ACC152 2024 Semester 2 Accounting 1 Assignment PDF

Accounting 1 ACC152  © STADIO No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means – electronic, electrostatic, magnetic tape, mechanical, photocopying, record...

Accounting 1 ACC152  © STADIO No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means – electronic, electrostatic, magnetic tape, mechanical, photocopying, recording or otherwise.  Note It is important to note that this study guide must be read in conjunction with the study material contained on the module course site accessed via your Learning Management System (LMS), CANVAS@mySTADIO. Please consult CANVAS@mySTADIO to confirm whether a prescribed textbook must be purchased. Where necessary we will refer to specific pages or chapters. There may also be reference to additional recommended reading material available for free or at a cost. This will be optional reading intended to enhance your understanding of the material. The content of the STADIO study guides and teaching documents are not intended to be sold or used for commercial purposes. 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STEP 1: COMPLETING YOUR ASSIGNMENT Your assignment answer must include the following sections: COVER PAGE Please include the following information on the first page of the assignment: Name, Surname, Student Number and Module Code. BODY 1. The assignment answers must be typed in MS Word format and saved as a PDF document (File > Save As > Save as Type: PDF). 2. Save your file (MS Word or PDF) with the following naming convention: [STUDENTNUMBER] [MODULECODE] [SURNAME].pdf E.g. 21111234 BCU101 Surname.pdf LIST OF REFERENCES Refer to the STADIO Referencing guide HERE for guidance. ©STADIO [Accounting 1 - ACC152] [Assignment – 2024 Semester 2] Page 1 of 7 Once you have completed your assignment and saved it, you must log in to CANVAS to submit your assignment by the due date. IMPORTANT: Ensure that you submit your assignment answers on or before the due date and time. STEP 2: SUBMITTING YOUR ASSIGNMENT ON CANVAS Once you have completed your assignment, log in to CANVAS as follows: 1. Log in to CANVAS using your MySTADIO details: (Username: [email protected] and Password: ID number) 2. A specific course inside of CANVAS for each of your modules has been created for you to submit your Assignment to. Select the desired module from the dashboard. 3. Submit your assignment before the end of the due date. PLEASE ENSURE THAT THE ANSWER THAT YOU SUBMIT IS IN MS WORD OR PDF FORMAT. NO SCANNED DOCUMENT OR SCREENSHOTS WILL BE MARKED. The process detailed above is the same on a personal computer and mobile device. You will, however, need to ensure that you have saved your completed assignment on the mobile device and have downloaded the CANVAS Student Application before attempting to submit. You do not require a CANVAS class ID and enrolment key to access your registered module class, as you have been allocated to the class based on your registration. If you do not see your module class appear, please contact the office for assistance. If you experience any difficulties during the submission process – after reading through the guide and attempting the prescribed steps – please do not hesitate to contact the office for assistance. ©STADIO [Accounting 1 - ACC152] [Assignment – 2024 Semester 2] Page 2 of 7  ARTIFICIAL INTELLIGENCE TRAFFIC LIGHT MATRIX (AIMat) Question/Part RED AMBER GREEN May NOT May MUST use AI Detail of AI use use AI use AI Part 1 You may not use AI here. Part 2 You may not use AI here. Part 3 You may not use AI here. General You may not use AI here. NOTE: STADIO employs AI writing detection tools to monitor AI use. Presenting work produced by AI as your own contravenes the STADIO Plagiarism policy. Refer to the STADIO Referencing Guide for guidance. ©STADIO [Accounting 1 - ACC152] [Assignment – 2024 Semester 2] Page 3 of 7 Note: All the questions in this assignment refer to the Case Study below. Consider the scenario below and answer the questions that follow. Classical Fashion is a family-run store which sells vintage clothing. The sole owner, Mrs V Styles, started the store many years ago because of her love for vintage clothes and expanded the store over the years to include various other types of clothing. The original store is still open to the public for walk-ins, but the main income stream is from wholesale sales to retailers. Mrs Styles’ family members share her passion to make the world a more classical, stylish place and are all involved in her business, in various capacities. However, none of them are particularly fond of numbers or keeping accounting records. Mrs Styles therefore approached you, as a family friend and accounting fundi, to assist with a few matters. Below follows an extract of the summary you made of all transactions after working through all the source documents provided to you by Mrs Styles’ daughter, Cathryn. The transactions below still need to be captured in the accounting records of Classical Fashion. All the following transactions relate to April 2024. 1.1 Inventory to the value R38 000.00 was bought on credit from an approved provider, The Best Fashion, on 1 April 2024 and invoice #478 was issued to Classical Fashion. 1.2 The monthly internet bill of R1 900.00 was paid via an electronic funds transfer (EFT) to Telkom, based on invoice 8973, dated 10 April 2024. 1.3 A second-hand delivery truck with a purchase price of R380 000.00 was bought on credit from WeBuyVehicles on 18 April 2024 (invoice #489). A cash deposit of R80 000.00 was paid to secure the purchase. 1.4 The rental payment of R15 000.00 for April 2024 for the headquarters office building was made on 20 April 2024, via an EFT to LinPop, as per invoice LP178, dated 20 April 2024. 1.5 Goods to the value of R13 000.00 were sold for cash, on 23 April 2024, recorded on the cash register roll. The cost price of the goods was R6 500.00. 1.6 Interest of R580.00 recorded on a debit bank balance, as per the bank statement on 30 April 2024, downloaded from FNB’s online banking website. 1.7 Goods to the value of R4 000.00 (cost) were sold on credit to Qualify materials (Pty) Ltd, for R8 000.00 and invoice number BB156 was issued on 30 April 2024. 1.8 Instead of buying new furniture, Mrs Styles decided to furnish her office by transferring items from her personal antique furniture collection to Classical Fashion on 30 April 2024. The furniture is valued at R55 000.00. Additional information: Classical Fashion is registered as a VAT vendor and VAT is charged at 15%. ©STADIO [Accounting 1 - ACC152] [Assignment – 2024 Semester 2] Page 4 of 7  Classical Fashion makes use of the perpetual inventory system to record inventory transactions (consult your prior accounting knowledge and the internet for more information on the difference between the periodic inventory system and perpetual inventory system). You do not need to distinguish between the different product and inventory categories for the purposes of this assignment. All final answers should be rounded up to two decimal places. Question 1 (25 marks) Refer to the transactions listed in the case study. Prepare an accounting equation table for the above transactions, by making use of the of the example provided for this purpose. Disregard VAT implications for the purposes of Task 1. Example: The business pays the telephone bill of R500 for the month. Assets Liabilities Owners’ equity Income Expenses Non-current Current Non-current Current DR CR DR CR DR CR DR CR DR CR DR CR Bank Telephone -500 +500 Transaction 1.1 (3) Transaction 1.2 (3) Transaction 1.3 (4) Transaction 1.4 (2) Transaction 1.5 (4) Transaction 1.6 (2) Transaction 1.7 (4) Transaction 1.8 (3) ©STADIO [Accounting 1 - ACC152] [Assignment – 2024 Semester 2] Page 5 of 7 Question 2 (25 marks) Refer to the transactions listed in the case study. Capture the transactions in the correct journals, also known as books of first entry, by making use of the template provided for this purpose. Remember to take VAT into consideration for Task 2. Transactions 1.1 – 1.8 include VAT where applicable. Transaction 1.1 (3) Transaction 1.2 (1) Transaction 1.3 (4) Transaction 1.4 (2) Transaction 1.5 (4) Transaction 1.6 (3) Transaction 1.7 (5) Transaction 1.8 (3) Question 3 (25 marks) The following information was obtained from the books of The Watch Store after comparing the bank account with the bank statement on 31 August 2024. The bank balance in the general ledger reflected a favourable balance of R21 521.00. The following EFTs were written out on the 31 August 2024 but did not appear on the bank statement: o EFT 345 for R 900.00 o EFT 351 for R1 000.00 o EFT 359 for R700.00 The bank statement shows the correct amount of R520 for a deposit made from a customer, but this was captured in the business books as R250. The total of the cash receipts journal, R42 329.00. The total of the cash payments journal, R59 700.00. An EFT 542 amounting to R2 200.00, received from a debtor, Mr Loue, was refused by the bank due to insufficient funds. An amount of R50 for interest expenses was erroneously written in the cash receipts journal. The amount should appear in the cash payments journal. A deposit of R300 for interest income does not appear in the cash receipts