1 TOE407-V/001/2006

ZAC407-G/001/2006

SCHOOL OF APPLIED ACCOUNTANCY

HONS BCOMPT/CTA

TREKAL-S/000

Dear Student

Please find the following:

Examination papers with solutions to the Hons BCompt/CTA examination of October 2005 which you
can use for preparation to the Qualifying Examination.

We wish you all the best with the upcoming examination!

Yours sincerely

PROF KOBIE KLEYNHANS

DIRECTOR: SCHOOL OF APPLIED ACCOUNTANCY
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QUESTION PAPER

TOE407-V

APPLIED FINANCIAL
ACCOUNTING
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QUESTION 1 40 Marks

On 1 January 2004 Sabie Ltd had the following balances with regard to property, plant and
equipment:

Accumu-
lated de-
Cost preciation
R’000 R’000

Land (two plots, cost: A: R150; B: R300) 450 -

Buildings (two buildings, cost: A: R2 000; B: R4 000) 6 000 600
Plant 4 000 1 600

All the above assets were acquired when Sabie Ltd was formed on 1 January 2002. Buildings and
plant are depreciated on the straight-line basis over 20 and 5 years respectively and carried at cost
less accumulated depreciation. Residual values are zero.

On 31 March 2004 building A was evacuated by Sabie Ltd and rented to Skukuza Ltd, one of
Sabie Ltd’s subsidiaries. The fair value of this land and building was determined at R250 000 and
R2 500 000 respectively.

On 30 June 2004 a machine, which is an integral part of the above plant, was destroyed by a fire
and replaced with a similar one for R800 000. The directors estimated the cost of the original
machine at R700 000. An insurance claim of R210 000 was received to cover some of the costs
incurred.

During the 2004 financial year political unrest in the vicinity of property B caused market values of
properties to drop sharply. On 31 December 2004 the value in use and the fair value less cost to
sell of property B were R2 000 000 and R2 400 000 respectively. It was estimated that the value of
the land is 10% of the total property.

Land and building on property A had the following fair values at 31 December 2004:

Land : R300 000

Building : R2 700 000

Sabie Ltd elected to use the fair value model for investment properties.

Ignore all tax implications.

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REQUIRED

Marks
(a) Prepare the following notes to the financial statements of Sabie Ltd for the year
ended 31 December 2004 in accordance with Statements of Generally Accepted
Accounting Practice:
• Property, plant and equipment
• Profit before tax 29
(b) Show the movements between the opening and closing balances of property, plant
and equipment (land and buildings only) for 2005 if the conditions which caused the
impairment of property B normalised by 31 December 2005. The fair values at that
date were R400 000 for the land and R5 000 000 for buildings. 6
(c) Discuss, with amounts, how property A will be reflected in the consolidated financial
statements of Sabie Ltd and its subsidiaries for the year ended 31 December 2004
if it is the policy of the group to disclose property, plant and equipment at cost less
accumulated depreciation as well as for the case where it is the policy of the group
to revalue property, plant and equipment. Your answer should be in accordance
with Statements of Generally Accepted Accounting Practice. 5
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QUESTION 2 45 Marks

The financial statements of Ivory Ltd, Crystal Ltd and Sapphire Ltd are as follows:

BALANCE SHEETS AS AT 31 DECEMBER 2005

Ivory Crystal Sapphire

Ltd Ltd Ltd
R R R
ASSETS
Non-current assets 2 994 000 995 000 100 000
Land at cost 100 000 100 000 100 000
Factory buildings at carrying amount 1 000 000 400 000 -
Machinery
Cost 1 600 000 1 000 000 -
Accumulated depreciation (806 000) (550 000) -
Investment in Crystal Ltd 1 000 000 - -
Investment in Sapphire Ltd - 45 000 -
Current account: Crystal Ltd 100 000 - -
Current assets 3 395 000 2 924 000 270 000
Inventories 1 250 000 1 000 000 100 000
Receivables 650 000 850 000 150 000
Bank 1 495 000 1 074 000 20 000

6 389 000 3 919 000 370 000

EQUITY AND LIABILITIES

Capital and reserves 3 835 000 2 156 000 300 000
Ordinary share capital (R1 shares) 1 400 000 800 000 100 000
Share premium 400 000 300 000 -
Non-distributable reserve 300 000 - -
Retained earnings 1 000 000 700 000 150 000
General reserve 735 000 356 000 50 000
Non-current liabilities 1 840 000 1 441 000 15 000
Long-term liability 1 700 000 1 200 000 10 000
Deferred tax 140 000 141 000 5 000
Current account: Ivory Ltd - 100 000 -
Current liabilities 714 000 322 000 55 000
Payables 564 000 222 000 45 000
Taxation payable 150 000 100 000 10 000

6 389 000 3 919 000 370 000

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INCOME STATEMENTS FOR THE YEAR ENDED 31 DECEMBER 2005

Ivory Crystal Sapphire

Ltd Ltd Ltd
R R R
Revenue 800 000 560 000 300 000
Cost of sales (190 000) (140 000) (150 000)
Gross profit 610 000 420 000 150 000
Other operating expenses (50 000) (30 000) (30 000)
Profit before tax 560 000 390 000 120 000
Income tax expense (140 000) (110 000) (60 000)
Profit for the period 420 000 280 000 60 000

EXTRACT FROM STATEMENTS OF CHANGES IN EQUITY FOR THE YEAR ENDED

31 DECEMBER 2005

Retained earnings Ivory Crystal Sapphire

Ltd Ltd Ltd
R R R
Balance on 31 December 2004 650 000 450 000 100 000
Profit for the period 420 000 280 000 60 000
Transfer to general reserve (20 000) (10 000) (5 000)
Dividend paid (30 June) (50 000) (20 000) (5 000)
Balance on 31 December 2005 1 000 000 700 000 150 000

Additional information

1. On 1 January 2003 Ivory Ltd acquired an 80% interest in Crystal Ltd, when the general reserve
and retained earnings of Crystal Ltd amounted to R150 000 and R350 000 respectively.

At date of acquisition Ivory Ltd valued certain factory buildings of Crystal Ltd with a carrying
amount of R150 000 at R250 000. The valuation was not taken up in the books of Crystal Ltd
and all other fixed property was deemed to be fairly valued. The remaining useful life remained
at 10 years.

At date of acquisition Ivory Ltd placed a value that is R20 000 lower than carrying amount on
the inventories of Crystal Ltd.

2. Crystal Ltd acquired its 90% interest in Sapphire Ltd on 1 January 2002 when the general
reserve and retained earnings of Sapphire Ltd amounted to R10 000 and R25 000 respectively.
On 1 January 2003 the general reserve and retained earnings of Sapphire Ltd amounted to
R15 000 and R30 000 respectively.

3. Ivory Ltd purchases all its inventories from Crystal Ltd. The latter makes a profit of 10% on the
selling price of the inventories. Ivory Ltd’s inventories on 31 December 2004 amount to
R1 200 000. The total sales of Crystal Ltd to Ivory Ltd for the year ended 31 December 2005
amount to R200 000. The inventories of Ivory Ltd are very slow-moving, but are not perishable
or subject to obsolescence.

4. Crystal Ltd has inventories on hand to the value of R20 000, purchased from Sapphire Ltd at
cost plus 25%, on 31 December 2005 (31 December 2004: R15 000). Total sales of
Sapphire Ltd to Crystal Ltd for the year ended 31 December 2005 amount to R50 000.
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5. The net realisable value of the inventories of Ivory Ltd and Crystal Ltd on 31 December 2005
amount to R1 240 000 and R1 050 000 respectively.

6. On 1 January 2005 Ivory Ltd sold machinery with a cost of R45 000 to Crystal Ltd for R55 000.
Crystal Ltd provides depreciation on machinery at 20% per annum on cost. The machinery
represented inventories in the hands of Ivory Ltd. Crystal Ltd does not use the machinery in the
production of inventories.

7. On 31 December 2005 Crystal Ltd declared a dividend of R100 000. Ivory Ltd declared a
R20 000 dividend on 31 December 2005. The dividends have not yet been accounted for in
their records.

8. The following items are included in the other operating expenses of Ivory Ltd:

Interest received from Crystal Ltd - R2 000

Rental received from Crystal Ltd - R1 500

9. The dividends received from the subsidiaries are included in other operating expenses.

10. Assume a tax rate of 29%.

11. Investments in subsidiaries are accounted for at cost in the separate financial statements of
the respective companies.

12. Assume that Ivory Ltd has always applied IFRS3 in the preparation of its consolidated financial
statements.

REQUIRED

Marks
(a) Prepare the consolidated income statement of Ivory Ltd and subsidiaries for the year
ended 31 December 2005. 35
Please note:
• The format of the financial statements must meet the requirements of
Statements of GAAP.
• Comparative figures and notes to the financial statements are not required.
(b) Calculate the amounts of the following items in the consolidated balance sheet as at
31 December 2005:
(i) Factory buildings 4
(ii) Inventory 6
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QUESTION 3 45 Marks

The management of Twintop Ltd is uncertain about the application of IAS 39 (AC 133): Financial
instruments: recognition and measurement. The following abridged financial statements have been
prepared for the year ended 31 July 2005, but need to be corrected in the light of the information
below:

INCOME STATEMENT

R
Operating profit 900 000
Finance cost (100 000)
Profit before tax 800 000
Income tax expense (320 000)
Profit for the period 480 000

STATEMENT OF CHANGES IN EQUITY

Ordinary Preference Retained

shares shares earnings
R R R

Balance at the beginning of the year 200 000 - 450 000

Shares issued - 250 000 -
Profit for the period 480 000
Dividends declared
- Ordinary shares (100 000)
- Preference shares (25 000)
200 000 250 000 805 000

BALANCE SHEET

R
Property, plant and equipment 900 000
Intangible assets 650 000
Investment in shares 300 000
Current assets 200 000
2 050 000

Ordinary shares 200 000

Preference shares 250 000
Retained earnings 805 000
Shareholders’ interest 1 255 000
Deferred tax 150 000
Debentures 300 000
Long-term loans 200 000
Current liabilities 145 000
2 050 000
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The following additional information was provided in respect of the statements:

1. INVESTMENT IN SHARES

The investment in shares is carried at cost. The cost of the shares was R300 000. The fair
value of the shares on 31 July 2005 was R450 000 and on 31 July 2004 R340 000. These
shares were purchased to hold as a long-term investment, and was classified as available for
sale.

2. PREFERENCE SHARES

On 1 August 2004, preference shares of R250 000 were issued at par. The preference shares
consist of 125 000 shares of R2 each with a dividend of 10% per year payable at the end of
the financial year. The preference shares are redeemable on 31 July 2008 at a premium of
10%.

3. DEBENTURES

The debentures were also issued on 1 August 2004 at a premium of 10%. The debentures
consist of 100 000 debentures of R3,00 each. The interest rate of the debentures is 12% p.a.
and is paid annually at the end of the financial year. The debentures are redeemable on
31 July 2007 at the nominal value. In terms of the contract, the debenture holders have the
option to convert the debentures into shares at any point in time. 50 Shares of R1 each shall
be issued for each debenture.

A market-related interest rate is 15% and the market value of Twintop Ltd’s shares is R5,00
per share.

4. LONG-TERM LOANS

Included in long-term loans is an amount of R100 000 relating to a foreign loan. On 1 January
2005 a loan of $10 000 was obtained when the exchange rate was $1 = R10. 10% of the
original amount of the loan is repayable annually from 1 February 2006. On 1 April 2005 the
company took out a 10 month forward exchange contract (FEC) to hedge the first instalment of
the loan against fluctuations in the exchange rate. The FEC of $1 000 was taken out at a
forward rate of $1 = R10,50. The relevant exchange rates were as follows:

At 1 April 2005

• Spot rate $1 = R10,13

At 31 July 2005

• Market-related exchange rate for a 6 month FEC $1 = R11,40

• Spot rate $1 = R11,00

Except for the original loan, the transactions in connection with the loan and FEC have not yet
been provided for at 31 July 2005. Interest implications relating to the loan may be ignored.

Assume hedging criteria are met.

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5. SPECULATIVE FUTURES

On 1 March 2005 the company purchased 100 share contracts on SAFEX for speculative
purposes when the market index for this type of future was 232. Transaction cost of R200 was
paid. A margin deposit of R10 000 was paid. A movement of one point in the index is worth
R10 per contract. The net creditor in connection with the contract, which is deducted from
current assets, is calculated as follows:

R
• Increase in the index until 30 June 2005 received in cash 20 000
• Less: Transaction costs (200)
• Less: Margin deposit paid (10 000)
9 800

On 31 July 2005 the index had increased by a further nine points.

