dispatched to the buyer (even if still physically present)

    3. Valuation at historical cost

    In FAC1502, inventory is valued at historical cost — the actual cost paid to acquire it. This is the default basis required by IAS 2 (Inventories).

    IAS 2 rule: Inventory must be measured at the lower of cost and net realisable value (NRV). If the cost is R100 but the inventory can only be sold for R80 (NRV), it must be written down to R80. This prevents overstating assets.

    4. Net realisable value (NRV)

    NRV is the estimated selling price in the normal course of business, less any estimated costs necessary to make the sale (e.g. selling costs, completion costs). When NRV falls below cost — due to damage, obsolescence or falling market prices — inventory must be written down to NRV.

    Valuation rule summary:
    If cost < NRV → value at cost
    If NRV < cost → value at NRV (write down to the lower figure)

    5. What is included in the cost of inventory

    The historical cost of inventory is more than just the invoice price. All costs incurred to bring the inventory to its present location and condition are included:

    Purchase price (per invoice)R X
    Add: Carriage inwards / railage on purchases+R X
    Add: Import duty (if imported goods)+R X
    Add: Insurance on goods in transit+R X
    Cost of goods purchasedR X
    What is NOT included in cost of inventory:
    ▸ Carriage outwards (delivery costs to customers) — this is a selling expense
    ▸ Packaging material used — this is a selling expense
    ▸ Abnormal wastage — this is charged to profit or loss, not inventorised
    ▸ Trade discount — deducted from the invoice price; not separately recorded

    Bombay Traders worked example

    Bombay Traders — year ended 28 February 20.4
    Periodic inventory system
    Cost of goods purchased
    Purchases106 000
    Less: Purchases returns(6 000)
    Add: Import duty10 000
    Cost of goods purchased110 000
    Cost of sales
    Opening inventory (28 Feb 20.3)20 000
    Add: Cost of goods purchased110 000
    Less: Closing inventory (28 Feb 20.4)(25 000)
    Cost of sales105 000
    Income statement
    Revenue (Sales R175 000 − Sales returns R5 000)170 000
    Cost of sales(105 000)
    Gross profit65 000
    Note: Carriage on sales (R4 800) and packaging material used (R7 200) are NOT included in cost of sales — they are distribution/selling expenses deducted from gross profit. Closing trading inventory (R25 000) excludes the packaging material on hand (R600) — that is shown separately under inventories on the SFP.

    6. The gross profit method

    When inventory cannot be physically counted — for example after a fire, flood or theft — the gross profit method is used to estimate the inventory value. The method works backwards from known sales and the historical gross profit percentage to calculate an estimated cost of sales, and from that, the estimated closing inventory.

    GP% on cost price
    GP% = (Gross profit ÷ Cost of sales) × 100

    To find Cost of sales from Sales:
    Cost = Sales × (100 ÷ (100 + GP%))

    Example: GP% on cost = 50%
    Cost = Sales × 100/150
    GP% on selling price (sales)
    GP% = (Gross profit ÷ Sales) × 100

    To find Cost of sales from Sales:
    Cost = Sales × (100 − GP%) ÷ 100

    Example: GP% on sales = 33⅓%
    Cost = Sales × 66.67/100

    Gross profit method — M Dry example (fire destroyed inventory)

    From prior year: Revenue R114 000, Cost of sales R76 000, Gross profit R38 000.
    Current year: Sales R120 000, Purchases R96 000. Fire occurred before year-end count.

    Step 1: Calculate prior year GP% on sales
    GP% on sales = (R38 000 ÷ R114 000) × 100= 33⅓%
    Step 2: Calculate estimated cost of sales for current year
    Gross profit = Sales × GP% = R120 000 × 33⅓%= R40 000
    Cost of sales = R120 000 − R40 000= R80 000
    Step 3: Calculate estimated closing inventory (before fire)
    Opening inventory (= prior year closing)44 000
    Add: Purchases96 000
    Goods available for sale140 000
    Less: Estimated cost of sales(80 000)
    Estimated closing inventory60 000
    Step 4: Value of inventory destroyed (25% lost)
    R60 000 × 25% = R15 000 destroyed by fireR15 000

    7. Consistency

    Whichever basis of inventory valuation is chosen — historical cost, FIFO, weighted average — it must be applied consistently from year to year. If the basis changes, the change and its effect must be disclosed in the notes to the financial statements. This is the consistency principle.