journal. The tenant paid the amount into the bank account of the business. A deposit (045) amounting R8 000 does not appear on the bank statement. The bank statement shows an unfavourable balance of R2 980. ©STADIO [Accounting 1 - ACC152] [Assignment – 2024 Semester 2] Page 6 of 7 Required: 3.1 Complete the general ledger of the bank account on 31 August 2024. (17) 3.2 Prepare the bank reconciliation statement on 31 August 2024. (8) ASSIGNMENT TOTAL: 75 MARKS ©STADIO [Accounting 1 - ACC152] [Assignment – 2024 Semester 2] Page 7 of 7  Table of contents Heading Page number Module purpose and outcomes 1 TOPIC 1 INTRODUCTION TO KEY ACCOUNTING CONCEPTS AND THE DOUBLE- ENTRY ACCOUNTING SYSTEM 2 1.1 Introduction 2 1.2 Accounting concepts and their definitions 3 1.3 Users of financial statements 39 1.4 Flow of transactions 41 1.5 The concept of debits and credits 50 1.6 Effects of transactions on the financial position (accounting equation) 57 Summary 70 Self-Assessment Questions 71 TOPIC 2 JOURNAL ENTRIES: BOOKS OF FIRST ENTRY 74 2.1 Introduction 74 2.2 Introduction to journals 75 2.3 The layout of the cash receipts and cash payments journal 77 2.4 The layout of the debtors journal 85 2.5 The layout of the debtors allowances journal 90 2.6 The layout of the creditors journal 93 2.7 The layout of the creditors allowances journal 98 2.8 The layout of the petty cash journal 102 2.9 The layout of the general journal 109 2.10 The layout of other journals 113 Summary 114 Self-Assessment Questions 116 TOPIC 3 GENERAL LEDGER AND CONTROL ACCOUNTS 124 3.1 Introduction 124 3.2 Posting procedure from journals to the general ledger 125 3.3 Different types of control accounts 140 3.4 Balancing of general ledger accounts 148 3.5 Preparation of a pre-adjustment trial balance 152 Summary 157 Self-Assessment Questions 158 TOPIC 4 BANK RECONCILIATION 165 4.1 Introduction 165 4.2 The need for bank reconciliations 166 4.3 Understanding reconciling items 167 4.4 Preparation of bank reconciliation statement 171 4.5 Practical examples of bank reconciliation 173 Summary 178 Self-Assessment Questions 179 TOPIC 5 YEAR-END ADJUSTMENTS 186 5.1 Introduction 186 5.2 Matching and prudence concepts 187 5.3 Depreciation adjustment 188 5.4 Inventory adjustments 192 5.5 Year-end adjustments 199 5.6 Preparation of final Trial balance 211 Summary 220 Self-Assessment Questions 221 TOPIC 6 INTRODUCTION TO THE PREPARATION OF FINANCIAL STATEMENTS224 6.1 Introduction 224 6.2 Statement of Profit or Loss and Other Comprehensive Income 224 6.3 The Statement of Financial Position — company 228 6.4 The structure of the Statement of Profit or Loss and Other Comprehensive Income — sole proprietor 236 6.5 The structure of the Statement of Financial Position — sole proprietor236 Summary 237 Self-Assessment Questions 238 GLOSSARY OF TERMS 241 Answers to Self-Assessment Questions 247 Topic 1 Self-Assessment Answers 247 Topic 2 Self-Assessment Answers 248 Topic 3 Self-Assessment Answers 256 Topic 4 Self-Assessment Answers 262 Topic 5 Self-Assessment Answers 265 Topic 6 Self-Assessment Answers 274  Module purpose and outcomes In this module you will be introduced to the basic principles of accounting. The double-entry principle and accounting equation are addressed. In addition, you will learn about different types of journal entries, ledger accounts and bank reconciliation statements. Different types of financial statements are also covered. On completion of the module, you should be able to: 1. Apply the principles of basic bookkeeping and accounting. 2. Analyse the effect of transactions on the financial position of a business entity. 3. Prepare journal entries and draw up the general ledger and control accounts. 4. Prepare bank reconciliations and year-end adjustments. 5. Interpret the different types of financial statements of a business entity on a basic level. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 1  Topic 1 Introduction to key accounting concepts and the double-entry accounting system 1.1 INTRODUCTION This topic relates to the following module outcomes: 1. Apply the principles of basic bookkeeping and accounting. 2. Analyse the effect of transactions on the financial position of a business entity. This topic will introduce you to the basic principles of an accounting system and will help you understand why it is necessary to have such a system in place. This uniform system applies to all business entities. It is necessary to identify the process that must be followed before preparing a set of financial statements. Once this process has been followed, you need to understand the reasons for preparing these statements. This topic will explore the purpose of the accounting system and the financial information that people use, as well as the different users of financial statements. It is also important to identify and understand the different forms of business entities and their financial periods. We will also define the different terminology used in the accounting equation. Remember, together with the double-entry system, the accounting equation is the starting point for the process of recording accounting data. Furthermore, the flow of a transaction, from entering the information into the accounting records to summarising the year’s records in the financial statements, will be covered. This is known as the accounting cycle. In this topic, you will gain knowledge in the following areas: 1. Accounting concepts and their definitions 2. Users of financial statements 3. Flow of transactions 4. Concept of debits and credits 5. Effect of transactions on the financial position of a business entity. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 2 1.2 ACCOUNTING CONCEPTS AND THEIR DEFINITIONS 1.2.1 Accounting as a system Accounting around the world is based on a double-entry system. The processing rules may differ from one country to another, but the system is the same. The name is a giveaway. In the simplest form, it means that you must pass two entries to ‘process’ any transaction. This concept is fundamental to everything from here onwards in this module. Although an entire topic is dedicated to this later, it is important that you first understand the principle. Later in the topic, we also study the accounting equation in more depth. Some of these points will then become clearer. It is important to emphasise that there is an offset that takes place in our everyday use of money. Have a look at this example: Example: You work for a full month. At the end of the month, you have a real asset — a salary receivable. When the transaction happens (on the 20th, 25th or the last day of the month) you ‘gain’ cash, but instantaneously ‘lose’ the receivable. Therefore, two transactions have taken place. If you then use part of your salary to pay debt, the following happens: you instantaneously ‘lose’ cash, but also ‘gain’ because you have settled a debt. This example shows that there are (at least) two entries for every transaction. For accounting information to be produced, financial data must be recorded, classified and summarised. This process can best be described as a system in which the data (that is the input into the system) is processed to produce the accounting information (that is the output). The accounting system is illustrated in the following figure. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 3  INPUT OUTPUT Transaction data Statement of Financial Position Periodic adjustments PROCESS Statement of Comprehensive Judgement inputs Income Statement of Cash Flows Other reports not covered in the module Figure 1.1 The accounting system The three components of the accounting system — input, process and output — will now be explained in detail. Input There are two sources of input into the accounting system: the transaction data and the periodic adjustments. Transactions are the various activities that a business carries out when conducting its operations. Each transaction is recorded on a source document, which indicates the origin of the transaction. Examples of source documents that would often be used to record transactions include (among others): Cash register roll, which records cash received through the cash register (till) for sales of goods or services rendered Invoice, which records sales or purchases of goods or services rendered on credit, for which the money will be received or paid at some specified future date Cash receipt, which is used as confirmation that a cash transaction has taken place and that cash has been received by the business entity — usually used for cash sales and payments of accounts by customers who had previously bought goods or received services on credit (such customers are called trade receivables or debtors) Bank deposit slip, which records the money deposited into the bank account. It is common practice for businesses to deposit cash from sales daily Credit note, which is issued by the seller (supplier) to record the cancellation of an entire invoice or part of an invoice for reasons such © STADIO (Pty) Ltd Accounting 1 ACC152 20a 4  as changes to the invoice after it was issued, damage to the goods or pricing mistakes on the original invoice Debit note, which is issued by the buyer to record the return of goods, previously bought on credit, to