6. TAX ISSUES

Assume that the current tax rate is 29% and the secondary tax rate is 12,5%. Current tax and
secondary tax on companies has been correctly provided for in the calculated profit.

Current tax and capital gains tax (where applicable) must be adjusted for each adjustment.
You can assume that the following tax rules are applicable:

• No adjustment in connection with secondary tax on companies must be made. For

taxation purposes a dividend remains a dividend.
• The accounting treatment of debentures will be accepted by the South African Revenue
Services.
• Section 24I of the Income Tax Act is applicable to exchange rate differences.
• The accounting treatment of futures is also accepted by the South African Revenue
Services.

REQUIRED

Marks
IN TERMS OF IAS 32 (AC 125) AND IAS 39 (AC 133) (FINANCIAL INSTRUMENTS)

(a) Provide the journals (including the tax journal) for the correction of the investment in
shares. 5
(b) Calculate the correct balance of the preference shares in the balance sheet on
31 July 2005. 4
(c) Calculate the correct balance of the debentures (liability component) in the balance
sheet on 31 July 2005. Assume that when splitting the liability and equity
component, the liability component is calculated first. 6
(d) Calculate the adjusted profit before tax for the year ended 31 July 2005. 7
(e) Calculate the adjusted tax expense for the year ended 31 July 2005. 5
(f) Prepare the adjusted balance sheet of Twintop Ltd on 31 July 2005. 18
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QUESTION 4 30 Marks

PART A 20 Marks

Household Enterprises Ltd, a listed company, is involved in the development and marketing of
household products on a regular basis.

The development of Duststar, an exiting new product was finalised during August 2003. Duststar
complied with all the criteria of asset recognition in respect of this development cost. By
31 August 2003 an amount of R8 000 000 was capitalised as an asset. Commercial production of
Duststar commenced during September 2003. The net profit per unit, amounted to R1,02, before
amortisation of development cost.

The board of directors estimated that 20 million units of Duststar will be sold over a five year period.

3,5 Million units were manufactured and sold for the year between 1 September 2003 and
31 August 2004. 4,2 Million units were manufactured and sold for the year ending 31 August 2005.

When preparing the financial statements for the year ended 31 August 2005, there were indications
that the carrying amount of the development cost of Duststar impaired materially. A competitor
introduced a similar product to the market at a significantly lower price. Duststar is still the better
product, but Household Enterprises Ltd was forced to lower the sales price. At 31 August 2005 new
calculations and estimates showed that the net profit, before the amortisation of development costs,
amounted to R0,28 per unit.

The cost of capital (17%) of Household Enterprises Ltd was used as the discount rate to calculate
the estimated profit per unit.

During the current year the company incurred research and development costs on two other
products. An extract from the financial information showed the following:

Supapot Shopcalc General

R R R
Research costs 323 000 257 000 60 000
Development costs:
Direct salaries (direct labour cost) 462 000 308 000 -
Direct material and services 209 000 154 000 -
General administration costs 110 000 77 000 220 000
Laboratory costs - - 154 000
Water and electricity - - 66 000

The development of both Supapot and Shopcalc commenced during April 2005. Shopcalc is a
revolutionary product, which could benefit every housewife. Financial sources to develop Shopcalc
are limited and certain technical adjustments must still be done to the product. Investors and
potential buyers of Shopcalc have their doubts regarding the viability of the product.

Apart from the above, both Supapot and Shopcalc comply with the criteria for asset recognition
regarding these development costs. Management is optimistic that Shopcalc will beat all
expectations and wants to capitalise the costs as an asset. The abovementioned products were
both in a development phase at year-end.

Laboratory costs and 40% of the water and electricity are allocated to the two products on the basis
of direct labour. (Ignore leave and bonus payments.)
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The tax rate is 29%.

Assume that all amounts are material.

Amortisation of intangible assets is calculated based on units sold as a percentage of total estimated
units.

REQUIRED

Marks
Disclose the above information in the intangible assets note (including information
regarding impairment) to the financial statements of Household Enterprises Ltd for the
year ended 31 August 2005. Ignore comparative figures. 20
Your answer must comply with Statements of Generally Accepted Accounting Practice.

PART B 10 Marks

The accountant of Data Ltd approached you to assist him with the note to the financial statements
for the year ended 31 December 2005, in respect of the post-employment benefit asset/liability.

He provides you with the following information:

R
Present value of obligation 31/12/2005 300 000
Fair value of plan assets 31/12/2005 400 000
Unrecognised actuarial losses 31/12/2005 250 000
Present value of contribution holiday (31/12/2004: R10 000) 31/12/2005 25 000
Unrecognised past service cost (the total past service cost was
R80 000 of which R30 000 was recognised as an expense during
the current year). 31/12/2005 50 000
The net gain on plan-asset and liabilities for the year ended
31/12/2005 was 150 000
The expected average remaining working lives of employees (years) 15

On 1 January 2005 the net cumulative unrecognised actuarial losses amounted to R420 000. It is
the policy of the company to recognise the minimum actuarial gain/losses according to the provi -
sions of IAS 19 (AC 116).92 and .93.

REQUIRED

Marks
Prepare the note as required by the accountant. 10

©
UNISA 2005
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SOLUTION

TOE407-V

APPLIED FINANCIAL
ACCOUNTING
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TOE407-V

QUESTION 1

(a) NOTES
Property, plant and equipment Land Buildings Plant Total Marks
R’000 R’000 R’000 R’000
Cost 450 6 000 4 000 10 450
Accumulated depreciation - (600) (1 600) (2 200)
Carrying amount 31 December 2003 450 5 400 2 400 8 250 1

Revaluation [W1] 100 725 - 825 4

Impairment loss [W2] (60) (1 240) (350) (1 650) 4
Additions - - 800 800 1
Transfer to investment properties (250) (2 500) - (2 750) 2
Depreciation - (225) (810) (1 035) 3
Carrying amount 31 December 2004 240 2 160 2 040 4 440
Cost 300 4 000 4 100 8 400 3
Accumulated depreciation and
impairment losses (60) (1 840) (2 060) (3 960) 3

Profit before tax

R’000
Included in the profit before tax are the following:
Income
Proceeds from insurance 210 2
Gain on fair value adjustment on investment property
(300 + 2 700 – 2 750) 250 2
Expenses
Impairment losses (1 650)
Machine destroyed by fire (350) 1½
Land and buildings: Adverse economic climate (1 300) 1½
Depreciation 1 035 1
29

WORKINGS

W1. Land and building transferred to investment property (A)

Land Building
Carrying amount 150 1 775a
Fair value 250 2 500
Revaluation 100 725
a
2 000 – (2 000/6 000 x 600) – (2 000/20 x 3/12) = 1 775

W2. Machine destroyed

Cost 700
Depreciation
2002 – 2003 (700/5 x 2) (280)
2004 (700/5 x 6/12) (70)
Carrying amount 30 June 2004 350
Impairment loss (350 – 0 = 350)
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Property B – Impairment loss

Land Building
Carrying amount 300 3 400a
b
Recoverable amount (2 400) 240 2 160c
Impairment loss 60 1 240
a
4 000 – (4 000/6 000 x 600) – (4 000/20) = 3 400
b
2 400 x 10%
c
2 400 x 90%

W3. Depreciation

Buildings
A: 2 000/20 x 3/12 25
B: 4 000/20 200
225

Plant
Machine destroyed [W2] 70
New machine (800/5 x 6/12) 80
Rest ((4 000 – 700)/5) 660
810

W4. Reversal of impairment loss

Land Building
Carrying amount (2 160 – 127) 240 2 033
Recoverable amount (400 and 5 000) limited to 300 3 200a
60 1 167
a
4 000 – (4 000/20 x 4) = 3 200

(b) Property, plant and equipment

Land Buildings Marks

R’000 R’000
Cost at 31 December 2004 300 4 000
Accumulated depreciation and impairment losses (60) (1 840)
Carrying amount 31 December 2004 240 2 160

Depreciation (2 160/17) - (127) 2

Reversal of impairment loss [W4] 60 1 167 3
Carrying amount 31 December 2005 300 3 200 1
Cost at 31 December 2005 300 4 000
Accumulated depreciation - (800)
6
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(c) Property A would have been reflected at cost less depreciation as property, plant and
equipment

The cost will be reflected at R150 000 and R2 000 000 respectively for land and
buildings.
The accumulated depreciation on Buildings would be R300 000.
The carrying amount of property A will be R150 000 for land and R1 700 000 for
buildings. 2

If revalued: Land Buildings

R’000 R’000
Carrying amount at 31 March 2004 250 2 500
Depreciation - (105)
Revaluation 50 350 3
Carrying amount (end of year) 300 2 700
40
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QUESTION 2 - Suggested answer

(a) IVORY LTD AND SUBSIDIARIES

CONSOLIDATED INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20.8

R Marks

Income (800 000 + 560 000 + 300 000 - 200 000(a) - 50 000(a) -
55 000(b)) 1 355 000 4
Cost of sales (190 000 + 140 0000 + 150 000 - 200 000(a) - 50 000(a) -
45 000(b) - 120 000(c) + 115 000(d) + 10 000(NRV) - 3 000(f) +
4 000(g)) (191 000) 9
Gross profit 1 164 000
Other operating expenses
(50 000 + 30 000 + 30 000 + 16 000(div) + 4 500(div) - 2 000(e) +
10 000(h)) (138 500) 6
Profit before tax 1 025 500
Income tax expense (140 000 + 110 000 + 60 000 + 34 800(c) -
33 350(d) - 2 900(NRV) - 2 900(b) + 580(e) + 870(f) - 1 160(g) -
2 900(h)) (303 040) 9
Profit for the period 722 460

Attributable to:
Equity holders of the parent 650 569
Minority interest (5 929 + 55 290 + 10 672) 71 891 7
722 460

a = Inter-group sales
b = Unrealised profit in machinery (Ivory Ltd)
c = Unrealised profit in opening inventories (Crystal Ltd)
d = Unrealised profit in closing inventories (Crystal Ltd)
e = Depreciation on inter-company transaction in respect of machinery (Ivory Ltd)
f = Unrealised profit in opening inventories (Sapphire Ltd)
g = Unrealised profit in closing inventories (Sapphire Ltd)
h = Additional depreciation on increase in value of factory buildings

(b) (i) FACTORY BUILDINGS

1 000 000 + 400 000 – (10 000 X 3) + 100 000 = 1 470 000 4

(ii) INVENTORY

1 250 000 + 1 000 000 + 100 000 – 10 000 – 115 000 – 4 000 = 2 221 000 6
45
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WORKINGS

W1. Unrealised profit in inventories (Crystal Ltd)

The closing inventories of Ivory Ltd must be written down to the net realisable value of
R1 240 000 in the records of Ivory Ltd.