    In FAC1502, only historical cost is used. The study guide notes that FIFO and weighted average exist but you are not required to apply them in this course.

    8. Disclosure on the SFP

    Inventory is a current asset. All different types of inventory are sub-classified under Inventories on the SFP. The accounting policy used for valuation must be disclosed in the notes.

    SFP extract — Current assets
    Inventories66 000
    Trading inventory (merchandise)60 000
    Consumable inventory (e.g. stationery, packaging)6 000
    Notes to the financial statements must disclose:
    ▸ The accounting policy for measuring inventory (historical cost, lower of cost and NRV)
    ▸ The cost formula used (FIFO, weighted average, etc.)
    ▸ Any write-down of inventory to NRV and the reversal thereof

    9. Inventory & gross profit calculator

    Calculate cost of goods purchased, cost of sales, gross profit, and estimate inventory using the gross profit method.

    Inventory calculator
    Mode

    10. Worked exercises

    Inventory questions in the FAC1502 exam style.

    Apply the inventory concepts
    Scenario 1 of 6

    11. Quick quiz

    Twelve questions covering the full study unit.

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    ]]>     https://www.neelshattingh.com/financialaccounting/lesson-10-inventory/feed/ 0     Lesson 9 – Trade and Other Receivables https://www.neelshattingh.com/financialaccounting/lesson-9-trade-and-other-receivables/ https://www.neelshattingh.com/financialaccounting/lesson-9-trade-and-other-receivables/#respond Wed, 22 Apr 2026 16:27:46 +0000 https://www.neelshattingh.com/?p=310 FAC1502 — Study Unit 9: Trade and Other Receivables
    FAC1502 — Study Unit 9

    Trade and Other Receivables

    Every time a business sells on credit it creates a debtor — and with debtors comes risk. This study unit covers everything that happens after the sale: encouraging early payment with discounts, charging interest on overdue accounts, writing off bad debts, and managing the allowance for credit losses.

    In this study unit
    1. Trade debtors and credit transactions
    2. Settlement discount granted
    3. Interest charged on overdue accounts
    4. Credit losses — direct write-off
    5. The allowance for credit losses
    6. Creating the allowance
    7. Increasing the allowance
    8. Decreasing the allowance
    9. Writing off when an allowance exists
    10. Recovery of credit losses
    11. Presentation on the SFP
    12. The debtors control account
    13. Allowance adjustment calculator
    14. Worked exercises
    15. Quick quiz

    1. Trade debtors and credit transactions

    A credit transaction is a sale where the buyer does not pay at the time of the sale. The person or business who owes money to the entity is a trade debtor. The period within which the debtor must pay is the credit term (e.g. 30 days from date of invoice).

    Because some debtors inevitably fail to pay, most entities that sell on credit take two steps to protect themselves: they offer discounts to encourage early payment, and they create an allowance for credit losses to anticipate future bad debts.

    2. Settlement discount granted

    Settlement discount is offered to encourage debtors to pay within the credit term. It is conditional — the debtor only earns the discount by paying on time.