the seller (supplier) Electronic funds transfer (EFT) proof of payment, which serves as proof that an electronic transfer of funds has been made into the business entity’s bank account Petty cash voucher, which records small amounts of money used from the petty cash Journal voucher, which records adjustments and corrections performed by accountants such as credit losses (bad debts) and depreciation expense for the year. The transactions recorded on each source document become inputs into the accounting system. The details on each source document need to be recorded by the business. Some inputs into the system may be generated internally without involving an external party such as a customer. Such events, which also have financial implications for a business, are known as periodic adjustments. The calculation of depreciation by accountants would be seen as a source document. Every entry into the financial pool of data must be recorded. Periodic adjustments are recorded in journals that must still be approved and retained. To illustrate the principle of a periodic adjustment, let us assume that a business owns a motor vehicle. The motor vehicle is used for business purposes and, in this capacity, is gradually ‘used up’. This usage represents a cost to the business, as the vehicle will become less reliable over time. Even though the usage of the vehicle might not involve cash payments, the fact that it is being used must be recorded. The periodic adjustment to reflect this event is known as depreciation. It is important to note that depreciation does not include the running costs of the vehicle such as fuel and repairs and maintenance costs. These are transactions that will be recorded on source documents. Depreciation transfers the cost of the asset to expenses over the useful life of the asset. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 5 Some of the entries require some degree of judgement. Some judgement calls become policy and only require updating when the policy is changed. For example, the useful life of a photocopying machine can suddenly reduce because of new technology, causing the remaining useful life of the machine to be less than previously estimated. Another example affects the recoverability of a debt, which could become questionable. An allowance for such doubtful debts must be created as the amount at which the debtor was initially recorded may not be fully recoverable. Process This component of the accounting system comprises the transformation of the input data into an organised and systematic database from which the financial reports — the output of the system — can be prepared. The process of the accounting system will be discussed in greater detail later in this topic. The output of the accounting system The output of the accounting system comprises the various financial reports produced by accountants. In accounting, the reports present the financial results of the operations (i.e. the Statement of Profit or Loss and Other Comprehensive Income) of a business for a particular period of time, and its financial position at a particular point in time (the Statement of Financial Position). The financial reports are collectively referred to as financial statements. In this topic, we will closely examine the process and output phases of the accounting system. In particular, the accounting equation will be used as a basis for recording the transactions and periodic adjustments of a business, as well as for preparing financial statements. Activity Write down the answers to the following: Explain what is meant by the double-entry system. Name the key elements that resulted in the establishment of the double-entry system of recording. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 6 You should now be able to identify the need for an accounting system and the information required by an accounting system. 1.2.2 Formalising financial reports The company’s operations are reported to interested parties through a set of financial statements. These interested parties may include management, investors, bankers, shareholders, suppliers, customers, or labour unions. A company generates various financial reports, each communicating information that is of interest to different parties. For purposes of this module, we will concentrate on the Statement of Profit or Loss and Other Comprehensive Income and the Statement of Financial Position. The Statement of Cash Flows forms part of financial statements; however, in this module, we will focus on the cash forecast, which is a forward-looking planning tool and not a mandatory annual report. The Statement of Changes in Equity is also beyond the scope of this module. 1.2.3 Statement of Profit or Loss and Other Comprehensive Income The Statement of Profit or Loss and Other Comprehensive Income presents the financial results of the entity over a specified period of time (usually a financial year), showing the business owner or manager exactly how the business has performed. As the overall objective of the business is to make a profit (and therefore improve the owner’s equity), this report is used to reflect whether a profit or loss has been achieved over the specified period. The financial result (i.e. profit or loss) is made up of the income earned less the expenses incurred by the entity in the relevant period, as follows: PROFIT = INCOME (REVENUE OR TURNOVER) − EXPENSES The following is an example of a Statement of Profit or Loss and Other Comprehensive Income. Remember that the heading of the Statement of Profit or Loss and Other Comprehensive Income must reflect the time period to which it relates, the name of the statement, and organisation’s name. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 7 Example: 4M SERVICES STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR ENDED 30 JUNE 20XX INCOME Revenue (services rendered) R 1 750 000 EXPENSES (R 1 250 000) Salaries R450 000 Rent paid R150 000 Depreciation R475 000 Repairs R175 000 NET PROFIT FOR THE YEAR R 500 000 1.2.4 Statement of Financial Position The Statement of Financial Position reports the financial position of the entity at a specific point in time. The financial position is made up of the following: 1. The assets that belong to the entity at that specific time 2. The liabilities (i.e. the debts) owed by the entity at that specific time 3. The owner’s equity (or net worth). This is the difference between the assets and liabilities of the business entity, and includes the capital invested by the owner and profits ploughed back into the business by the owner (i.e. retained earnings), less drawings (i.e. the cash and goods taken by the owner from the business for private use). The Statement of Financial Position shows where funds (i.e. the money) have come from and how they have been used. MONEY IN = MONEY OUT Capital invested + Owner’s equity Retained earnings = Assets + Borrowings/debt Liabilities © STADIO (Pty) Ltd Accounting 1 ACC152 20a 8 Money in should always be equal to money out. Therefore, the diagram above can be restated using the accounting equation as follows: THE ACCOUNTING EQUATION OWNER’S EQUITY + LIABILITIES = ASSETS (MONEY IN) (MONEY OUT) OR OWNER’S EQUITY = ASSETS − LIABILITIES (Capital + retained earnings) (what we own) (borrowings) Remember that the Statement of Financial Position reflects the financial health of a business at a specific point in time. Example: The following is an example of a Statement of Financial Position: 4M SERVICES STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE 20XX ASSETS Non-current assets 800 000 Property, plant and equipment 800 000 Current assets 3 400 000 Inventory 1 350 000 Accounts receivable 1 850 000 Cash and cash equivalents 200 000 Total assets 4 200 000 EQUITY AND LIABILITIES Capital and reserves 1 950 000 Capital 1 200 000 Retained earnings 750 000 Non-current liabilities 950 000 Long-term loan 950 000 Current liabilities 2 250 000 © STADIO (Pty) Ltd Accounting 1 ACC152 20a 9 Bank overdraft 300 000 Accounts payable 1 950 000 Total equity and liabilities 4 200 000 1.2.5 The Statement of Cash Flows A third financial statement can be prepared from the accounting information generated by the accounting system. This statement, which is called a Statement of Cash Flows, is prepared after the Statement of Financial Position and the Statement of Profit or Loss and Other Comprehensive Income, and reports on the results of the cash transactions of the business. The Statement of Cash Flows differs from a cash-flow forecast, which is prepared before any transactions have taken place. The cash-flow forecast is a budget of the future (i.e. the expected) cash movements. In practice, the Statement of Cash Flows (SOCF) usually has three headings: 1. Cash flows from operating activities (e.g. cash received from customers and cash paid to suppliers and employees) 2. Cash flows from investing activities (e.g. buying non-current assets) and 3. Cash flows from financing activities (e.g. obtaining a loan). The Statement of Cash Flows (SOCF) produces a different result from a Statement of Profit or Loss and Other Comprehensive Income. The reason for this is that the SOCF is prepared using the cash basis of accounting (that is, reporting only cash receipts and payments), while the Statement of Profit or Loss and Other Comprehensive Income is prepared using the accrual basis of accounting (reporting all revenue and expenses for the period, whether paid, received or not). In practice, the financial statements of a business comprise: 1. The Statement of Financial Position 2. The Statement of Profit or Loss and Other Comprehensive Income 3. The Statement of Cash flows 4. The Statement of Changes in Equity and 5. Explanatory notes. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 10  Note The SOCF is regarded as an important source of information about the cash transactions of an enterprise, but it is beyond the scope of this module. 1.2.6 The financial period of an enterprise If we consider the lifespan of a business, we can identify the various stages through which it will progress. The business is created, it will trade/operate, and continue to trade/operate into the foreseeable future, or eventually it will cease to trade/operate and be wound up. Throughout these periods, the owners, lenders and all other parties involved will need information about the business in order to make economic decisions. Activity List the sets of information that you, as a business owner, need to have at your fingertips in order to manage your business efficiently. Refer to your answer above. Now, let us consider the timeline of a business: Business Business starts ceases Generally, a business owner is in business to make a profit. The owner intends to generate a profit from the time the business starts trading to the time the owner decides to exit the business or cease trading. The problem is that the business owner does not know when the business is going to cease trading; and if he does, he cannot wait until the business ceases trading to determine whether or not a profit has been made. In practice, what happens is that the business owner breaks up the total period of existence into smaller, equal-sized periods. These could be months, quarters, or years. Business cycles differ from one company to another. Understandably, a supermarket that sells goods at least once a day has a different cycle to a construction company that works on different projects, some of which could © STADIO (Pty) Ltd Accounting 1 ACC152 20a 11 take years to complete. However, annual reports are the minimum standards required by law, and almost every business prepares monthly reports. When reading these reports, it is important to read the notes to the annual financial statements in order to understand the rules applied to group activities over the period of the year. Start Future Equal periods of trading Now The business owner looks at the results of each trading period and determines what profit (or loss) has been achieved. Note Profit is essentially the difference between revenue and expenses. The documents that the business owner examines are: 1. Statement of Profit or Loss and Other Comprehensive Income for the period just ended (i.e. an historical performance) 2. Statement of Financial Position at the current date (i.e. at a point in time) 3. Cash-flow forecast for the forthcoming periods (i.e. a future outlook). These documents can be matched to the lifeline of the business as follows: Start Future Equal periods of trading (e.g. weeks, months or years) 1. Statement of 3. Cash flow Profit or Loss and forecast for the Other future period Comprehensive Income for the previous period 2. Statement of Financial Position at this point in time Figure 1.2 The lifeline of a business © STADIO (Pty) Ltd Accounting 1 ACC152 20a 12 For accounting purposes, one must differentiate between individuals and other forms of enterprise. Individuals are persons who operate their business in their own capacity. Examples of this are natural persons who trade as sole proprietors or who trade in partnerships. These individuals will have a financial period that commences on 1 March of each year and runs for a period of 12 months, ending on 28/29 February the following year. This coincides with the year of assessment, as prescribed by the South African Revenue Services (SARS). All other entities may have a financial period of a year that commences at any date and ends 12 months later. Companies, both public and private, and close corporations fall within this category. All activities (i.e. transactions) that take place in this 12-month period must be recorded in various financial records. This means that all purchases, manufacturing expenses, sales, and other income that occurred in a financial period must be accounted for within that period of 12 months. This is normally referred to as the financial records for the year of an enterprise. 1.2.7 Understanding financial analysis The process of financial statement analysis consists of the application of analytical tools and techniques to financial statements and data, in order to derive from them measurements and relationships that are both significant and useful in decision-making. First and foremost, financial statement analysis serves the essential function of converting data (of which, thanks to computers, there is a bewildering quantity and variety) into useful information. The processes of financial statement analysis can be described in various ways, depending on the objectives to be achieved. Financial statement analysis can be used as a preliminary screening tool when evaluating loan applications, equity investments, or merger candidates. It can be used as a tool to forecast the future financial results and identify current and potential problem areas. It can also serve as a tool in the evaluation of management. Above all, financial statement analysis reduces the reliance on pure hunches, guesses, and intuition. This reduces and narrows down the inevitable areas of uncertainty that accompany all decision-making processes. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 13 In summary, financial statement analysis is a very important tool in aiding decision-making. We have dedicated an entire topic to this issue in a later module in the qualification. Note Financial statement analysis does not lessen the need for judgement, but rather establishes a sound and systematic basis for its rational application. Different categories of people and organisations will use the financial information that is disclosed in the financial records of an enterprise. They need this information to make decisions when investing in an enterprise or lending funds to the enterprise. This process is called the financial analysis of the enterprise. Activity The financial statements of ABC Stores have just been finalised for the year ended 31 December 2022. Identify and explain the use of these financial statements, and the reasons for the performance of financial analysis. Write these answers in a notebook. 1.2.8 The process component of the accounting system One normally starts a business by asking the following questions: From which source(s) will the enterprise obtain funds to commence trading? In which specific industry am I going to trade? What is going to be sold or manufactured, and at what cost (i.e. expense)? Even though you may have great ideas, you cannot just open a business and start trading without knowing whether you will receive more money (i.e. income) than you will pay in expenses. Therefore you need to know how to process all of the information of an accounting system. The process component of the accounting system transforms the input data into an organised and systematic database from which the financial statements can subsequently be prepared. This requires the recording of transaction data from the source documents and the periodic adjustments into a set of © STADIO (Pty) Ltd Accounting 1 ACC152 20a 14 accounting records that will classify and summarise these events. The accounting record we will use for the recording of transactions and adjustments is the accounting equation. Before proceeding, we will redraft the diagram of the accounting system shown in Figure 1.1, in terms of the functions performed at each stage of the system. This is illustrated in Figure 1.3. INPUT PROCESS OUTPUT Identifying Recording Reporting Measuring Classifying Evaluating Data capturing Summarising Analysing Comparing Figure 1.3 The functional perspective of the accounting equation Figure 1.3 sets out the accounting functions that occur in each phase of the accounting system. Our focus in this topic will be on the process phase, — recording, classifying, and summarising the transaction data and periodic adjustments of a business. You should now be able to: identify the need to keep records of transactions entered into by an enterprise during a financial period. understand and describe the process component of an accounting system from the input data (i.e. the source documents) to an organised and systematic database (i.e. the accounting records) from which financial statements can be prepared. You will recall from earlier in the topic that the accounting equation is: 1. ASSETS = OWNER’S EQUITY + LIABILITIES Applying basic mathematics, we can also write the equation as follows: 2. OWNER’S EQUITY = ASSETS − LIABILITIES or as: © STADIO (Pty) Ltd Accounting 1 ACC152 20a 15  3. LIABILITIES = ASSETS − OWNER’S EQUITY We encourage you to not simply