Opening inventories = 1 200 000 x 10/100 = 120 000 - 34 800(tax) = 85 200

Closing inventories = 1 250 000 x 90/100 = 1 125 000 - 1 240 000 = 115 000 - 33 350(tax)
= 81 650
OR = 1 250 000 x 10/100 - (1 250 000 - 1 240 000) = 115 000 - 33 350(tax)
= 81 650

W2. Unrealised profit in inventories (Sapphire Ltd)

Opening inventories = 15 000 x 25/125 = 3 000 - 870(tax) = 2 130

Closing inventories = 20 000 x 25/125 = 4 000 - 1 160(tax) = 2 840

W3. Unrealised profit in machinery (Ivory Ltd)

Unrealised profit = 55 000 - 45 000 = 10 000 - 2 900(tax) = 7 100

Additional depreciation = 10 000 x 20% = 2 000 - 580(tax) = 1 420
Deferred tax (31/12/20.8) = 2 900 - 580 = 2 320

W4. Analysis of the shareholders’ interest of Sapphire Ltd

Crystal Ltd (90%)

Total At Since Minority
interest
i At acquisition
Share capital 100 000
General reserve 15 000
Retained earnings 30 000
145 000 130 500 14 500
Investment in Sapphire Ltd (45 000)
Negative goodwill 85 500

ii Since acquisition
• To beginning of current year:
General reserve (3) 30 000 27 000 3 000
Retained earnings (1) 67 870 61 083 6 787
• Current year:
Profit after tax (2) 59 290 53 361 5 929
Transfer to general reserve (5 000) (4 500) (500)
General reserve 5 000 4 500 500
Dividend paid (5 000) (4 500) (500)
297 160 136 944 29 716

(1) 70 000 - 2 130 (unr profit inventories) = 67 870

(2) 60 000 + 2 130 (unr profit opening inventories) - 2 840 (unr profit closing inventories)
= 59 290
(3) 50 000 - 5 000 - 15 000 = 30 000
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W5. Analysis of shareholders’ interest of Crystal Ltd

Ivory Ltd (80%)

Total At Since Minority
interest
i At acquisition
Share capital 800 000
Share premium 300 000
Revaluation reserve (1) 71 000
Negative goodwill –
Sapphire Ltd 85 500
General reserve 150 000
Retained earnings (2) 335 800
1 742 300 1 393 840 348 460
Investment in Crystal Ltd (1 000 000)
Negative goodwill 393 840

ii Since acquisition
• To beginning of current
year:
General reserve (3) 223 000 178 400 44 600
Retained earnings –
Crystal Ltd (4) 14 800 11 840 2 960
Retained earnings –
Sapphire Ltd 61 083 48 867 12 216
• Current year:
Profit after tax –
Crystal Ltd (5) 276 450 221 160 55 290
Profit after tax –
Sapphire Ltd 53 361 42 689 10 672
Transfer to general
reserve (14 500) (11 600) (2 900)
General reserve (6) 14 500 11 600 2 900
Dividend paid (20 000) (16 000) (4 000)
Dividend declared (100 000) (80 000) (20 000)
2 250 994 RE 216 956 450 198
GR 190 000

(1) (250 000 - 150 000) x 71% = 71 000 and depreciation is 100 000/10 = R10 000 per
annum
(2) 350 000 – (20 000 x 71%) (inventories) = 335 800
(3) 356 000 - 150 000 - 10 000 = 196 000(J) + 27 000(T) = 223 000
(4) (450 000 - 350 000) + 14 200(inventories) - 85 200(unr profit opening inventories) -
(10 000 x 71% x 2) (add depr) = 14 800
(5) 280 000 + 85 200(unr profit opening inventories) – 81 650 (unr profit closing inventories) -
7 100 (depreciation) = 276 450
(6) 10 000(J) + 4 500(T) = 14 500
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QUESTION 3 - Suggested solution

(a) Investment in shares

Marks
Investment in shares (450 000 - 300 000) 150 000
Equity (450 000 - 340 000) 150 000 3
Provide fair value adjustment
Equity 21 750
Deferred tax (450 000 - 300 000) x 29% x 50% 21 750 2
Provide capital gains tax above R370 000
5

(b) Preference shares (classified as liability)

Cash flows
1 August 2004 250 000
31 July 2005 (25 000)
31 July 2006 (25 000)
31 July 2007 (25 000)
31 July 2008 (25 000)
31 July 2008 (275 000)

Internal interest rate 12,0896% 2

Balance 1 August 2004 250 000

Interest charged 12,0896% 30 224
Payment (25 000)
255 224 2
4

(c) The liability component is the present value of the debenture payments.

Present value of debenture:

• Interest of R36 000 over 3 years at 15% 82 196 2

• Capital of R300 000 after 3 years at 15% 197 255 2
279 451

Balance:
Value 1 August 2004 279 451 1
Interest at 15% 41 918 1
Payment (36 000)
285 369
6
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Marks
(d) Profit before tax 800 000
Interest on preference shares (30 224) 1
Debentures’ interest (41 918 – 36 000) (5 918) 1
Foreign exchange difference on loan ($10 000 x (R11,00 – R10,00) (10 000) 1
Foreign exchange contract ($1 000 x (11,00 – 10,13)) 870 1
Finance charges on FEC ($10 000 x (,37 - ,40)) 30
Increase in index until 30 June 20 000 1
Transaction costs (200) 1
Increase in index on 31 July (100 x 9 x R10) 9 000 1
783 558
7

(e) Tax expense 320 000

Preference shares (permanent difference) (dividends) - 1
Debentures (5 918 x 29%) (1 716) 1
Exchange rate (10 000 x 29%) (2 900) 1
FEC (900 x 29%) 261 1
Forward contract (29 000 – 200) x 29% 8 352 1
323 997
5

(f) BALANCE SHEET

Property, plant and equipment 900 000 1

Intangible assets 650 000 1
Other investments 450 000 1
Current assets (200 000 + 20 000 – 200 + 9 000 + 900) 229 700 2
2 229 700

Ordinary shares 200 000 1

Available for sale surplus (150 000 – 21 750) 128 250 1
Debenture option (300 000 – 279 451) 20 549 1
Retained earnings (450 000 + 783 558 (d) – 323 997 (e)
– 100 000 Div) 809 561 4
1 158 360
Deferred tax (150 000 + 21 750 (a)) 171 750 1
Debentures (c) 285 369 1
Preference shares 255 224 1
Long-term loans (200 000 + 10 000) 210 000 1
Current liabilities (145 000 – 1 716 (e) – 2 900 + 261 + 8 352) 148 997 4
2 229 700
20
Maximum 18
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QUESTION 4 - Suggested answer

PART A

3. Intangible assets (internally generated)

Capitalised development costs

Duststar Supapo Marks
t
Carrying amount of un-amortised development cost at
beginning of year 6 600 000 -
Gross amount 8 000 000 - ½
Accumulated amortisation 1 400 000 - 1
Capitalised during the year [W1] - 779 240 3
Amortised during current year (1 680 000) - 1
Impairment in current year [W3] (1 476 000) - 4
Un-amortised carrying amount at the end of the year 3 444 000 779 240
Gross amount [W1] 8 000 000 779 240 3½
Accumulated amortization and impairment losses 4 556 000 - 1

The development cost of Duststar is systematically amortised over its expected

benefits of 20 million units. The expected remaining units are 12 300. 1

The selling price of Duststar was decreased as a result of a significant decrease in

the selling price of similar products. 1

Consequently, the carrying amount of the development cost of Duststar decreased

in value. 1

The impairment loss calculated amounts to R 1 476 000.

The recoverable amount of the development cost of Duststar was determined by

calculating the value in use, using a discount rate of 17%. 2

Supapot is still in a developing phase. 1

20

WORKINGS

W1. Allocation of development cost

Supapot
Direct salaries 462 000 ½
Direct material and services 209 000 ½
General administration cost - ½
Laboratory cost (154 000 x 462/770) 92 400 ½
Water and electricity (66 000 x 40% x 462/770) 15 840 1
Capitalise 779 240
3
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W2. Allocation of development cost

Shopcalc (not required)

Direct salaries 308 000

Direct material and services 154 000
General administration cost -
Laboratory cost (154 000 x 308/770) 61 600
Water and electricity (66 000 x 40% x 308/770) 10 560
To be written off 534 160

W3. Duststar (not required)

Development cost capitalized 8 000 000

Potential sales: units 20 000 000
Development cost per unit 40 cents
Amortised 2004 (3 500 000 x 40c) 1 400 000
2005 (4 200 000 x 40c) 1 680 000
Estimated potential net profit before development cost
[(20 000 000 – (3 500 000 + 4 200 000)) x 28c] 3 444 000
Carrying amount of development cost at 31 August 2005
(8 000 000 – 1 400 000 – 1 680 000) 4 920 000
Impairment loss 1 476 000

PART B

Post employment benefit asset R

Present value of obligation (300 000) 1

Fair value of plan assets 400 000 1
Unrecognised actuarial losses 250 000 1
Unrecognised past service cost 50 000 1
Unrecognised post-employment benefit asset
(R400 000[W1] – (325 000 [W2]] + 55 000 [W3]) (20 000) 6
380 000

Proof: PV of contribution holidays 25 000

Net cumulative unrecognised actuarial losses 250 000
Actuarial gain recognised 55 000
Unrecognised past service cost 50 000
380 000
10

WORKINGS

W1. Post employment benefit asset at end of 2003: according to par .55

Present value of obligation (300 000) ½

Present value of plan assets 400 000 ½
Unrecognised actuarial losses 250 000 ½
Unrecognised past service costs 50 000 ½
400 000
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W2. According to par .59(b)

Present value of contribution holiday 25 000 ½

Net unrecognised actuarial losses 31/12/2003 250 000 ½
Unrecognised past service costs 50 000 ½
325 000

W3. According to par .59 the post-employment benefit asset should be the lower of [W1]
and [W2] therefore R325 000. As par .59(b) is applicable the provision of par .59A
should be taken into account, and more specifically par .59A(b), as net actuarial gains
originated during the period. 1

Application of par .59A(b)

Net actuarial gain for the period 150 000 ½

Past service cost (80 000) ½
Net actuarial gain after deduction of past service costs 70 000
Increase in contribution holiday (25 000 – 10 000) 15 000 ½
Gain to be recognised immediately 55 000
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QUESTION PAPER

TOE408-W

APPLIED MANAGEMENT
ACCOUNTING
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QUESTION 1 40 marks

Better Building Industries Limited manufactures two products which are used in the construction
industry. The company uses an absorption costing system for recording purposes and its year-end
is 31 August.

The two products manufactured by the company are known as the Busy Brush and the Glide Roller.
The following is the unit cost structure per product:
Brush Roller
R R
Direct material 4 6
Direct labour 2 4
Variable overheads 2 4
Fixed overheads 12 8
Total cost 20 22

Average monthly production 8 000 units 15 000 units

Average production over a six month period 48 000 units 90 000 units

Fixed overheads are absorbed into production using the average monthly production as the
allocation basis and any volume variances are written of to the income statement in the month that
they occur.

At a board meeting after the completion of the first half of the financial year the budgeted income
statement for the six months ending on 31 August 2006 were presented for consideration. Results
in the statements indicated an expected profit for Brushes of R304 000 and for Rollers of R410 000.
The budgeted Income Statement for the six months ending on 31 August 2006 is set out as follows:

Brush Roller
Budgeted sales quantity 48 000 units 85 000 units
Budgeted production quantity 40 000 units 90 000 units
R R
Budgeted sales revenue 1 440 000 2 380 000
Budgeted manufacturing costs 960 000 1 870 000
Direct material 160 000 540 000
Direct labour 80 000 360 000
Variable overheads 80 000 360 000
Fixed overheads 480 000 720 000
800 000 1 980 000
Add: Finished products
Inventory on 1 March 2006
(12 000 units) 240 000
( 5 000 units) _________ 110 000
1 040 000 2 090 000
Less: Budgeted finished products
Inventory 31 August 2006
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( 4 000 units) (80 000)

(10 000 units) (220 000)
Budgeted manufacturing profit 480 000 510 000
Under-recovered overhead (96 000) -
Administration costs (fixed) (80 000) (100 000)
Budgeted profit 304 000 410 000

The above statement was received with great skepticism as past experience indicated that Brushes
were always more profitable than Rollers.

The sales director points out that the proposed sales plan for the second half of the year is identical
to that of the first half which showed a budgeted profit of R400 000 for Brushes and R314 000 for
Rollers. Actual results for the first half of the year to date are also in line with the accepted budget
for the period ending 28 February 2006.

The production director emphasizes that identical assumptions as to the unit variable costs, selling
prices and manufacturing efficiency underlie both budgets, but that a change in the budgeted
production pattern is planned.

Budgeted production Brush Roller

1st half of the year to 28 February 2006 48 000 units 78 000 units
2nd half of the year to 31 August 2006 40 000 units 90 000 units

The production director urges that the company’s budgeting procedures be overhauled as he can
see no reason why the net profit for Brushes should fall from R8,33 to R6,33 per unit sold, whereas
for Rollers it should rise from R3,69 to R4,82 per unit.

REQUIRED Marks

(a) Determine the opening inventory for the six month period ended 28 February 2006
and reconstruct the company’s budget for the first half of the financial year ended 28
February 2006 in a manner that is consistent with the half-year budget ending 31
August 2006 as shown above. 15

(b) Restate the budget for Both Brushes and Rollers for the six-month period ending
31 August 2006 in a manner that will show the results of the company’s performance
more meaningfully. 8
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(c) Briefly explain why the method adopted by you in part (b) of this question is preferred
by management accountants for budgeting purposes, in comparison to the method
used by the management of Better Building Industries Limited. 3

(d) Labour is increasingly being seen as a fixed cost for companies in South Africa.
Assuming that this is true for Better Building Industries Limited as well, calculate the
break-even point for the company as a whole for the budgeted six-month period
ending 31 August 2006. You may assume for purposes of the calculation that the
budgeted sales levels represent the normal sales mix for the company. 5

(e) The managing director has read an article on Black Economic Empowerment (BEE)
on the Internet (found at www.naacam.co.za), and noted the following two
paragraphs:

“The Black Economic Empowerment strategy is a necessary government intervention

to address the systematic exclusion of the majority of South Africans from full
participation in the economy.”