    EX
    Exercise 9.1 — Client purchases R2 850 on credit (VAT inclusive at 14%)
    A client purchases goods for R2 850 (VAT inclusive) on 1 March 20.0. Credit term: 30 days. If paid before 31 March a 2% settlement discount applies.
    At date of sale: Debtors R2 850 | Sales R2 500 | VAT output R350
    If discount earned: Discount = R2 850 × 2/100 = R57 (includes VAT of R7)
    Net sales discounted: R2 500 × 2% = R50 | VAT on discount: R50 × 14/100 = R7
    Amount received: R2 850 − R57 = R2 793
    Journal — when debtor pays with discount
    Bank2 793
    Settlement discount granted50
    VAT input (VAT portion of discount)7
    Debtors control2 850
    Receipt from debtor — 2% settlement discount allowed
    Settlement discount granted is an expense — it reduces the effective selling price. The VAT adjustment goes to the VAT input account (not VAT output) because the seller is reclaiming the VAT overpaid on the portion not received.

    3. Interest charged on overdue accounts

    If a debtor does not pay within the credit term, many entities charge interest on the outstanding balance. This interest is income for the seller and increases the debtor’s account.

    Formula: Interest = Outstanding balance × (Rate% / 100) × (Months / 12)

    Example: R550 outstanding for 1 month at 18% p.a.
    Interest = R550 × 18/100 × 1/12 = R8,25
    New balance = R550 + R8,25 = R558,25
    General journal — interest charged to debtor
    Debtors control / Individual debtor account8,25
    Interest income8,25
    Interest charged at 18% p.a. for 1 month on overdue balance

    4. Credit losses — direct write-off

    When management determines a specific debt is irrecoverable, it must be written off immediately. The debt becomes a credit loss (expense) and the debtor’s account is cleared.

    !
    A Langa owes R660 — declared insolvent
    General journal — AM Traders, 15 May 20.0
    Credit losses (Bad debts)660
    A Langa / Debtors control660
    Write A Langa’s account off as irrecoverable
    Two postings required: Credit Debtors control in the general ledger AND credit A Langa’s account in the debtors ledger. Both must be reduced. The Credit losses account is closed to the profit or loss account at year-end.

    5. The allowance for credit losses

    Because it is impossible to know in advance exactly which debts will go bad, many entities create an allowance for credit losses — a general provision based on the estimated percentage of debtors that will not pay. This is a contra-asset account: it always has a credit balance and is deducted from the Debtors control account on the SFP.

    Key principle: When the allowance is created or adjusted, the Debtors control account is not touched. Only two accounts move: Credit losses (expense, Dr) and Allowance for credit losses (contra-asset, Cr). The debtors control is only reduced when an actual bad debt is confirmed and written off.

    At year-end the allowance is reviewed and adjusted to the required balance. Three situations can arise:

    Creating (first time) Increasing Decreasing
    No allowance exists yet
    Required allowance = R800

    Dr Credit losses R800
    Cr Allowance for credit losses R800
    Allowance must be larger
    Existing R800 → New R1 200
    Increase = R400

    Dr Credit losses R400
    Cr Allowance for credit losses R400
    Allowance must be smaller
    Existing R1 200 → New R1 000
    Decrease = R200

    Dr Allowance for credit losses R200
    Cr Credit losses R200

    6. Creating the allowance — Trio Traders

    At 30 June 20.0, outstanding debtors total R20 000. The financial manager sets the allowance at R800.

    General journal — 30 June 20.0 (year-end adjustment)
    Credit losses800
    Allowance for credit losses800
    Allowance for credit losses created at year-end (R800)
    SFP presentation — Trade and other receivables
    Debtors control20 000
    Less: Allowance for credit losses(800)
    Net carrying amount of debtors19 200
    The allowance is a contra-asset. It always has a credit balance. It is subtracted from the Debtors control account (debit balance) to show the net recoverable amount on the SFP. The Debtors control account itself remains unchanged.

    7. Increasing the allowance

    The following year, Trio Traders has debtors of R30 000 and credit losses of R730 already written off. The allowance must increase from R800 to R1 200.

    Required allowance: R1 200
    Existing allowance (b/d): R800
    Adjustment needed: R1 200 − R800 = R400 increase
    General journal — 30 June 20.1 (year-end adjustment)
    Credit losses400
    Allowance for credit losses400
    Allowance adjusted: New R1 200, Existing R800, Increase R400

    At year-end the Credit losses account shows the total charge for the year: R730 (actual write-offs) + R400 (allowance increase) = R1 130 — all closed to profit or loss.