learn these off by heart, but to make sure you understand these equations. Either way, it is a fundamental accounting concept and, together with the double-entry system, the foundation on which to build any accounting knowledge. Later in the topic, this concept is worked through in detail with a case study; however, below is an example to aid your understanding at this point. Example: A business owner contributes R2 000 to the firm, so the firm has R2 000 in its bank account. The owner’s net worth is R2 000 (assets = owner’s equity). Should the firm now borrow R5 000 from a financial institution, it will have R7 000 in the bank. Is the owner now worth R7 000? Clearly not. He needs to deduct liabilities from assets to get his net worth (see Formula 2 above). He is still worth R2 000 (R7 000 − R5 000). Looking at this, by using Formula 3, we know the loan from the bank is R5 000; therefore, liabilities are clearly R5 000. The R5 000 debt equals the bank balance (i.e. the assets) of R7 000, less the owner’s equity of R2 000. If you were to write the above in the accounting equation, it would be as follows: ASSETS = OWNER’S EQUITY + LIABILITIES (A = OE + L) Bank (R2 000) = Capital (R2 000) + 0 Bank (R7 000) = Capital (R2 000) + Loan (R5 000) The accounting equation reflects a situation in which all assets owned or controlled by a business are subject to claims by owners and creditors. We will use the accounting equation to record business transactions and periodic adjustments. To illustrate the principles of recording business transactions and adjustments, assume that, in February 20XX, J. Jones decided to start a business in the health industry. The business, which J. Jones decided to call Jones’s Gym, © STADIO (Pty) Ltd Accounting 1 ACC152 20a 16 would provide a gymnasium and training facilities to the public. It would not, however, trade any products, as it is a service undertaking. J. Jones expected the business, which was due to commence operations in March 20XX, to do well (i.e. to make a profit). To commence business, J. Jones deposited R200 000 into the bank account of Jones’s Gym on 1 March 20XX. The transaction was recorded in the accounting equation as: Date Assets = Equity + Liabilities 1 March R 200 000 R 200 000 R0 This indicates that the business has assets (i.e. cash) of R200 000. This is also the amount that the business owes to J. Jones, the owner. The amount should therefore be recorded as equity. No creditors or potential investors have placed resources in the business at this stage, so there are no liabilities owing by the business. Note Note that the equation balances. The assets equal equity plus liabilities. This state of equilibrium must always exist because assets will always be equal to equity and liabilities at any point in time. The accounting equation is the foundation of, and starting point for, the recording process. All accounting transactions and adjustments that affect both financial position and financial performance can be recorded and organised in terms of this equation. To understand how to do this, the terms ‘assets’, ‘liabilities’, and ‘equity’ need to be examined in more depth. Assets Assets are resources controlled by the business as a result of past events, from which future economic benefits are expected to flow to the business. Assets are further classified as non-current assets and current assets. Non-current assets Non-current assets are assets with a useful life of more than 12 months. These assets are purchased for purposes other than trade or resale. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 17 Example: The following are examples of non-current assets: Land and buildings Machinery Equipment Vehicles Furniture. Current assets Current assets are assets with a useful life of less than 12 months. These are used, consumed, or sold by the business in order to create additional value by earning net income, and are also items owing to the business (i.e. trade receivables/debtors control). Example: The following are examples of current assets: Inventory Accounts receivable/debtors control Bank (i.e. a favourable bank balance) Petty cash Cash float Consumable stores on hand. Liabilities Liabilities are the present obligations of a particular business entity to transfer assets (usually by paying money), or to provide services to other entities in the future because of past transactions or events. Liabilities therefore represent claims against the assets of a business. Liabilities are further classified as non- current liabilities and current liabilities. Non-current liabilities These obligations will mainly be in respect of entities from which the business borrowed money, such as banks and other financial institutions. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 18 Current liabilities An entity often needs to purchase products or services, and it may be necessary to purchase these on credit (from, say, suppliers of goods or services). Equity Equity is the owner’s residual (i.e. the remaining) interest in the assets of an enterprise after deducting all the entity’s liabilities. This residual interest represents the amount of the owner’s claims against the business if all of the assets are realised (i.e. sold) for cash at the amounts at which they are recorded, and all of the liabilities are discharged (i.e. paid) at the amounts at which they are recorded. We will now continue with the example of Jones’s Gym, using the accounting equation to record the transaction data and periodic adjustments of the business for March 2022. Remember, equity comprises capital and retained earnings. Initial capital is the contribution that the owner made to the business; and after a few years, that amount is not as visible anymore (however, it is not less valid, as it is a product of a number of things after a few years, not initial capital only. Rather, it is less clearly defined). Equity will always be assets minus liabilities. One of the contributors to owner’s equity is retained earnings. This is the sum of the profits that were not distributed to the owner over the years. It is already established that profit = income less expenses. It has also been established that owner’s equity includes profit. It can therefore be concluded that: OWNER’S EQUITY = CAPITAL + INCOME − EXPENSES − DRAWINGS Again, using mathematics, the equation can be rewritten into five different variants. The purpose of this module, however, is for you to understand that any profit not distributed to the owner forms part of equity. We will cover this again at a later stage. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 19 1.2.9 The double-entry principle (a rule) Earlier, we looked briefly at the double-entry system. For every amount that accountants ‘process’, at least two entries into different accounts are required. We process entries in ledger accounts. Ledger accounts are groupings of similar transactions. For example, if we regularly purchase bond paper, we will open an account called ‘stationery’, and all the entries in the month relating to stationery are recorded in the stationery ledger account. At the end of the period, it is then easy to see what the total stationery cost is. You can imagine the hundreds of thousands of entries for a large firm, and if we do not group like with like, understanding the accounts will be impossible. These ledger accounts are then grouped together again and classified for the financial statements. Accounts are classified into asset accounts, equity accounts, and liability accounts. In its simplest form, a ledger account can be visualised as the letter ‘T’. In the past, when manual bookkeeping was common, firms purchased ledger books with a vertical line down the middle of each page. When the page was given a name on top, it resembled the letter ‘T’. In these days of automation, ledger prints still resemble the letter ‘T’. The left side of the centre line is the debit side and the right side is the credit side. This is important. Read it again. Study it. For the purposes of Topic 1, we are focusing on understanding the effect of a transaction on equity, assets, or liabilities. But for now, you need to understand the effect only in terms of increases and decreases. A useful summary The framework shown in Table 1.1 presents a useful overview of the accounting equation and the related subcategories. Examples of relevant accounts are given under the related categories. You will need to know this information before you attempt further work. Using the double-entry principle, we can record the effect of the following transactions by Jones’s Gym on the accounting equation, by asking the following questions: 1. Which elements (i.e. assets, equity, and/or liabilities) in the equation are affected by these transactions? © STADIO (Pty) Ltd Accounting 1 ACC152 20a 20 2. Which of the following elements will increase or decrease? Recording of transactions As explained, the amount of R200 000 contributed by the owner, J. Jones, was deposited into a newly opened bank account in the name of Jones’s Gym on 1 March 20XX. The business then prepared itself to start business by concluding the following transactions during March 20XX: Table 1.1 Jones’ Gym’s transactions during March 20XX Date Transaction 3 March Acquired premises for R105 000. This amount was paid through an electronic funds transfer (EFT). 