“Government will use a ‘balanced scorecard’ to measure progress made in achieving

BEE by enterprises and sectors.”

The managing director of Better Building Industries Ltd realizes that the company has
not complied fully with the Black Economic Empowerment strategy, and asks for your
input on the following issues:

 A short list of the legislative measures adopted by the government in 2

order to tackle inequalities in our country;

 A list of the possible risks faced by the company due its non-adherence 4
to BEE requirements;

 An explanation of what a balanced scorecard is and how it will be 3

applied to measure the success of the BEE strategy.
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QUESTION 2 40 marks

Romano (Pty) Ltd is a manufacturer of small components and industrial parts. The company has a
31 December financial year end.

The majority of the company’s employees belong to trade unions. Two trade unions are especially
popular with the employees. In 2005 an average wage increase of approximately 22% was awarded
to employees of the company and the trade unions are now seeking an increase of at least 12% for
2006.

Mr Ray, managing director of the company, said the following at the recent management meeting:

 “Owing to the company’s performance and current state of affairs, it cannot afford the wage
demands” and
 “If the company was to meet the wage demands, it would be necessary to retrench a significant
number of employees.”

The ‘Alpha Group Trade Union’, which represents 35% of the company’s employees, is now
threatening the company with mass action unless their demands are met. Mr Ray is to negotiate with
the trade unions shortly and requests your assistance in providing financial information to support his
views as stated above.

Mr Ray provides you with the following information:

2005 2004 2003
R000 R000 R000

Sales 24 000 22 400 21 000

Cost of sales 18 200 16 200 15 200
Gross profit 5 800 6 200 5 800

Net income / (loss) before interest (240) 800 1 000

Interest paid 760 360 120
Net income / (loss) before taxation (1 000) 440 880
Taxation - 132 264
Deferred taxation (300) - -
Net income / (loss) (700) 308 616

Dividends paid - - 200

Shareholders’ funds 2 008 2 708 2 400
Remuneration and benefits
Employees (excluding directors) 12 340 10 140 8 920
Directors 640 560 480
Depreciation 360 430 400

The inflation rate is currently approximately 5%.

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Interest rates in the South African economy have consistently decreased over the last five years.
The current prime bank lending rate amounts to 10%.

The financial manager has analysed the possibility of the strike and gathered the following
information:

 The employees represented by Alpha Group demand a 12% wage increase, but are willing to
suspend the strike should a wage increase of 9% be granted. This increase will have to be
backdated to the beginning of the current financial year, i.e. the increase will apply from
1 January 2006 until 31 December 2006.

 The company expects that if a strike does take place, it will last one month after which the union
will settle for an increase of 5%, similarly backdated to the beginning of the company’s financial
year.

 The employees who will take part in the strike contribute to approximately 35% of the company’s
total turnover. The contribution ratio on these products, after taking the labour costs into account,
amount to 50%.

 Sales are incurred evenly throughout the year and the sales levels are not expected to be
significantly different in 2006 from 2005. All sales for the period of the strike relating to the
products produced by this employee group, will be lost if the strike is allowed to proceed.

 If the strike does take place, maintenance staff whose wages are also already incorporated into
the contribution ratio given above, will be used to carry out an overhaul of the conveyor system
using R25 000 worth of materials. This overhaul would otherwise be undertaken by an outside
contractor at a cost of R100 000, including materials.

REQUIRED Marks

(a) Briefly list the advantages that a value added statement may have over a
conventional income statement. 3

(b) Describe how the use of value added statements may bring special benefits to

● value added incentive schemes; and 2

● performance measurement. 2
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(c) Prepare value added statements for the 2003 and 2005 financial years. 10

(d) Prepare a memorandum to Mr Ray, the managing director of Romano (Pty) Ltd,
using the information highlighted in the value added statements and other
appropriate trends and ratios in order to assist him in his negotiations with the trade 15
unions.

(e) Ignoring the company’s precarious financial position, state, with explanations and full
supporting data, whether from a purely economic point of view, concentrating only
on the information gathered by the financial manager, you would advise the
management to allow the strike to go ahead, rather than agree to the union’s 5
demand.

(f) Explain briefly what factors, not considered in the above evaluation, might have
adverse financial effects for the company if the strike were to take place. 3

QUESTION 3 40 marks

Ethica Ltd is a pharmaceutical research and development company that aims to bring innovative
new drugs to the market on an international basis. Founded in 1994 it initially focused on
establishing its research profile and then in 2001 the company began to invest in its development
capabilities. It is now beginning preparations for commercial manufacturing and marketing having
completed a rights issue in June 2005 to raise the funds needed. Ethica Ltd has obtained the rights
to a number of generic products, which will form the foundation of their production process. Their
research and development has yielded one commercial product, which currently has no market
competition.

Petrochem Ltd is a leading international company in the oil, gas, solar power and petrochemicals
industry which was conceptualised in the 1960’s and started operations in 1970. The company is
listed on both the Johannesburg and New York Security Exchanges. Its main business activities are
in exploration and production (17%), refining and marketing (76%) and chemicals (7%). This year it
reported the fifth consecutive year of increased profits before exceptional items. Its focus for the
future is on a performance enhancement programme aimed at increasing volumes and achieving
cost efficiencies against a background of increasing prices.

Petrochem Ltd has over the last five years concluded several joint venture projects with partners
around the globe to develop identified projects in those countries by using Petrochem’s know how.
They disclose their production capacities, utilisation and contractual agreements fully. Forecasts for
the near future have in the past turned out to be very reliable and analysts place great store on it.
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Financial information for the year ended 30 September Petrochem Ltd Ethica Ltd
2005

Return on sales (NPAT / Sales)% 5,7% (287)%

Research and development / Sales % 0,3% 360%
Asset turnover (Sales / Total assets) 1,32 0,5
Asset leverage (Total assets / Equity) 2,33 1,06
Return on equity (NPAT / Equity) % 17,6% (14,42)%
Interest expense / Average debt % 6,7% 12,6%
Current ratio 1,0 20,0
Total debt (ST + LT) / (Total debt + Equity) 0,24 0,02
Cash and marketable securities / Current assets % 10,7% 98,2%
Operating free cash flow (R’000) R3 001 000 R(37 468)
Earnings per share (cent) 433c (4,5)c
Dividend per share (cent) 110c 0
Market capitalisation (R millions) R45 616 R79,5

REQUIRED
Marks
(a) Using the information above, analyse the financial performance of the two
companies to explain to what extent the financial information reflects the different
activities of the two industries. 16

(b) List the additional information you would require to complete your financial analysis
to make it more meaningful. 10

(c) Nominate and motivate the valuation method you think would be most useful in
determining the intrinsic value of Petrochem Ltd. 6

(d) Petrochem Ltd is compelled by the industry charter to acquire a BEE partner. List
the issues in this regard that the Board of Directors should consider. 8
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QUESTION 4 40 marks

NMC Ltd is a major vehicle manufacturer in South Africa. Management is considering the
installation of a new paintshop at a cost of R800 million. The following information was gathered in
respect of this project:

● Paint capacity will increase from 3 000 vehicles to 5 000 vehicles per month. The additional
capacity will allow NMC Ltd to accept an initial export order of 1 000 vehicles per month that
was not possible before. The existing paintshop is running at 2 800 vehicles per month.
● The average paint cost per vehicle will decrease from R5 000 to R4 400 (whilst quality will be
improved).

● Existing working capital requirements of R50 million will be cut by 20%.

● NMC Ltd will use an inter-company treasury loan at a fixed interest rate of 12% per annum to
fund the expansion. The impact of the loan on NMC Ltd’s weighted average cost of capital
(WACC) is to decrease this cost from 15,2% to 14,0%.

● NMC Ltd has an effective tax rate of 20%.

● The South African Revenue Service has indicated that the paintshop can, for tax purposes,
be written off over 5 years. The estimated useful life of the paintshop is 8 years.

● NMC Ltd will obtain export credits to be used as a set-off against the cost of importing other
model ranges. The monetary value of this is estimated as R176 million per annum for the
two years of the initial export contract – the cash benefit will be due at the end of each export
year.

The management accountant has prepared the following project evaluation:

R million

Initial outlay – year 0 (800,0)

Recovery years 1 – 8 (note 1) 1 311,5
Tax benefits years 1 – 8 (note 2) 144,1
Net present value 655,2

Based on the above net present value, the management accountant has recommended that NMC
Ltd proceeds with the new project.
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Note 1 – Recovery

R4 400 x 5 000 vehicles x 12 months = R264 million

Annuity – 8 years at 12% factor = 4,968
Value (R264 million x 4,968) = R1 311,5 million

Note 2 – Tax benefits

Annual benefit over 8 years = R100 million
Tax rate 29% - benefit = R29 million
Value (R29 million x 4,968) = R144,1 million

REQUIRED Marks

(a) Comment on the approach used by the management accountant in as much

detail as possible. Then substantiate your comments with a detailed numeric
evaluation of the paintshop project and make a final recommendation, taking into
consideration all the relevant information. 30

(b) Briefly discuss the impact of the loan arrangement on NMC Ltd’s WACC. 4

(c) Briefly discuss the impact of the paintshop project on a valuation of NMC Ltd. 6

8
UNISA 2005
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SOLUTION

TOE408-W

APPLIED MANAGEMENT
ACCOUNTING
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QUESTION 1

(a) Opening inventory

Opening inventory + Production – Sales = Closing inventory

Therefore: Opening inventory = Closing inventory + Sales – Production

Brushes:
Opening inventory = 12 000 + 48 000 – 48 000
= 12 000 units (2)

Rollers:
Opening inventory = 5 000 + 85 000 – 78 000
= 12 000 units (2)

Budgeted income statement for the six months ended 28 February 2006

Brush Roller
Budgeted sales quantity 48 000 units 85 000 units
Budgeted production quantity 48 000 units 78 000 units

R R
Budgeted sales revenue 1 440 000 2 380 000 (1)
Budgeted manufacturing costs 960 000 1 870 000
Direct material 192 000 468 000 (1)
Direct labour 96 000 312 000 (1)
Variable overheads 96 000 312 000 (1)
Fixed overheads 576 000 624 000 (1)
960 000 1 716 000
Add: Finished products
Inventory 1 September 2005
(12 000 units) 240 000 (1)
(12 000 units) _________ 264 000 (1)
1 200 000 1 980 000
Less: Budgeted finished products
Inventory 28 February 2006
(12 000 units) (240 000) (1)
( 5 000 units) (110 000) (1)
Budgeted manufacturing profit 480 000 510 000
Under-recovered overhead - (96 000) (1)
Administration costs (fixed) (80 000) (100 000) (1)
Budgeted profit 400 000 314 000 __
(15)
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(b) Budgeted income statement for the six months ending 31 August 2006

Brush Roller
Budgeted sales quantity 48 000 units 85 000 units
Budgeted production quantity 48 000 units 90 000 units

Brush Roller
R R
Budgeted sales revenue 1 440 000 2 380 000
Budgeted variable manufacturing cost of sales 384 000 1 190 000
Direct material 160 000 540 000
Direct labour 80 000 360 000
Variable overheads 80 000 360 000
320 000 1 260 000 (2)
Add: Finished products
Inventory 1 March 2006
(12 000 units) 96 000 (1)
( 5 000 units) _________ 70 000 (1)
416 000 1 330 000
Less: Budgeted finished products
Inventory 31 August 2006
( 4 000 units) (32 000) (1)
(10 000 units) (140 000) (1)
Budgeted contribution 1 056 000 1 190 000
Budgeted fixed manufacturing overheads (576 000) (720 (2)
Administration costs (fixed) (80 000) 000) __
(100 000)
Budgeted profit 400 000 370 000 (8)

Calculations

Value of opening inventory on 1 March 2006

 Brushes: 12 000 x (R4 + R2 + R2) = 12 000 x R8 = R96 000
 Rollers: 5 000 x (R6 + R4 + R4) = 5 000 x R14 = R70 000