    8. Decreasing the allowance

    The following year, Trio Traders has debtors of R25 000 and R960 in credit losses already written off. The allowance must decrease from R1 200 to R1 000.

    Required allowance: R1 000
    Existing allowance (b/d): R1 200
    Adjustment needed: R1 200 − R1 000 = R200 decrease
    General journal — 30 June 20.2 (year-end adjustment)
    Allowance for credit losses200
    Credit losses200
    Allowance adjusted: New R1 000, Existing R1 200, Decrease R200
    When the allowance decreases: The entry is reversed — Dr Allowance for credit losses / Cr Credit losses. This reduces the credit losses charge for the year. Net credit losses expense = R960 (write-offs) − R200 (allowance decrease) = R760 charged to profit or loss.

    9. Writing off when an allowance exists — Method 2

    When an actual bad debt is identified and an allowance exists, there are two methods. FAC1502 primarily uses Method 2: write off directly to the Credit losses account (same as without an allowance), then adjust the allowance to the required balance at year-end separately.

    M2
    Method 2 — B Down owes R730, declared insolvent (30 Nov 20.0)
    Allowance b/d = R800. During the year B Down (R730) is written off. At year-end the required allowance is R1 200.
    Step 1: Write off the actual bad debt (30 Nov 20.0)
    Allowance for credit losses730
    B Down / Debtors control730
    B Down’s account written off — Method 2 (against allowance)
    Step 2: Adjust allowance to required balance at year-end (30 Jun 20.1)
    Credit losses1 130
    Allowance for credit losses1 130
    Allowance adjusted to R1 200: Existing after write-off = R70; Increase needed = R1 130
    After Step 1: Allowance balance = R800 − R730 = R70. Required = R1 200. Increase needed = R1 200 − R70 = R1 130. This is the total credit losses expense for the year (all charged via the allowance adjustment).

    10. Recovery of credit losses

    Sometimes a debt that was previously written off is unexpectedly recovered. When this happens:

    1. Open a Credit losses recovered account (income)
    2. Dr Bank / Cr Credit losses recovered
    General journal — recovery of a previously written-off debt
    BankX
    Credit losses recoveredX
    Recovery of [debtor name]’s account previously written off
    Credit losses recovered is income — it is shown under “other income” in the Statement of Profit or Loss. It offsets the original Credit losses expense that was recorded when the debt was written off. VAT implications apply: when a debt is recovered, the VAT previously reclaimed must be paid back to SARS.

    11. Presentation on the Statement of Financial Position

    Debtors are classified as current assets — the entity expects to collect them within one year (the normal business cycle). Under IFRS, trade and other receivables are shown net of the allowance.

    SFP extract — Current assets (Trade and other receivables)
    Trade debtors (Debtors control)30 000
    Less: Allowance for credit losses(1 200)
    Net trade receivables28 800
    Accrued incomeX
    Other receivablesX
    Total trade and other receivablesXXX
    Remember: The Debtors control account (gross) stays at its full balance in the ledger. Only the net amount (after deducting the allowance) is shown on the SFP face. The notes disclose the gross amount and the allowance separately.

    12. The debtors control account

    The debtors control account in the general ledger is a summary account. It is updated monthly from the journal totals. The individual debtor accounts are maintained in the debtors ledger (subsidiary ledger), which is updated daily from the journals.

    Golden rule: The total of all individual balances in the debtors ledger must always equal the balance of the Debtors control account in the general ledger. If they don’t, an error exists somewhere in the posting.

    What posts to Debtors control (Dr): Sales journal total | Interest charged (GJ) | Credit losses recovered reinstating debtor
    What posts to Debtors control (Cr): CRJ total (receipts from debtors) | Sales returns journal total | Credit losses written off (GJ) | Settlement discount granted (CRJ)

    13. Allowance adjustment calculator

    Enter the existing allowance balance and the required new balance to calculate the adjustment entry needed.