4 March Purchased gym equipment on credit for R65 000. 6 March Obtained a long-term loan of R45 000 from the bank. The loan bears interest at 18% per annum, payable quarterly in arrears. The loan is repayable on 9 March 20XX. 10 March Bought consumables, such as handwashing soap, oils, and creams amounting to R1 800, to be used by gym members. The amount was paid by bank card. 12 March Jones’s Gym placed advertisements in the local newspaper at a cost of R3 900. 17 March Deposited R9 700 in the bank. This was received from members for fitness training and gym usage for the period 4 March to 16 March 20XX. 20 March Concluded non-refundable contracts with new members for R15 200. The money has not yet been received. 31 March Paid the following amounts: R13 000 to fitness trainers, masseurs, and nutritionists. R9 000 to the suppliers of the equipment purchased on 4 March. We will now record the transactions of Jones’s Gym within the framework of the accounting equation. Each transaction will be considered in the light of its impact on the accounting equation i.e. how the assets under the control of the business have changed, and how these changes affect the claims against the business. The information in the accounting equation will be used to draft a Statement of Financial Position, and a Statement of Profit or Loss and Other Comprehensive Income. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 21 The effects of the transaction on 1 March 20XX have already been explained at the beginning of the topic. ‘Cash’ in the bank increases assets, and R200 000 is also entered under equity, because it is the amount owing to the owner, J. Jones. The transaction will be recorded in the accounting equation (A = OE + L) as follows: Mar Accounts affected Assets Equity Liabilities 01 Cash increases, capital + 200 000 + 200 000 increases Note Note that we already have a Statement of Financial Position (with two Statement of Financial Position items: assets = equity). Table 1.2 Statement of Financial Position of Jones’s Gym as at 1 March 20XX ASSETS Current assets R200 000 Bank R200 000 Total assets R200 000 EQUITY AND LIABILITIES Capital R200 000 Total equity 200 000 Total equity and liabilities R200 000 Any further transactions recorded will affect the accounting equation and therefore the Statement of Financial Position. We will now analyse the remaining transactions in terms of this framework: 3 March: purchased premises, costing R105 000, for cash Premises are an asset. Cash is also an asset. Premises were acquired, so assets will increase. However, cash was spent, which results in a decrease in assets. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 22 The transaction will be recorded in the existing accounting equation as follows: Date Accounts affected Assets Equity Liabilities Mar 01 Cash increases, capital increases + 200 000 + 200 000 03 Premises increases, bank + 105 000 decreases − 105 000 Balances 200 000 200 000 Note The accounting equation remains in equilibrium after each transaction. Table 1.3 Statement of Financial Position of Jones’s Gym as at 3 March 20XX ASSETS Non-current assets 105 000 Property, plant and equipment 105 000 Current assets 95 000 Bank 95 000 Total assets 200 000 EQUITY AND LIABILITIES Capital 200 000 Total equity 200 000 Total equity and liabilities 200 000 4 March: purchased equipment costing R65 000 on credit 1. Equipment is an asset. Money owed to the supplier represents a liability, known as trade payables or creditors control. 2. When equipment is purchased, assets increase. The creation of trade payables or creditors control causes liabilities to increase. The transaction will be recorded in the existing accounting equation as follows: © STADIO (Pty) Ltd Accounting 1 ACC152 20a 23  Date Accounts affected Assets Equity Liabilities Mar 01 Cash increases, capital + 200 000 + 200 000 increases 03 Premises increases, bank + 105 000 decreases − 105 000 04 Equipment increases, trade payables increase + 65 000 + 65 000 Balances 265 000 200 000 65 000 Table 1.4 Statement of Financial Position of Jones’s Gym as at 4 March 20XX ASSETS Non-current assets 170 000 Property, plant and equipment 170 000 Current assets 95 000 Cash and other cash equivalents 95 000 Total assets 265 000 EQUITY AND LIABILITIES Capital 200 000 Total equity 200 000 Current liabilities 65 000 Trade and other payables 65 000 Total equity and liabilities 265 000 6 March: received a long-term loan of R45 000 from the bank 1. Money in the bank is an asset and a loan from the bank is a liability because it must be repaid to the bank by 9 March 20XX. 2. When money is received, assets increase. The loan received causes liabilities to increase. The transaction will be recorded in the existing accounting equation as follows: © STADIO (Pty) Ltd Accounting 1 ACC152 20a 24 Date Accounts affected Assets Equity Liabilities Mar Cash increases, capital + 200 000 + 200 000 01 increases Premises increases, bank + 105 000 03 decreases − 105 000 Equipment increases, trade + 65 000 + 65 000 04 payables increase Cash increases, loan + 45 000 + 45 000 06 increases Balances 310 000 200 000 110 000 Table 1.5 Statement of Financial Position of Jones’s Gym as at 6 March 20XX ASSETS Non-current assets 170 000 Property, plant and equipment 170 000 Current assets 140 000 Cash and other cash equivalents 140 000 Total assets 310 000 EQUITY AND LIABILITIES Capital 200 000 Total equity 200 000 Non-current liabilities 45 000 Long-term loan 45 000 Current liabilities 65 000 Trade and other payables 65 000 Total equity and liabilities 310 000 The transactions of Jones’s Gym recorded to date relate to setting up the operating structure of the business. However, it has not yet begun operating, which it will have to do to generate revenue. Wealth creation, as measured through the financial performance of a business, is achieved if the business makes a profit. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 25 Recall that profit is determined as: NET PROFIT = INCOME − EXPENSES Income Revenue is the net inflow of cash or receivables that arises in the module of the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of the enterprise’s resources. Revenue is measured by the charges to customers or clients for goods supplied and services rendered to them, and by the charges and rewards from the use of resources by them. It excludes amounts collected on behalf of third parties, such as Value-Added Tax (VAT). Note Different types of revenue that may be earned (depending on the nature of a business) include sales, the rendering of services, membership fees, consultation fees, royalties, rent, and commission earned. Revenue earned also includes transactions for which cash has not yet been received, but the goods have been delivered or the service has been rendered; therefore, the word ‘earned’ is used, rather than ‘received’. For example, a business may provide services during December 20XX, but receive the money only in January of the following year. This is revenue earned during December 20XX, and it must be recorded in the accounting equation during December 20XX. The revenue was earned in December, because a service, measured in monetary terms, for which the client must ultimately make payment, was provided during that period. This is also known as ‘accrued income’. Expenses incurred Expenses are the costs of assets consumed and services used in order to earn revenue. Example: Expenses include electricity and water, salaries, depreciation, telephone, and rent paid. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 26 It is possible for an expense to be incurred but not yet paid. For example, a business may use the telephone during December 2018, but only settle the account in January 2019. The telephone was used in December, so it is an expense for that period and must be recorded as such. From the preceding discussion, it is apparent that revenue earned and expenses incurred both affect equity. If revenue earned is greater than expenses incurred, the business makes a profit. A profit represents a return to the owner on his investment and will increase the claim of the owner against the assets of the business. If expenses incurred are greater than the income earned, the business incurs a net loss and equity will be decreased. It follows that: Revenue earned will increase equity. Expenses incurred will decrease equity. By including revenue earned and expenses incurred in the determination of net profit or loss, we are using the accrual basis of accounting. As explained in this topic, this specifies that revenue and expenses should be recognised in the period in which they are earned and incurred, respectively, and not necessarily when the amounts are received or paid. We can now continue to record the transactions of Jones’s Gym. 10 March: purchased consumables costing R1 800 for cash. 1. Consumables represent an expense, and cash is an asset. 