Value of closing inventory on 31 August 2006

 Brushes: 4 000 x (R4 + R2 + R2) = 4 000 x R8 = R32 000
 Rollers: 10 000 x (R6 + R4 + R4) = 10 000 x R14 = R140 000

Budgeted fixed manufacturing overheads

 Brushes: 48 000 x R12 = R576 000
 Rollers: 90 000 x R8 = R720 000

(c) Preference of variable costing method

A variable costing method was adopted in part (b) of this solution. (1)

This method is often preferred by management accountants as:

 it highlights those costs that can vary in the short term, and which should therefore be
manageable; (1)
 it clearly shows how profit will change because of a change in volume; (1)
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 it shows the relevant costs to be considered in the event of a relevant costing decision;
(1)
 profits are not influenced by changes in opening and closing inventory levels. (1)
Maximum (3)

(d) Break-even point for six-months ending 31 August 2006

Total fixed cost = Manufacturing overheads + Administration costs + Labour

= R(576 000 + 720 000 + 80 000 + 100 000 + 80 000 + 360 000)
= R1 916 000 (1)

Contribution:
Brushes: Selling price – Variable costs
= R30 – (R4 + R2)
= R24 (1)

Rollers: Selling price – Variable costs

= R28 – (R6 + R4)
= R18 (1)

Weighted contribution based on normal mix

(48 / 133 x R24) + (85 / 133 x R18) = R20,17 (1)

Break-even for the company as a whole

= Total fixed cost / weighted contribution
= R1 916 000 / R20,17
= 95 014 products (1)

(e) Black Economic Empowerment

A short list of the legislative measures adopted by government

 National Small Business Act: national strategy for the development and promotion of
small business in South Africa, with the creation of new black-owned and –controlled
enterprises as a key component of the strategy. (1)
 Preferential Procurement Act: preferential procurement by government, through a more
accessible tendering process and point system for awarding tenders to target groups. (1)
 Competition Act: allows for exemptions from the provisions on anti-competitive practices
where such practices promote the ability of black-owned and –controlled enterprises to
become competitive. (1)
 Employment Equity Act: outlawed all forms of unfair discrimination at work. (1)
 Employment Equity Act: requires all enterprises employing more than 50 employees to
take affirmative action to bring about a representative spread of designated groups in all
occupations and organisational levels within defined time periods. (1)
 National Empowerment Fund: a trust to hold equity stakes in state-owned enterprises
and other private enterprises on behalf of historically disadvantaged persons. (1)
 Every industry is responsible for drawing up its own Charter according to which BEE
should be adopted and implemented. The company should comply with the Charter for
the construction industry. (1)
 Broad Based Black Economic Empowerment Act – legislates the principles of
empowering the previously disadvantaged companies. (1)
 Any other valid point. (1)
Maximum (2)
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Possible risks faced by the company due to its non-adherence to BEE requirements

The company is most likely not complying with the requirements of the Employment Equity
Act. The risks faced in this regard include the following:

 Fines imposed by Government for not adhering to the principles of the Act by specified
deadline times;
 Loss of Government contracts (especially important as the company is in the
construction industry);
 Loss of other contracts, especially relating to clients and partners who are BEE-
compliant;
 Loss of goodwill from black clients;
 Threats of strikes by employees;
 Lawsuits brought by employees who feel disadvantaged;
 Lack of motivation and productivity from employees who do not feel empowered;
 Generally poor publicity due to an apparent lack of social responsibility;
 A tremendous increase in employment costs in future (e.g. employment costs, recruiting
and training costs) in order to become BEE-compliant;
 Any other valid point.

1 each, maximum (4)

The balanced scorecard and its application

Management accounting control systems traditionally focused mainly on financial measures

of performance. The need for a balanced set of measures that link financial and non-financial
measures of performance lead to the development of the balanced scorecard. (1)

The aim of a scorecard is to provide a set of measures that give government or top
management a fast but comprehensive overview of an organisational unit or company. (1)

A scorecard attempts to provide a comprehensive framework for translating strategic

objectives into a coherent set of measurable performance measures. (1)

As far as BEE is concerned, government will use a balanced scorecard to measure progress
made in achieving BEE by enterprises and sectors. (1)

The use of a common scorecard by different stakeholders provides a basic framework

against which to benchmark the BEE process in different enterprises and sectors. (1)

The scorecard will measure 4 core elements of BEE:

 Direct empowerment through ownership and control of enterprises and assets;

 Human resource development and employment equity;
 Indirect empowerment through preferential procurement and enterprise development.
 Participation in management of enterprises. (2)

The scorecard also allows government departments, state-owned enterprises, and other
public agencies to align their own procurement practices and individual BEE strategies. (1)
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The scorecard will be issued as a Code of Good Practice and applied by the government
whenever it grants licences for regulated economic activity, grants concessions to private
enterprises to act on behalf of the state, sells assets or state-owned enterprises, enters into
public-private partnerships or engages in economic activity. (1)
Maximum (3)

QUESTION 2 - SUGGESTED SOLUTION

(a) Advantages of a value added statement over a conventional income statement

 The calculation of value added excludes the cost of bought-in goods and services and
therefore the statement highlights the wealth created by the organisation’s own efforts. (1)

 Value added can be used as the basis of an incentive scheme. Any bonuses based on value
added will be associated with real wealth creation and will not simply be based on an
increase in output, which might not be saleable at a profit. (1)

 Value added calculations are not affected by subjective depreciation changes. Depreciation
is treated as an appropriation of value added. (1)

 Value added is a better measure of performance than profit because managers can have
more control over value added than over profit. Therefore the use of value added as a
performance measure can improve management motivation. (1)
Maximum (3)

(b) How the use of value added statements brings special benefits

 to value added incentive schemes

Value added incentive schemes can be very beneficial to both an employer and the
employees because they provide an incentive to create more wealth. (1)

Management could agree that value added / wages cost should be a certain minimum ratio
(i.e. 1:0,9) Any excess value added could be shared between the employer and the
employees, the employees’ share being paid as a bonus. (1)

Value added has a number of advantages when used as the basis of an incentive scheme.
As mentioned above, bonuses will be directly related to the creation of wealth. Such schemes
can give incentive to all employees, not only production personnel. Value added can be
calculated fairly quickly and effort can therefore be rapidly rewarded. Also more realistic new
profit figures centered on controllable costs  more realistic far incentive purposes. (2)

Value added may be more acceptable to employees than conventional profit measures
because it does not include subjective depreciation charges. (1)
Maximum (2)
 to performance measurement

Value added can be used as a performance measure because it may be more easily
controlled than profit. (1)
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Examples of the type of ratios which could be calculated are as follows:

o Value added per employee

o Value added / wages cost
o Value added / fixed assets
o Value added / working capital
o Value added / sales (2)

Maximum (2)
Maximum (2)

(c) Value added statements

The question asks for the value added statements for 2003 and 2005. The statement for 2004
is given for information purposes only. No marks were awarded in respect of calculations for
the 2004 financial year.

ROMANO (PTY) LTD

VALUE ADDED STATEMENT FOR THE PERIOD ENDED 31 DECEMBER

2005 % 2004 % 2003 %

Sales 24 000 22 400 21 000
Less cost of goods & services 10 300 10 470 10 200 (1)
Value added 13 700 100 11 930 100 10 800 100 (1)

Applied as follows
Employees 12 980 10 700 9 400
Employees’ remuneration 12 340 90,1 10 140 85,0 8 920 82,6 (2)
Directors’ remuneration 640 4,7 560 4,7 480 4,4 (2)

Providers of capital 760 360 320

Dividends - - - - 200 1,9 (1)
Interest 760 5,5 360 3,0 120 1,1 (1)

Government – taxation - 0,0 132 1,1 264 2,4 (1)

Reinvested / withdrawn (40) 738 816

Retained income / (loss) (700) (5,1) 308 2,6 416 3,9 (1)
Depreciation 360 2,6 430 3,6 400 3,7 (1)
Deferred tax 300 2,2 - - - - (1)
13 700 11 930 10 800
Maximum (10)

Note: Various alternatives are possible. Depreciation may be included under ‘cost of goods
and services’. Deferred taxation may even be set off against current taxation.
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(d) Memorandum with information for trade union negotiations

ROMANO (PTY) LTD: INTERNAL MEMORANDUM

To: Mr Ray
From: ASP Irant (1)

INFORMATION WITH REGARD TO NEGOTIATIONS WITH TRADE UNION

With regard to your request for an analysis of the company’s financial information for the purpose
of negotiation with the trade union on wage increases, I would like to furnish the following
information.

Statement of value added

The portion of value added which accrued to the labour force, has risen from 87% in 2003 to
94,8% in 2005. (1)

Specifically, for the employees other than directors, the portion of value added which accrued to
the labour force has risen from 82,6% in 2003 to 90,1% in 2005. (1)

The portion relating to the directors remuneration has not changed between 2003 and 2005! (1)

Against this, the contribution to providers of equity capital has declined over the same period,
although in total contributions to providers of capital have risen. However, the latter is the result of
the high level of interest currently being paid / incurred by the company. (1)

The interest being paid by the company keeps increasing whilst the interest rates for the country
as a whole are decreasing steadily. The company is using more and more external finance (which
is can no longer afford) to fund the business operations. Will reduce profits in future. (1)

The portion of value added retained for future expansion has decreased from 7,6% (3,9% + 3,7%)
in 2003 to a negative rate of 0,3% in 2005. It would seem that the share of the labour force in
value added is already such that no re-investment, and consequently no growth, is possible. (1)

It is thus clear that any further extension in labour’s share is undesirable. (1)

Turnover
Turnover has increased by 6,7% ([R22 400 – R21 000] / R21 000) between 2003 and 2004 and by
7,1% ([R24 000 – R22 400] / R22 400) between 2004 and 2005 (or by 14,3% between 2003 and
2005). (2)

However, if the current rate of inflation of approximately 5% is taken into account, the company
has in real terms not experienced any significant growth. This is obviously not a situation in which
wage demands should be considered. Wage demands will be more closely linked to inflation.
(1)

Gross profit
Although the gross profit percentage stayed relatively constant at 27,6% (R5 800 / R21 000) for
2003 and 27,7% (R6 200 / R22 400) for 2004, it has declined to 24,2% (R5 800 / R24 000) in
2005. (2)
The large wage increase in 2005 has played a part in this decline, although other factors probably
contributed as well. (1)
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Net profit
The following table shows the net profit percentage, before and after tax, for the various periods.

(Net profit / Sales) 2005 2004 2003

Before tax - 4,2% 2,0% 4,2% (1)
After tax - 2,9% 1,4% 2,9% (1)

The negative growth referred to earlier, is clear. Each R1 of sales currently results in a loss of 4,2
cents.
(1)

Interest cover
The increased interest commitments, evidenced from the value added statement, implies that the
company finds it more difficult to meet its interest payments from current revenue, and in fact
cannot do so any more.
(1)

This is further shown by the decline in interest cover from 8,3 in 2003 (R1 000 / R120) to 2,2 in
2004 and a negative figure in 2005. (2)

Return on shareholders’ funds

The percentages return on shareholders’ funds over the three year period are

2005 2004 2003

Shareholders’ funds: beginning of the year 2 708 2 400 1 784 (1)
Shareholders’ funds: end of year 2 008 2 708 2 400
Average 2 358 2 554 2 092 (1)

Net income after tax / Average equity funds - 29,7% 12,1% 29,4% (2)

The dramatic decline leading to a negative return in 2005 is worrying; shareholders are indeed at a
disadvantage to labour.
(1)

Conclusion
It is evident from the above analysis that the company’s financial position progressively declined,
although labour has increasingly prospered. It is clear that fundamental changes have to be made
in order for Romano (Pty) Ltd to proceed. In these circumstances substantial wage increases are
out of the question.
(1)

I trust that this analysis will be of assistance to you in your negotiations with the labour unions.

Yours sincerely,
___
ASP Irant Maximum
(15)

(e) Should the strike be allowed to proceed?

Cost of allowing the strike to proceed R

Contribution foregone on lost sales (1 month) R24 000’ / 12 x 35% x 50% (350 000) (1)
Payrise for the full year R12 340’ x 35% x 5% (215 950) (1)
(565 950)
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Saving on conveyor maintenance cost 75 000 (1)

(490 950)
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Cost of agreeing to the increase R

Payrise for the full year R12 340’ x 35% x 9% (388 710) (1)

From a purely economic point of view, ignoring all other information, it would be best to accept the
demands of the union as it would cost the company less.
(1)

(5)

(f) Effects if the strike was to take place

 The sales lost might never be regained so that annual sales would be permanently reduced.