    Allowance for credit losses — adjustment calculator

    14. Worked exercises

    Trade receivables questions in the FAC1502 exam style.

    Identify the correct treatment
    Scenario 1 of 6

    15. Quick quiz

    Twelve questions covering the full study unit.

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    P ]]>     https://www.neelshattingh.com/financialaccounting/lesson-9-trade-and-other-receivables/feed/ 0     Lesson 8 – Cash and Cash Equivalents https://www.neelshattingh.com/financialaccounting/lesson-8-cash-and-cash-equivalents/ https://www.neelshattingh.com/financialaccounting/lesson-8-cash-and-cash-equivalents/#respond Tue, 21 Apr 2026 04:45:50 +0000 https://www.neelshattingh.com/?p=307

    FAC1502 — Study Unit 8: Cash and Cash Equivalents
    FAC1502 — Study Unit 8

    Cash and Cash Equivalents

    Cash is the lifeblood of any entity. Without it, even a profitable business can fail. This study unit covers how cash is controlled, how to detect differences between the entity’s records and the bank’s records, and how small day-to-day cash payments are managed through petty cash.

    In this study unit
    1. The nature of cash and cash equivalents
    2. Internal control over cash
    3. Why a bank reconciliation is necessary
    4. What appears on the bank statement
    5. Key terminology
    6. The reconciliation procedure
    7. Bank reconciliation statement format
    8. Worked example — Benson Traders
    9. Bank reconciliation builder
    10. Petty cash journal
    11. Worked exercises
    12. Quick quiz

    1. The nature of cash and cash equivalents

    In accounting, cash includes not just physical coins and notes, but also postal orders, cheques, and credit card transactions. Cash equivalents include savings accounts and any short-term investment that can be converted to cash within 12 months. Both qualify as current assets on the statement of financial position.

    Golden rule: Cash must be handled carefully. A shortage of cash — even in a profitable business — can lead to its downfall. Cash flow problems are one of the leading causes of business failure.

    2. Internal control over cash

    Because cash is so easily misappropriated, strong internal controls are essential. The following measures should be in place:

    • Segregation of duties — at least two employees must be involved so that one person’s error or dishonesty is caught by another’s normal duties
    • Independent records — cash receipts must be recorded so actual cash received can be checked against a daily record
    • Daily banking — all cash received must be deposited into the bank daily
    • Payments by cheque or EFT — all payments except petty cash must be made by cheque or electronic transfer (never by cash)
    • Journal vs bank statement comparison — the cash journals must be compared with the bank statement regularly
    • Bank reconciliation — the bank account balance must be reconciled with the bank statement balance at least monthly

    3. Why a bank reconciliation is necessary

    In theory, since both the entity and the bank record the same transactions, the balance in the entity’s bank account and the balance on the bank statement should always agree. In practice, they almost never do at any given point in time — because of timing differences and items the entity doesn’t yet know about.

    A bank reconciliation statement is prepared to explain and account for every difference between the two balances. The process has two steps:

    1. Update the entity’s records — record items that appear on the bank statement but not yet in the entity’s cash journals (these require journal entries)
    2. Prepare the bank reconciliation statement — list items that are in the entity’s records but not yet on the bank statement (these don’t require journal entries — the bank will deal with them)

    4. What appears on the bank statement

    The bank statement is prepared from the bank’s perspective. Remember: when you deposit money, you are a creditor of the bank — the bank owes you the money. So on the bank statement:

    Bank statement perspective (the bank’s books):
    ▸ Credit entries on the bank statement = money deposited = increases your account
    ▸ Debit entries on the bank statement = cheques paid out = decreases your account

    This is the opposite of your ledger:
    ▸ Debit entries in your Bank account = money deposited = increases your balance
    ▸ Credit entries in your Bank account = payments made = decreases your balance

    The bank statement typically shows: opening balance, deposits credited, cheques debited, bank charges, interest on overdraft or credit, direct deposits by third parties, dishonoured cheques, stop orders, and corrections of errors.