2. The expense will decrease equity, and cash, as it is being paid, will reduce assets. The transaction will be recorded in the existing accounting equation as follows: Date Accounts affected Assets Equity Liabilities Mar 01 Cash increases, capital + 200 000 + 200 000 increases 03 Premises increases, bank + 105 000 decreases − 105 000 04 Equipment increases, trade + 65 000 + 65 000 payables increase © STADIO (Pty) Ltd Accounting 1 ACC152 20a 27 06 Cash increases, loan increases + 45 000 + 45 000 10 Consumables (expense) −1 800 − 1 800 increase, cash decreases Balances 308 200 198 200 110 000 Table 1.6 Statement of Financial Position of Jones’s Gym as at 10 March 20XX ASSETS Non-current assets 170 000 Property, plant and equipment 170 000 Current assets 138 200 Cash and other cash equivalents 138 200 Total assets 308 200 EQUITY AND LIABILITIES Capital 200 000 Retained profit −1 800 Total equity 198 200 Non-current liabilities 45 000 Long-term loan 45 000 Current liabilities 65 000 Trade and other payables 65 000 Total equity and liabilities 308 200 Note Important: Retained profit = Income − Expenses − Drawings. 12 March: paid for advertisements costing R3 900 An advertisement is an expense and cash is an asset. An expense will reduce equity, and cash, as it is being paid, will reduce assets. 17 March: deposited fees received of R9 700 © STADIO (Pty) Ltd Accounting 1 ACC152 20a 28 1. Fees represent revenue and cash is an asset. 2. The revenue earned will increase equity, and cash received will increase assets. The transactions will be recorded in the existing accounting equation as follows: Date Accounts affected Assets Equity Liabilities Mar Cash increases, capital + 200 000 + 200 000 01 increases Premises increases, bank + 105 000 03 decreases − 105 000 Equipment increases, trade + 65 000 + 65 000 04 payables increase Cash increases, loan + 45 000 + 45 000 06 increases − 1 800 − 1 800 10 Consumables (expense) increase, cash decreases − 3 900 − 3 900 12 Advertising increases, cash decreases + 9 700 +9 700 17 Cash increases, revenue increases Balances 314 000 204 000 110 000 20 March: entered into non-refundable contracts of R15 200 for introductory course on credit This transaction represents revenue earned, because the five-day introductory courses would have been provided by Jones’s Gym before the end of March. 1. Revenue is income and trade receivables are assets. 2. Revenue increases equity. Although cash has not yet been received, assets will also increase. There are now members that owe the business money. 31 March: paid R13 000 for salaries and R9 000 to suppliers of equipment 1. Salaries are an expense which decreases equity. Cash is paid and, because cash is an asset, assets will decrease. 2. The business started to repay trade payables incurred when the equipment was acquired on 4 March. Trade payables are a liability, and © STADIO (Pty) Ltd Accounting 1 ACC152 20a 29  liabilities will decrease by R9 000. Assets will also decrease since cash is paid out to the supplier of the equipment. The three transactions above will be recorded in the existing accounting equation as follows: Date Accounts affected Assets Equity Liabilities Mar Cash increases, capital + 200 000 + 200 000 01 increases 03 Premises increases, bank + 105 000 decreases − 105 000 04 Equipment increases, trade + 65 000 + 65 000 payables increase 06 Cash increases, loan + 45 000 + 45 000 increases − 1 800 − 1 800 10 Consumables (expense) increase, cash decreases − 3 900 − 3 900 12 Advertising increases, cash decreases + 9 700 +9 700 17 Cash increases, revenue increases + 15 200 + 15 200 20 Trade receivables increase, revenue increases − 13 000 − 13 000 31 Salaries increase, cash decreases − 9 000 − 9 000 Trade payables decrease, cash decreases Balances 307 200 206 200 101 000 Table 1.7 Statement of Financial Position of Jones’s Gym as at 31 March 20XX ASSETS Non-current assets 170 000 Property, plant and equipment 170 000 Current assets 137 200 Trade receivables 15 200 Cash and other cash equivalents 122 000 Total assets 307 200 © STADIO (Pty) Ltd Accounting 1 ACC152 20a 30 EQUITY AND LIABILITIES Capital 200 000 Retained profit 6 200 Total equity 206 200 Non-current liabilities 45 000 Long-term loan 45 000 Current liabilities 56 000 Trade and other payables 56 000 Total equity and liabilities 307 200 1.2.10 Measuring performance What about the financial performance of Jones’s Gym? The business commenced operations, so it should be possible to measure the extent of its success. Revenue and expenses affect equity, so it is this column (i.e. equity) to which we need to direct our attention in order to assess the performance of the business. There are two ways of doing this: 1. By comparing the opening and closing balances of equity in the equation. This would yield an increase of R206 200 (R206 200 − nil), suggesting that net income of this amount was earned. 2. By analysing the details in the equity column. There are six amounts in the column, namely: +R200 000, −R1 800, −R3 900, +R9 700, +R15 200, and −R13 000. Of these, only five affect the financial performance. These are revenues of R9 700 and R15 200, totalling R24 900, and expenses of R1 800, R3 900 and R13 000, totalling R18 700. By combining these five figures, net income of R6 200 (R24 900 − R18 700) is obtained. The difference between the total of the equity column and the net income for the month represents the owner’s capital contribution to the business, which is not part of net income. The details of the financial performance of the business can be set out in a Statement of Profit or Loss and Other Comprehensive Income as follows: © STADIO (Pty) Ltd Accounting 1 ACC152 20a 31  Table 1.8 Statement of Profit or Loss and Other Comprehensive Income of Jones’s Gym for the month ended 31 March 20XX Revenue R 24 900 Expenses −R 18 700 Net Profit R 6 200 Note Transactions other than revenue and expenses can affect equity. We have seen that contributions by owners increase equity. Conversely, cash or goods taken out of the business by the owner for personal use (i.e. drawings) will decrease equity. This situation can be summarised as follows: Contributions by the owner increase equity Drawings by the owner decrease equity Neither capital contributions nor drawings affect net income. 1.2.11 Recording periodic adjustments If J. Jones were to review the financial statements of Jones’s Gym at this stage, he might well ask questions such as: Has the decrease in the value of the gym equipment due to usage been accounted for? Has the interest due on the loan been accounted for? These questions relate to adjustments that may be required in order to accurately reflect the financial position and performance of a business. In order to examine such adjustments, we need to extend the example of Jones’s Gym. Additional information 1. The Jones’s Gym accountant decided that premises would not be depreciated, but that all equipment acquired should be depreciated at 20% per annum. 2. It is established that R940 of the R1 800 of consumables purchased on 10 March were still unused as at 31 March. 3. Interest on the loan has not yet been taken into account. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 32 Each of these adjustments derived from the additional information will now be discussed. Depreciation The equipment acquired on 4 March should be depreciated to reflect its approximate usage. As the equipment was acquired on 4 March, we can assume that it was in use for approximately one month. Depreciation should accordingly be provided for as follows: 20% × R65 000 × 1/12 = R1 083 Depreciation is an expense, so it will reduce equity. The other effect of the transaction is to show the equipment at a lower amount, so assets should be decreased. Note This concept will be discussed in greater detail in later topics. Consumables used The purchase of consumables costing R1 800 on 6 March was recorded as an expense. From the information provided, it is evident that consumables (costing R940) have not yet been used up. To continue reflecting R1 800 as an expense would be incorrect. To correct this, the unused amount (R940) should be deducted from expenses and shown as an asset. Expenses are now reduced, which has a positive effect on equity. Equity increases by R940, and assets increase by R940 (i.e. consumable stores on hand). Interest on the loan The business has had the use of the loan for about 24 days since 6 March 20XX, so a charge must be recorded to reflect this. This charge, ‘interest on loan’, is payable at 18% per annum. It might be argued that the interest should be recorded only when it is paid, but this is incorrect, because the use of the service (namely, the loan) took place in March. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 33  Interest on loan should be recorded, because it meets the definition of an expense incurred, even though it has not yet been paid. The amount to be recorded is: 18% × R45 000 × 24/365 = R533 (rounded off to the nearest Rand) Interest on loan is an expense, so it will reduce equity. The amount has yet to be paid, so it will increase liabilities (i.e. expense payable/accrued expense). The adjustments will now be recorded in the existing accounting equation as follows: Date Accounts affected Assets Equity Liabilities Mar 01 Cash increases, capital increases + 200 000 + 200 000 03 Premises increases, bank decreases + 105 000 −105 000 04 Equipment increases, trade payables + 65 000 + 65 000 increase 06 Cash increases, loan increases + 45 000 + 45 000 10 Consumables (expense) increase, − 1 800 − 1 800 cash decreases 12 Advertising increases, cash − 3 900 − 3 900 decreases 17 Cash increases, revenue increases + 9 700 +9 700 20 Trade receivables increase, revenue increases + 15 200 + 15 200 31 Salaries increase, cash decreases − 13 000 − 13 000 Trade payables decrease, cash − 9 000 − 9 000 decreases Depreciation expense increases, − 1 083 − 1 083 equipment decreases Consumable stores on hand + 940 + 940 increases, consumables decrease Interest on loan increases, expenses − 534 + 534 payable (accrued expenses) increase Balances 307 057 205 523 101 534 © STADIO (Pty) Ltd Accounting 1 ACC152 20a 34  Table 1.9 Statement of Financial Position of Jones’s Gym as at 31 March 20XX ASSETS Non-current assets 168 917 Property, plant and equipment 168 917 Current assets 138 140 Consumable stores on hand 940 Trade receivables 15 200 Cash and other cash equivalents 122 000 Total assets 307 057 EQUITY AND LIABILITIES Capital 200 000 Retained profit 5 523 Total equity 205 523 Non-current liabilities 45 000 Long-term loan 45 000 Current liabilities 56 534 Trade and other payables 56 000 Expenses payable/accrued expenses 534 Total equity and liabilities 307 057 Table 1.10 Statement of Profit or Loss and Other Comprehensive Income of Jones’s Gym for the month ended 31 March 20XX Revenue (9 700 + 15 200) R24 900 Expenses (3 900 + 13 000 + 1800 − 940 + 1 083 + 534) R19 377 Net profit for the month R 5 523 Activity For each of the following transactions, identify and write down the effect of the transaction on: 1. Owner’s equity © STADIO (Pty) Ltd Accounting 1 ACC152 20a 35 2. Assets 3. Liabilities. Transactions: a) An asset is disposed of at a profit. b) A debtor who owes R200 is declared insolvent. The debtor pays 50 cents in the Rand and the balance needs to be written off as irrecoverable. What is the effect on equity/assets/liabilities of the writing off of the debt? c) The Board of Directors declares an ordinary dividend of 20 cents per share. The dividend is yet to be paid by the end of the financial year. d) A vehicle was stolen and the insurance company did not pay out the claim. e) Interest is earned on a fixed deposit. f) A vehicle was stolen and the insurance company replaces the vehicle immediately. g) A fixed deposit matures and pays out to the company bank account. h) The company had an overdraft facility of R1m. The bank increased the facility to R1.5m. i) The company pays wages from the overdraft. j) The company lost a CCMA case and must pay the employee three months’ salary. You will need to understand and describe the accounting equation. This is the foundation and starting point for the recording process of accounting data. Assets = Owner’s Equity + Liabilities 1.2.12 Assessing the usefulness of financial statements Do the latest financial statements provide information that is useful to investors? The two statements still provide limited details about the financial position and performance of the business. An indication of the value of the investment of J. Jones can, however, be obtained from the Statement of Profit or Loss and Other Comprehensive Income. As J. Jones’s investment of R200 000 is the equity at the beginning of the period (month), an indication of the performance of his investment can be obtained by calculating the return on his equity. This is done as follows: © STADIO (Pty) Ltd Accounting 1 ACC152 20a 36 (Net income for the period/investment at beginning of period) × 100 For Jones’s Gym, this will be: (R5 523/R200 000) × 100 = 2.76% This represents the return on equity for one month, so J. Jones can multiply this figure by 12 to obtain an approximate annual return. This will yield an annual return on equity of 33%, which Jones can compare to the return he expected to earn from the business, given the particular risk level of Jones’s Gym. Note, however, that this return of 33% per annum is an approximation, as the business did not actually conduct business for a full month. This percentage assumes that the return on equity earned in March will be earned for the remainder of the financial year. Furthermore, return on equity, while indicative of the performance of a business, does not really give the owner an idea of the value of his investment. This can be determined only by assessing the future cash inflows and cash outflows of the business. 1.2.13 The bookkeeping process The starting point in bookkeeping is the transaction. Once the transaction has occurred, the recording of the transaction begins. This is then followed by the reporting of the financial results by means of financial statements. From an accounting point of view, all businesses consist of transactions. A transaction is a mutual transfer of value between two parties. As an example, let us assume you buy jeans from a clothing store. You give the clothing store a sum of money (e.g. R595) and the clothing store sells you the pair of jeans. There has been a ‘mutual transfer of value between two parties’, because you paid the store money and in return you received a pair of jeans. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 37 The following are examples of transactions incurred by a clothing retailer: A cash sale of goods A sale of goods on credit A payment received from a trade debtor The purchase of inventory on credit The purchase of inventory for cash A payment to a trade creditor The interest charged on its bank account The payment of expenses (e.g. salaries) The purchase of non-current assets. All the economic activities of the enterprise occur through transactions. These transactions are the starting point of the bookkeeping process. The bookkeeping process classifies, records, summarises and, finally, reports on the results of these transactions. In some businesses, the volume of transactions may be low (e.g. a business that rents out only one property), while another business may conduct a large number of transactions (e.g. Pick n Pay). A small business may use manual bookkeeping records, while a large business will rely on a computer-based bookkeeping system. In the end, the primary tasks of accounting (namely, classification, recording, summarising, and reporting) remain the same. Now that you understand that the supermarket, the hardware store, and the video store all apply the same accounting process, you will appreciate how a sound understanding of the fundamental aspects of the accounting process will enable you to understand all businesses better. Transactions = economic activities Transaction = mutual transfer of value between two parties Transaction = starting point of the bookkeeping process The stages of the bookkeeping process: 1. Classification 2. Recording 3. Summarisation 4. Reporting. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 38 Before continuing with this topic, please complete the following activity: Activity For each of the following transactions, write down whether it will be classified as an asset, a liability, capital, income, or an expense: 1. Bought a manufacturing plant for R80 000 on credit from a supplier 2. Sold goods for R45 000, cash 3. Paid R4 200 for water and electricity. The bookkeeping process always starts with a transaction. From the time that a transaction occurs, you need to understand how it is recorded in the books of a business, and the flow of this recording to the financial statements. 1.3 USERS OF FINANCIAL STATEMENTS 1.3.1 Introduction The following stakeholders have an interest in the financial statements and may want to analyse them by means of ratio analysis: The owner(s) The owner needs to determine the return made on the capital investment. The owner can compare the return with the returns available on alternative investments in the market. The owner would also want to understand the risk that the business is carrying in terms of debt. The Statement of Comprehensive Income ratios will assist the owner in better managing the business. Investors Investors are interested in the stability, liquidity and profitability of the firm. Investors will look for the best investment opportunities, so the ratio analysis will enable them to compare various businesses in order to make informed economic decisions. © STADIO (Pty) Ltd Accounting 1 ACC152 20a 39 Creditors and financiers Creditors and financiers are interested in the ability of the company to pay them back. Ratio analysis can provide the necessary information. By granting a loan to a business, the bank is actually making an investment on which a return in the form of interest is expected. The more financially stable the business is, the lower the risk that the bank will not receive its money. Employees Employees have an interest in the ability of the business to compensate them for their labour for as long as possible. Closely linked to employees are labour and trade unions that represent the employees. Before wage negotiations, labour and trade unions review the business’ financial results to gauge the entity’s ability to afford their demands and whether the pressures that management speak of are true. Customers Customers are interested in the company’s ability to continue trading. A firm may supply a customer with a key ingredient/component. Stability of supply is important