(1)

 Bad publicity as a result of a strike might lead to a general loss of confidence in the reliability of
the company and might have an adverse effect on future sales.
(1)

 Other employee groups could follow suit as they may perceive the strike to have been
successful.
(1)
 Any other valid point.
(1)
Maximum
(3)
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QUESTION 3 - SUGGESTED SOLUTION

(a) ● The two companies are not in the same industry and are at different stages of their
life-cycle, they therefore cannot and should not be compared. (2)

Ethica Ltd

● Performance is poor at this stage viz ROS, ROE and EPS negative. (1)

● Turnover is low (asset turnover) with a high proportion of R & D. This is however
expected given their line of business. (2)

● Interest charge relatively high but in line with a young start-up company. (1)

● Current ratio abnormally high - trade has not yet impacted on current assets or
liabilities. (1)

● The bulk of current assets consist of cash obtained from the rights issue 3 months
before the year end. (1)

● The company is equity financed at this stage – debt ratio linked to rights issue. (1)

● Operating cash negative – in line with start-up phase. (1)

● EPS is negative – expected given start-up costs, R & D and life cycle. (1)

● No dividend paid as earnings negative – common for this stage of the business life
cycle. (1)

● Market capitalisation indicates a small cap company – below R1 billion. (1)

Petrochem Ltd

● Return on sales (NPAT) acceptable at 5,7%. (1)

● R & D not a major factor (less expected here), company employs a strategy of joint
ventures. (1)

● Asset turnover low, may indicate a large asset based – very capital intensive industry.
(1)

● Asset leverage normal, linked with gearing indicator that own funds used to finance
fair part of business. (1)

● Interest expense below local market rates – funding may be obtained outside RSA at
cheaper rates and expected to have a good credit rating. (1)

● Current ratio below the theoretical norm, but company sitting with cash and generates
fairly substantial operating cash – ok (2)

● Gearing ratio due to larger equity component, good, but cost of capital may (1)
be impacted. (1)

● Dividend cover fair at app 4 (433 ÷ 110) (1)

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● Good cash flows. (1)

● Market capitalisation high as to be expected from dual listed company. (1)

Max 16

(b) ● Peer information for comparative purposes. (1)

● Turnover trend – growth? (1)

● Market share – competitors. (1)

● Gross margins to judge other expenses. (1)

● Target for return on equity to measure performance. (1)

● Debt roll-out (payback) and facilities available – maturity profiles. (2)

● Mix of current assets and liabilities to do operating ratios. (1)

● Cash flow detail to determine use of cash and funding. (1)

● P/E ratio to assess market perception on company and share price. (1)

● Dividend policy to judge payouts and dividend history. (1)

● Shareholder breakdown as assist with price evaluation / security / transaction

possibility. (1)

● Planned capital projects that will add value to the company. (1)
Max 10

(c) ● Cash flow valuation. (1)

● Operational cash positive (although detail required). (1)

● Disclosure is made of capacities etc. (1)

● Joint ventures disclosed. (1)

● Estimates, what if’s in calculating prices, costs, margins and capacities, will be
possible. (2)

● Risk assessment on market sector can be done. (1)

● Petrochem will have an obtainable beta, or Gordon can be applied to get cost of
equity. (1)

● Investment in working required. (1)

● Cost of debt is obtainable, thus the estimate of WACC can be done. (1)
Max 6
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(d) ● Shareholders will have to be informed/convinced of the need of such transaction;

especially those abroad will not care much for local charters. (2)

● Funding such a deal could pose a problem for any prospective partner – 10% to 20%
amount to R9 bn to R18 bn. (2)

● Payment structure to be determined: cash / time allowed. (1)

● Funding for BEE: Loans, pref shares, combination? (1)

● Transfer part of assets on sell shares in Petrochem. (1)

● Any industry charter requirements. (1)

● Petrochem’s local market share will have to be assessed – competition board

approval required? (1)

● Empowerment platform

∆ broad-based – which partners (1)

∆ own qualifying employees. (1)

● Transaction covering an operational entity may be more feasible in light of above. (1)

● Contractual issues: selling of shares (1)

breach of contract, performance escape clauses etc. (2)
Max 8
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QUESTION 4 - Suggested solution

(a) Detailed comment on management accountant’s approach

The candidate could have taken one of two views:

1. That the new paintshop will replace the existing one (new paintshop’s capacity:
5 000 cars per month); or
2. That the new paintshop will supplement the existing one (new paintshop’s
capacity: 2 000 cars per month) (Alternative)

● The management accountant’s calculated recovery (saving), made use of an

incorrect:

o Cost per vehicle; and (1)

o Number of vehicles. (1)

In calculating the recovery (saving):

o The cost per vehicle should be the incremental saving per vehicle of R600
(R5 000 – R4 400), not a saving of R4 400 per vehicle; and (1)
o The saving should relate to the current production of 2 800 vehicles per month,
not the full 5 000 vehicles; or (1)
o The saving should relate to the number of cars of the current production of 2 800
vehicles, that would now be painted by the new paintshop of 1 000 cars per month
(2 000 capacity – 1 000 for export), not the full 5 000 vehicles. (Alternative)

● The recovery was not shown after tax – the correct tax rate would be the effective tax
rate of 20%. (1)

● He failed to deduct the incremental cost of painting the vehicles for the export
order. (1)

● The saving in working capital of R10 million (20% x R50m) was not taken into
account.
(1)

● The loan rate of 12% was used for discounting purposes, which is incorrect as:

o It is pre-tax; and (1)

o It ignores other forms of capital – therefore the discount rate should be the target
WACC (1)

● The tax benefit was calculated over 8 years in stead of the stipulated 5 years. (1)

● The impact of the export tax credits was ignored – should be treated as a cash inflow
for evaluation purposes. (1)

● No recovery on the existing paint shop or the new one was shown. This should be
confirmed as zero. (1)

● The life expectancy of 8 years and immediate use after two years should be
confirmed. (1)
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● For the export order: The cash inflow for sales as well as cash outflow for other
incremental cost should be confirmed and included in the evaluation (after tax). (1)
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● Impact of inflation should be considered. (1)

● The annuity approach is fine as cash flows do not change. (1)

Inflow for 8 yrs or factor

Detailed numeric evaluation of project

0 1 2 3 4 5 6 7 8
R’m R’m R’m R’m R’m R’m R’m R’m R’m
Initial outflow (800,0) (1)

Saving 16,1 16,1 16,1 16,1 16,1 16,1 16,1 16,1 (1)
5,8 5,8 5,8 5,8 5,8 5,8 5,8 5,8
2 800 1 000 (alt) x12 (1)
x R600 (saving) (1)
x 0,8 (after tax) (1)

Export: Additional paint cost (42,2) (42,2) Outflow for 2 yrs or factor: (1)
1 000 x 12 (1)
x R4 400 (incr cost) (1)
x 0,8 (after tax) (1)

Working capital saving

R50m x 20% inflow 10 (1)
Outflow (10) (1)

Export credits 176,0 176,0 (1) Amount; (1) Inflow for 2 yrs or factor: (2)

Wear and tear tax benefit 32,0 32,0 32,0 32,0 32,0 Inflow 5 yrs or factor: (1)
R800m ÷ 5 (1)
x 20% (1)

Unknowns
- After-tax receipt new machine ?
- After-tax receipt old machine ?
- Export sales cash inflow (after tax) ? ? (1)
- Export other incremental costs (after (?) (?) (1)
tax)

Totals (excluding unknowns) (790,0) 181,9 181,9 48,1 48,1 48,1 16,1 16,1 6,1

Discount factor (14%) or 1,00 0,88 0,77 0,67 0,59 0,52 0,46 0,40 0,35 (1)
Alternative: (15,2%) 1,00 0,87 0,75 0,65 0,57 0,49 0,43 0,37 0,32

NPV (excluding unknowns) (388,6) (A)

Cumulative NPV factors (annuity factors) 14% 15,2% Also awarded

2 years 1,647 1,622 if annuity
factors used
5 years 3,433 3,336 this rate
8 years 4,639 4,458

Final recommendation

● Whenever the NPV is negative we normally do not recommend that the project proceed, but (1)
● In this case the present value of the unknowns should be calculated, if > (A) then the project
should be accepted. (1)
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Also consider:
● Further export orders or local demand could make the investment more beneficial. (1)
● The improved quality of the paintwork could increase the quality rating of the vehicles which
could result in more local/export demand. (1)
Maximum (30)

(b) Impact of the loan agreement on WACC

Discussion of the new current WACC:

● In calculating the new actual WACC:

o The cost of the inter-company loan (after tax) will be lower than that of equity; the
loan proportion of the WACC would increase, thereby reducing the new actual
WACC; (1)
o The increase in debt will at the same time normally increase the company’s risk
profile, thereby resulting in an increase in the cost of equity (ke); (1)
o The net decrease in WACC indicates that the capital structure moved closer to the
optimal debt-equity ratio. (1)
o In this case the debt is inter-company, so the conditions of loan will need to be
investigated in order to determine the impact on ke. (1)

Discussion of the target WACC

● The appropriate discount factor to use for a capital investment decision is not the
current WACC, but the target WACC, which should use (1)

o For the weights: The target debt-to-equity ratio or market values; and (1)
o For the rates: The market-related rates (1)

● It should be determined if the interest rate on the inter-company loan represents a

market-related rate, or cheap financing (based on the percentage it seems too low for
a specialised asset). (1)

o If market-related: The same arguments as for the current WACC would apply (1)
o If not market-related: Use a market-related rate in calculating the target WACC (1)
and calculate the benefit of cheap financing (as part of the financing decision). (1)

● The target WACC should be representative of the risk associated with the usage of
the funds, not the source thereof. (1)

● The risk associated with a capital investment should preferably be determined

objectively for every project, but quite often a subjective approach is used due to a
lack of information or for cost-benefit reasons. The subjective approach often utilises
a company’s target WACC and subsequently add or deduct a risk percentage. For
asset replacements the risk is often seen as less so a few percentage points are
deducted. (1)
Maximum: (4)
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(c) Impact of the paintshop project on a valuation of NMC Ltd

● The project would influence NMC’s value in two ways:

o It would impact on NMC’s risk-profile; and (1)

o It would effect future benefits (earnings or cash flow) (1)

Value is a function of both risk and future benefits.

● Impact on risk:

o If the project results in an reduced risk-profile then a lower discount percentage

would be appropriate (lower target WACC if using the free cash flow method, or
lower earnings-yield percentage if using the earnings-yield method of valuation).
(1)
o If the project results in an increased risk-profile then a higher discount percentage
would be appropriate.
o The project would probably result in the same risk-profile or reduce it. (1)

● Impact on future benefits

o The likely future benefits (cash flow) was discussed under part (a) as part of the
capital investment decision
o Other possible future benefits will need to be considered, they could include:

 The removal of constraints, creating additional capacity. (1)

 New vehicle ranges may be considered. (1)
 Improved quality – lower claims from customers re defective paintwork, or
higher customer satisfaction – brand improvement. (1)
 Improved quality could increase the chances of obtaining further export
sales (1)
which could be critical to NMC’s future – it could ensure local competitiveness and alignment with
NMC’s strategic business plan. (1)

● A NPV calculation is in effect a cash flow-based valuation (see part (a)). (1)

● The paintshop project will most probably add value to NMC Ltd. (1)
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QUESTION PAPER

TOE409-X

APPLIED TAXATION
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QUESTION 1 40 marks

This question consists of two unrelated parts.

Part 1 20 marks

Carl and Megan Flyn have been married in community of property for more than 30 years. Carl is
semi-retired while Megan is still working as a teacher. They have decided to do some serious estate
planning, pending the retirement of Megan within three years. Their financial adviser requested
them to each prepare a detailed list of all their assets and investments they currently have,
stipulating the original cost, the current market value and whether or not the assets/investments had
been valued on 1 October 2001. Once presented with such a list, the financial adviser will propose a
restructuring of their current joint estate.

Carl and Megan like to spend the school holidays at their sea cottage in Margate. Megan inherited
this sea cottage on 15 July 2002 from the estate of her late father. The property was transferred into
her name on that date. The sea cottage had a market value of R850 000 on 15 July 2005. Her late
father had the sea cottage valued on 1 October 2001 and the market value on that date was
R800 000. The last will of Megan’s late father stipulated that the sea cottage may never become
part of any joint estate Megan might be part of.