    5. Key terminology

    Outstanding cheque
    A cheque issued by the entity and recorded in the CPJ but not yet presented to the bank for payment. Appears on the bank recon — debit side.
    Deposit not yet credited
    A deposit recorded in the CRJ but not yet credited by the bank. Appears on the bank recon — credit side.
    Dishonoured (R/D) cheque
    A cheque deposited but returned by the drawer’s bank (insufficient funds). Requires a CPJ entry — reverses the original receipt. The debtor’s account must be reinstated.
    Stale cheque
    A cheque more than 6 months old. The bank will not honour it. The cheque must be cancelled — the amount is credited back in the CRJ.
    Bank charges
    Service fees charged by the bank on the statement. Must be added to the CPJ — not recorded until the statement is received.
    Interest on overdraft
    Interest charged by the bank when the account is overdrawn. Added to the CPJ as an expense.
    Direct deposit
    A payment made directly into the entity’s bank account by a third party (e.g. a debtor). Must be added to the CRJ when noticed on the statement.
    Stop order
    A recurring payment authorised by the entity (e.g. insurance premium). Appears on the statement — must be recorded in the CPJ.
    Favourable balance
    The account has money in it. In the entity’s books: debit balance. On the bank statement: credit balance.
    Unfavourable / overdrawn
    The account is overdrawn (in the red). In the entity’s books: credit balance. On bank statement: debit balance (marked DT, DR or OD).

    6. The reconciliation procedure

    Step 1: Update entity’s records (journal entries required)
    Items on the bank statement not yet in the cash journals:

    • Bank charges → add to CPJ
    • Interest on overdraft → add to CPJ
    • Stop orders → add to CPJ
    • Direct deposits received → add to CRJ
    • Interest received on credit balance → add to CRJ
    • Dishonoured (R/D) cheques → add to CPJ (reverse the original receipt)
    • Stale cheques → cancel in CRJ
    • Errors in entity’s books → correct in relevant journal
    Step 2: Bank reconciliation statement (no journal entries)
    Items in entity’s journals not yet on the bank statement:

    • Outstanding cheques (issued but not yet presented) → Debit side of recon
    • Deposits not yet credited by the bank → Credit side of recon
    • Errors made by the bank → adjust bank statement side accordingly
    The key distinction: If the entity must do something (record it), update the cash journals. If the bank must do something (pay a cheque, credit a deposit), it goes on the bank reconciliation statement — the entity has already recorded it.

    7. Bank reconciliation statement format

    The bank reconciliation statement begins with the balance per bank statement and adjusts to arrive at the balance per bank account in the entity’s ledger. Both sides must agree.

    Entity Name
    Bank Reconciliation Statement as at [date]
    Item
    Debit (R)
    Credit (R)
    Favourable balance per bank statementX
    (OR: Unfavourable balance per bank statement on the Debit side)X
    Deposits not yet credited by bankX
    Outstanding cheques not yet presented for paymentX
    Errors made by bank (credit if bank understated credits)X
    Favourable balance per bank accountXX
    Balance positions:
    A favourable bank statement balance → Credit side of recon
    An unfavourable (overdrawn) bank statement balance → Debit side of recon
    A favourable bank account balance → Debit side of recon
    An unfavourable (overdrawn) bank account balance → Credit side of recon

    Both sides must total the same amount. ✓

    8. Worked example — Benson Traders (July 20.0)

    Step 1: Items to add to the cash journals (entity must act)

    After comparing the bank statement with the June reconciliation and the July cash journals, the following items were identified on the bank statement but not in the journals:

    • CRJ additions: Rental income R850 (direct deposit by R Charles) and Interest received R80
    • CPJ additions: Dishonoured cheque — S Swan R200 (R/D) | Dishonoured cheque — P Saxo R300 (R/D) | Insurance stop order R500 | Bank charges R43 | Deposit book error R20 (bank debited entity in error — later corrected as credit)

    After updating the journals, the bank account in the ledger shows a closing balance of R18 807 (favourable).