Carl started an electrical engineering business before he and Megan got married. Before their
marriage they signed an agreement that Carl’s business will not form part of their joint estate. This
agreement is still in place. The business is still an active business and Carl is the sole proprietor of
the business. He is substantially involved in the operations of the business.

The following list of assets and investments was prepared by Carl as at 31 January 2005:

Description Original cost Market value on Market value on

1/10/2001 31/01/2005
R R R
2004 Mercedes Benz C260 250 000 245 000
1985 Porsche 928 70 000 200 000 240 000
Yacht (11 meters) 250 000 300 000 350 000
Paintings in residence 30 000 250 000 315 000
Listed share portfolio 120 000 255 000 380 000
Kruger Rands (regarded as an investment
for income tax purposes) 45 000 75 000 100 000
Stamp collection 20 000 40 000 50 500
Small business (with active business
assets) – sole proprietor 200 000 350 000 900 000
Primary residence 250 000 800 000 1 200 000

The financial adviser suggested the following restructuring to these assets/investments:

 Sell the Porsche 928 for R240 000 and invest the proceeds in a money market account.
 Sell the yacht for R350 000 and invest the proceeds in a townhouse for the earning of future
rental income.
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 Sell 50% of the paintings for R157 500 and settle the outstanding balance of the hire purchase
agreement on the Mercedes Benz.
 Sell 50% of the listed share portfolio (held for speculative purposes) for R190 000 and invest the
proceeds in preference shares.
 Sell the Kruger Rands for R100 000 and invest the proceeds in government bonds.
 Sell the stamp collection for R50 500 and invest the proceeds in a money market account.
 Sell the small business assets as a going concern for R900 000 (excluding any trading stock and
VAT) and invest the proceeds in student flats at the local university to generate rental income.
The business assets will not be sold on credit terms. You may assume that none of the small
business assets were depreciable assets.

Carl accepted all the suggestions of his financial adviser regarding the selling of “his” assets and
investments to restructure their estate, except for the selling of the stamp collection. He has decided
to rather give it to his son, John, now 25, to continue expanding the collection.

The following list of assets and investments was prepared by Megan as at 31 January 2005:

Description Original cost Market value on Market value on

1/10/2001 31/01/2005
R R R
Sea Cottage 350 000 800 000 950 000
2000 VW Golf 100 000 65 000 50 000
Listed shares – long-term investment 275 000 400 000 550 000
Persian carpets – part of household
carpets 50 000 100 000 145 000
Household furniture 200 000 300 000 315 000

The financial adviser suggested the following restructuring of these assets and investments:

 Sell the sea cottage for R950 000 and invest the proceeds in government bonds.
 Sell 50% of the listed share portfolio and invest the proceeds in a money market account.
 Sell all the Persian carpets and invest the proceeds in preference shares.

Megan has accepted all the suggestions of her financial adviser regarding the selling of “her” assets
and investments to restructure their estate.

Both Carl and Megan have decided to adopt the market value of their respective assets and
investments as at 1 October 2001, as the base cost thereof. All assets and investments will be sold
and realised during February 2005, for their market value as at 31 January 2005. Megan has an
assessed capital loss of R7 500 brought forward from the 2004 tax year. Carl is currently 58 years
old and Megan 56. Carl has never had any other business or business interest in the past.

REQUIRED
Marks
Calculate the taxable capital gain on the assets and investments realised during
February 2005, for both Carl and Megan for the 2005 year of assessment. If the
proceeds of a particular asset or investment is not subject to capital gains tax, please
indicate your reason for that. 20
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Part 2 20 marks

Mr JX, currently 56 years old, is the financial director of Broad Based Technologies Limited, a listed
company. Mr JX is also a keen exotic bird breeder. He claims that spending his spare time
breeding birds is medicine for the mind and soul. During the 2005 tax year he realised an assessed
loss of R12 500 on this part-time business. (See note 3).

Mr JX received the following remuneration from Broad Based Technologies Limited for the year from
1 March 2004 to 28 February 2005:
R

 Basic salary (all retirement funding employment) 360 000

 Incentive bonus (non-retirement funding employment) 120 000
 Travel allowance (non-retirement funding employment) – Note 1 68 000
 Entertainment allowance (non-retirement funding employment) 12 000
 Long-service award (non-retirement funding employment) – Note 5

Mr JX made the following contributions and payments for the year from 1 March 2004 to 28 February
2005:
R

 Pension fund contributions 28 000

 Retirement annuity contributions 25 000
 Medical aid contributions 27 500
 Income protection policy contributions 2 750
(Proceeds of this policy will be gross income, as defined, in the hands of the recipient)
 Entertainment expenditure 6 250
(Mr JX kept accurate records of whom he entertained, the reason for the entertainment
as well as the date of the entertainment)
 Donation to a Public Benefit Organisation 5 000
(The necessary Section 18A tax certificate was obtained)

Notes

1. Mr JX bought his vehicle, a BMW 320i, in July 2003 for R251 500 (including VAT). Due to his
work as financial director he often has to visit branches and retail outlets during the tax year.
He keeps an accurate logbook of all his business trips. The vehicle’s odometer was logged
at 35 000 km’s at 1 March 2004 and closed off at 62 000 km’s at 28 February 2005. The
official business kilometres for the 2005 tax year were logged to be 15 500 kilometres. Mr JX
will submit his logbook together with his annual income tax return for 2005.

2. Mr JX was given an option to acquire 15 000 shares in Broad Based Technologies Limited at
R12,50 per share on 1 November 2004. The market value of the shares was R16 per share
on that date. Mr JX will not be allowed to sell any of the shares within 4 years after
exercising the option.

Mr JX exercised the option to acquire the 15 000 shares, on 31 January 2005, when the
shares had a market value of R18,50 per share.
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3. Mr JX regards his business as an exotic bird breeder as a bona fide business, as the majority
of his clients are owners of Pet Shops. He seldom sells birds to private individuals. Mr JX
has reason to believe that the business will become profitable in the next five years.

4. Mr JX made payments for qualifying medical expenses of R8 890 during the 2005 tax year.
He has proof of payment for the full amount. None of the said medical expenses were
recovered from the medical aid fund.

5. Mr JX received a set of platinum coins as a long-service award in January 2005. Mr JX has

just completed a first period of 15 years of service to Broad Based Technologies Limited.
Broad Based Technologies Limited paid R8 000 (excluding VAT) for this set of platinum
coins. The set of platinum coins was handed over to Mr JX during a company function held
on 15 February 2005. After the function a colleague of Mr JX approached him with an offer
to purchase the set of platinum coins for R12 500. Mr JX, who experienced a cash flow
problem in his exotic bird breeding business, immediately saw the opportunity to address this
problem and agreed to sell the set of platinum coins to his colleague for R12 500. The
colleague paid him the amount in cash on 25 February 2005.

6. Mr JX is a compassionate person and has made the following additional donations

(excluding the R5 000 reflected under the contributions and payments made for the 2005 tax
year) to the following persons during the 2005 tax year:

Date Amount
R
Mrs JX, his wife 31 March 2004 25 000
Julian JX, his son 31 May 2004 20 000
Lee JX, his daughter 30 June 2004 15 000
Aids Care – a Public
Benefit Organisation 30 September 2004 4 000
EA – a political party 31 December 2004 3 000

Mr JX is not in possession of a section 18A tax certificate for his donation to Aids Care.

REQUIRED
Marks
(a) Calculate the taxable income of Mr JX for the 2005 tax year, stating reasons
when an income item, deduction or payment should be disregarded. 15

Refer to Appendix A for the travel allowance table.

(b) Calculate the donations tax payable, if any, by Mr JX for the 2005 tax year.
State your reason if any donation would be exempt from donations tax. 5
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QUESTION 2 45 marks

This question consists of four unrelated parts

Part 1 16 marks

Apricot (Pty) Limited is a resident company that deals with the acquisition and disposal of
commercial property in South Africa. Apricot (Pty) Limited has a 28 February year-end. The
company acquired commercial property for R1 200 000 from Mr. Banana on 1 March 2005 and
payment was made on this same date. This property was purchased with its existing lessees (100%
occupation and all with lease agreements for at least five years) and Apricot (Pty) Limited received
rental income of R195 000 per month for the two months ending 30 April 2005. Apricot (Pty) Limited
is entitled to this rental income according to the purchase contract. The company also incurred the
following expenses in respect of the property:

R
Repairs 80 500
Electricity and water 42 300
Legal expenses regarding the drawing up of the purchase contract 90 400

The commercial property was sold on 30 April 2005 to Melon (Pty) Limited. Melon (Pty) Limited
purchased the property with the intention of earning rentals from it and does not intend to sell it in
the near future. In terms of this contract, Melon (Pty) Limited must pay Apricot (Pty) Limited an initial
amount of R350 000 (on 30 April 2005) plus 15% of the gross profits generated by the commercial
property, calculated annually for four subsequent years commencing on 30 April 2006. The gross
profit generated by Melon (Pty) Limited from the commercial property purchased during the period
1 May 2005 to 30 April 2006, amounted to R1 850 000. Melon (Pty) Limited has a 30 April year-end.

REQUIRED
Marks
(a) Calculate the taxable income that will result from the above transactions for Apricot
(Pty) Limited for the 2006 and 2007 years of assessment. Support your calculations
by discussing and referring to the applicable sections in the Income Tax Act.
Assume that the tax legislation will remain unchanged for the 2006 and 2007 years
of assessment. Ignore any possible VAT (Value-Added Tax) implications. 11

(b) If you assume that Apricot (Pty) Limited and Melon (Pty) Limited are both registered
VAT-vendors and that the property is sold for R1 400 000 in total, discuss whether
the supply of the commercial property can be regarded as the supply of a going
concern for VAT-purposes. 5
16
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Part 2 16 marks

Yummies (Pty) Limited (“Yummies”) manufactures jams that are in demand throughout South Africa.
The company is a resident of the Republic. Its financial year ends on the last day of April each year.
Yummies purchased an existing patent (as defined in the Patents Act, 1978) on 1 June 2004, from a
company in the United States of America for $40 000. Payment was made on 30 June 2004. This
patent relates to a new manufacturing process of jams where no preservatives are used. Yummies
used this patent for the first time on 30 June 2004 to manufacture their new Yummy Strawberry Jam.
During the course of the year Yummies realised that the process followed according to the American
patent, is not suitable for the South African climate. The company decided to replace the patent with
a locally developed patent. The American patent was sold on 1 March 2005 to another American
company for $45 000 cash. The new patent was purchased on the same date from Jams
Incorporated, a South African company, for R380 000. In addition to the patent sold, Yummies also
sold a delivery vehicle during April 2005 and incurred a capital loss of R15 000 thereon.

Ruling exchange rates were as follows:

Date Exchange rate

1 June 2004 $1 = R7,25
30 June 2004 $1 = R7,35
1 March 2005 $1 = R6,95

The average exchange rate for the 2005 year of assessment was $1 = R7,10.

REQUIRED
Marks
(a) Discuss (with reasons) if paragraph 66 of the Eighth Schedule (re-investment in
replacement assets) may be elected in the above scenario and what the effect
will be on taxable income. 3

b) Calculate the income tax payable by Yummies (Pty) Limited for the 2005 year
of assessment. Assume a taxable net profit before tax of R295 000 before
taking the above transactions into account. Ignore any VAT implications. 13
16

Part 3 5 marks

Mrs Thief, a bookkeeper, misappropriated a sum of R180 000 in cash over a period of two years
from her employer. When confronted with the evidence of her crime, she broke down and
confessed. Since she had spent the misappropriated cash on her paraplegic son, she had no
money or other assets to repay the misappropriated cash. She was immediately dismissed and
charged with theft. She was found guilty, but due to the extenuating circumstances found to be
present by the judge, she was given a suspended jail sentence. Her former employer took no further
action against her to recover the money stolen.

REQUIRED
Marks
Discuss whether the R180 000 misappropriated by Mrs Thief is in the nature of “income”
in her hands. Also cover in your answer, any possible Capital Gains Tax implications.
Support your answer with reference to the applicable case law. 5
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Part 4 8 marks

After a number of burglaries at his business premises, Mr Cane Nine decided to purchase a watch
dog for which he paid R2 800. The dog cost R50 per month to feed. Licence fees of R20 and
veterinary fees of R3 500 were also incurred. The veterinary fees were incurred when the dog was
shot by an intruder.