    Step 2: Bank reconciliation statement

    Items in the entity’s journals but not yet on the bank statement:

    • Outstanding cheque No 11 (donation, dated 23/6/20.0) — R200 (still unpresented)
    • Outstanding cheque No 18 (Telkom, dated 30/7/20.0) — R180
    • Deposit not yet credited (deposited 1/8/20.0) — R1 800
    Benson Traders
    Bank Reconciliation Statement as at 31 July 20.0
    Item
    Debit (R)
    Credit (R)
    Favourable balance per bank statement17 387
    Deposit not yet credited (deposited 1/8/20.0)1 800
    Cheque No 11 — dated 23/6/20.0 (Donation) — not yet presented200
    Cheque No 18 — dated 30/7/20.0 (Telkom) — not yet presented180
    Favourable balance per bank account18 80719 187
    Both sides total R19 187. The bank account balance of R18 807 is confirmed. ✓

    Note: Cheque No 11 (the donation) was also outstanding last month. If a cheque remains outstanding for 6 months it becomes a stale cheque and must be cancelled.

    9. Bank reconciliation builder

    Enter your bank statement balance and the outstanding items to build a reconciliation statement and verify your bank account balance.

    Build your bank reconciliation
    Bank statement balance is

    10. The petty cash journal

    It is impractical — and inefficient — to write a cheque for every small expense like stamps, tea, or taxi fares. The solution is a petty cash system.

    The imprest system

    Under the imprest system, the petty cash fund starts with a fixed amount called the petty cash float. Each payment is supported by a petty cash voucher. At regular intervals (or when the float runs low), the fund is restored to its original amount by drawing a cheque from the bank account equal to the total payments made. This means the float is always the same amount at the start of each period.

    Imprest system rule:
    Petty cash float = Cash in box + Total of vouchers at any given time.
    At the end of the period: Cash remaining + Total payments = Opening float.
    A cheque is drawn to restore the float to its full amount.

    The petty cash journal (PCJ)

    The petty cash journal has two sides: a receipts side (when cash cheques are received to top up the float) and a payments side (recording every payment by category). At month-end, the column totals on the payments side are posted to the relevant expense accounts in the general ledger.

    Worked example — Pitsi Dealers (August 20.4)

    Float: R200. Payments made during August. Float restored twice (15 Aug and 31 Aug).

    Receipts Payments
    Date Fol Total Date Details Voucher Total Wages Postage Sundries
    Aug 1b/d200 Aug 4Cleaner’s wages0726060
    15CPJ6170 7Stamps0731515
    15CPJ6190 11Cleaner’s wages0746060
    14Stationery0753535
    18Cleaner’s wages0766060
    19Tea, coffee & milk0774040 (Refreshments)
    25Cleaner’s wages0786060
    27Taxi fare — owner0793030 (Drawings)
    30Balance c/d200
    560 56024015105 (Sundries)
    Sep 1b/d200
    Posting the PCJ at month-end:
    Dr Wages R240 | Dr Postage R15 | Dr Stationery R35 | Dr Refreshments R40 | Dr Drawings R30 | Cr Petty cash control R360 (total payments). The float balance of R200 remains as the debit balance in Petty cash control.
    Owner drawings from petty cash: When the owner takes money from petty cash for personal use, it is recorded in the Drawings/Sundries column — NOT as a business expense. The taxi fare in the example above is an owner drawing.

    11. Worked exercises

    Bank reconciliation and petty cash questions in the FAC1502 exam style.

    Classify the reconciling item
    Scenario 1 of 6

    12. Quick quiz

    Twelve questions on cash control, bank reconciliation and petty cash.

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