REQUIRED
Marks
Discuss with reasons whether Mr Cane Nine can claim all, some or none of the costs
incurred for normal income tax purposes. Support your answer with reference to the
applicable case law. 8
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QUESTION 3 40 marks

This question consists of two separate unrelated parts.

Part 1 15 marks

Old Age Investments (Pty) Limited‘s financial year ended on 28 February 2005. In terms of the
company’s existing policy, an interim dividend is declared annually on 30 September and a final
dividend on 31 March.

No secondary tax on companies was payable when the dividend was declared on 30 September
2004 as the dividends that accrued to Old Age Investments (Pty) Limited during that dividend cycle
exceeded the dividend declared by R9 000.

A final dividend of R90 000 was declared on 31 March 2005.

During the period 1 October 2004 to 31 March 2005 the following dividends accrued to Old Age
Investments (Pty) Limited:
R R

1. From companies listed on the South African stock exchange 36 000

2. A first and final distribution was received from the liquidator of a
South African registered company in which Old Age
Investments (Pty) Limited had a 60% interest. The amount was
made up as follows:
Repayment of share capital 100
Profits earned prior to 31 March 1993 8 500
Profits earned after to 31 March 1993 6 500
Profits of a capital nature:
- earned prior to 1 October 2001 2 800
- earned after 1 October 2001 1 800 19 700
3. From a South African registered company in which Old Age
Investments (Pty) Limited held 100% of the issued shares. The
subsidiary met all the requirements for exemption in terms of
section 64B(5)(f) and consequently made the election as
provided for in that section. 5 000
4. A distribution from a collective equity investment scheme made
up as follows:
- Rent (a section 11(s) distribution) 3 600
- Interest 700
- Dividends from RSA resident companies 6 700
- Foreign dividends 300 11 300

REQUIRED
Marks
Calculate the secondary tax on companies for which the company is liable in respect
of the dividend that was declared by Old Age Investments (Pty) Limited on 31 March
2005. Provide reasons for not taking into account any dividends accrued, as
outlined above, into your calculations. 15
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Part 2 25 marks

The Share trust was created and registered in South Africa during 2002 in terms of the last will and
testament of the late Grandfather. The place of effective management of the trust is also in South
Africa. The only capital and income beneficiary of the trust, is the Grandchild (a minor) of
Grandfather. All income and capital vests in the beneficiary. You may assume that all decisions
made by the trustees to acquire assets, will not be to the detriment of the beneficiary.

The trust owns the following assets:

Shares

On 28 February 2002 all the shares in Shares (Pty) Limited were transferred to the trust in terms of
the last will and testament of Grandfather by the executer of his estate. The market value thereof at
the date of death was R1 500 000.

On 1 March 2004 all the shares in Home (Pty) Limited were transferred to the trust in terms of the
last will and testament of Grandmother by the executer of her estate. Home (Pty) Limited owned a
residence in which Grandmother resided and the following information is available:

The company acquired a residence on 1 November 2001 at a cost of R750 000 (value added
tax included) and was financed by shares held 100% by Grandmother. The company never
traded and the residence was used by Grandmother as her private residence to the date of
her death. The trustees in consultation with the Grandchild decided to sell the residence, to
deregister the company and then to use the money received to purchase a holiday home at
the coast. The property (and therefore also the company) was worth R1 200 000 at the date
of death of Grandmother and was sold for R1 300 000. You may assume that there was no
cost in respect of the sale of the property and the deregistration of the company. The
company was finally deregistered on 1 February 2005 and the trustees placed the net cash
received of R1 300 000 for the time being, on call in the name of the trust.

Block of flats

The block of flats was acquired during the 2004 year of assessment by the trustees on behalf of the
trust for an amount of R6 000 000. The purchase was financed by a loan from Father. In terms of
the loan agreement no interest is payable on the loan, but the future dividends from Shares (Pty)
Limited will be used to repay the loan.

Patent

The net rental income in 2004 of R200 000 from the above block of flats, was not paid to the
beneficiary, but was used on 1 March 2004 to acquire a patent at a cost of R800 000. The balance
of the purchase consideration was advanced as a loan from Shares (Pty) Limited to the trust. In
terms of the loan agreement the outstanding amount carries no interest, but the loan must be repaid
from dividends received from Shares (Pty) Limited with the first payment due on 31 March 2005.
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During the 2005 year of assessment the following amounts accrued / were incurred by the trust:

R
Interest earned on call account 5 800
Amount accrued from the rental of the flats 600 000
Collection fees paid to the agents responsible for the administration of the block of
flats 6 000
Repair done to the block of flats 54 000
Payments made to the beneficiary from net rental income 120 000
Purchase of patent 800 000
Royalties received on patent 42 000
Dividends received on shares in Shares (Pty) Limited 45 000
The trustees used this amount to repay the loan from Father
Dividend from Home (Pty) Limited (to be calculated by the candidate) -

The trustees are not entitled to any remuneration.

REQUIRED
Marks
(a) Calculate with reasons being given the taxable income of:
(i) The Share trust 1
(ii) Father (only the taxable income accruing or deemed to accrue to him
from the trust in terms of the provisions of section 7 of the Income Tax
Act) 5
(iii) Grandchild (assuming the Grandchild has no other income). 15
21
Grandfather, Grandmother, Father and Grandchild are relatives and
Grandchild is the minor child of Father.

(b) With the assumption that Shares (Pty) Limited has profits in excess of
R1 200 000 that may be distributed as a dividend and has no excess
dividends carried forward from the previous dividend cycle, discuss the tax
implications for the company in respect of the loan made to the trust. 4
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QUESTION 4 35 marks

You are dealing with the following four independent tax-related queries that have been forwarded to
you by the senior partner of your audit firm.

Query 1 8 marks

Mr Archie Techt, a well-known South African architect, designed a block of holiday flats for his friend,
Mr Mani Pulator. The flats were built overlooking a beach. Instead of being paid a fee for designing
the block of flats, Mr Archie Techt instead agreed with Mr Mani Pulator that he and his close family
would be granted the exclusive and free use of a flat in the building for the next 20 years whenever
he required it. He would not, however, be entitled to rent the flat to any other person for reward or
otherwise.

REQUIRED
Marks
Discuss whether Mr Archie Techt would be taxed on this free use of the flat. If so,
indicate on what basis the free use will be calculated. 8

Query 2 7 marks

Mr Sabe Shaik is the founder of the Shaik Family Trust and has made an interest-free loan to this
trust in the amount of R1 million. The trustees of the trust have invested the amount in local interest
and dividend generating investments. Any income from or capital gain related thereto can, in terms
of the discretionary powers of the trustees, be distributed to any one of Mr Shaik’s three children (in
whatever proportion the trustees should decide on), who are the specified beneficiaries (both capital
and income) under the trust deed. Notwithstanding the fact that no other conditions have to be met
(like the attainment of any prescribed age), the trustees in their discretion decided to re-invest the full
income earned during the 2005 year of assessment in the name of the trust. In addition, no
beneficiary acquired any vested right to any capital asset or capital gain of the trust by reason of the
exercise of the discretionary powers of the trustees.

On 28 February 2005, Mr Shaik realised that he had not utilised the opportunity during the year of
assessment to donate R30 000 to the trust and in this way benefit from the section 56(2)(b)
exemption. He instructed his accountant (who also performs the accounting function for the trust) to
reduce the amount of his outstanding loan account to R970 000 (by way of a closing journal entry) in
drawing up the trust’s financial statements for the year ended 28 February 2005.

All relevant parties are residents of the Republic. Mr Shaik is currently taxed at the maximum
marginal rate of normal tax and is married out of community of property.

REQUIRED
Marks
Discuss whether such reduction of the outstanding loan account will have any normal
tax implications for any relevant party and, if so, indicate the extent thereof as well as
the person on whom the resultant normal tax liability will fall. 7
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Query 3 14 marks

Leaving his home to drive to work on 1 March 2004, Mr Mat Mattheus was hijacked and a luxury
Mitsubishi Pajero (4x4 passenger vehicle) that had been provided to him by his employer (a
registered category B VAT vendor, solely making taxable supplies), has since then remained on the
South African Police Service’s list of stolen vehicles not recovered. His employer had originally
acquired it under an arm’s length cash transaction at a cost of R250 800 (including VAT). On 25 April
2004 the insurance company (also a VAT vendor) settled his employer’s claim in this regard and the
total payment amounted to R159 600.

On 1 May 2004 his employer utilised this insurance pay-out by way of a deposit in purchasing a Colt
4x4 bakkie (not a double cab), the exclusive right of use of which was once more provided to Mr
Mattheus with effect from this date. The cash cost of this vehicle amounted to R319 200 (including
VAT) while finance charges over the four-year period of this instalment credit agreement (as defined
in paragraph (a) of the definition in the Value-added Tax Act) was set at R31 920.

His employer accepted liability for all of the costs relating to this vehicle and paid the following
amounts to registered vendors up to 28 February 2005:

R
Deposit 159 600
Instalments: 10 x R3 990 39 900
Insurance premiums: 10 x R855 8 550
Fuel 4 446
Service 3 876

REQUIRED
Marks
(a) Discuss the VAT implications arising from each of the abovementioned
transactions for his employer for the relevant tax periods as covered from
1 March 2004 to 28 February 2005. Show all your calculations, but you need
not do individual calculations for each tax period in so far as the costs paid by
his employer are concerned. 11

(b) Based on the above information, calculate the amount, if any, to be included in
Mr Mattheus’ gross income for his 2005 year of assessment. 3
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Query 4 6 marks

Big Heart Limited and Prime Land (Pty) Limited are both registered VAT vendors and are further
connected persons, as defined for the purposes of the Value-added Tax Act. In an effort to
restructure the activities of the group at the commencement of their current years of assessment, it
was decided to transfer a commercial property (shopping complex) from Big Heart Limited to Prime
Land (Pty) Limited. It was resolved to effect such transfer at a value of R5,7 million (including VAT),
which was lower than the property’s open market value of R6,84 million. The total cost of the
property for Big Heart Limited amounted to R5,13 million (including VAT).

Prime Land (Pty) Limited did not have the required cash resources to finance the acquisition, while
financial institutions were reluctant to supply these funds with the knowledge that only 15% of the
floor space had at that stage been taken up by potential medium-term tenants. This negated any
possibility of charging the transaction with VAT at the zero rate (not a supply of a going concern) and
further meant that an interest-bearing loan (2% below prime rate) had to be advanced to this
company by Big Heart Limited.

At the end of the year of assessment, Prime Land (Pty) Limited had only managed to repay
R285 000 (more or less 5%) of the capital amount outstanding in respect of the loan. In addition to
this, the total interest charge of R484 500 in respect of this same year had also been settled. Both
companies solely make taxable supplies.

REQUIRED
Marks
Discuss all of the VAT implications arising from the above restructuring exercise for
both relevant companies in respect of the current year of assessment. 6

©
unisa 2006
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TRAVEL ALLOWANCE APPENDIX A

Travel allowance for years of assessment commencing on or after 1 March 2000

(Government Gazette no. 20931 of 25 February 2000)

Where the value of the vehicle - Fixed Fuel Maintenance

cost cost cost
R c c
does not exceed R30 000 16 916 23,1 17,1
exceeds R 30 000 but does not exceed R 35 000 18 984 23,5 17,3
exceeds R 35 000 but does not exceed R 40 000 21 051 23,8 17,8
exceeds R 40 000 but does not exceed R 45 000 23 116 24,3 18,5
exceeds R 45 000 but does not exceed R 50 000 25 197 24,8 19,2
exceeds R 50 000 but does not exceed R 55 000 27 670 25,3 19,9
exceeds R 55 000 but does not exceed R 60 000 29 778 25,5 20,6
exceeds R 60 000 but does not exceed R 70 000 33 873 25,9 21,3
exceeds R 70 000 but does not exceed R 80 000 38 102 26,1 22,2
exceeds R 80 000 but does not exceed R 90 000 40 538 26,3 22,7
exceeds R 90 000 but does not exceed R100 000 44 535 26,5 23,4
exceeds R100 000 but does not exceed R110 000 48 533 26,8 24,1
exceeds R110 000 but does not exceed R120 000 51 110 27,5 24,8
exceeds R120 000 but does not exceed R130 000 54 990 28,1 25,5
exceeds R130 000 but does not exceed R140 000 58 803 28,9 26,2
exceeds R140 000 but does not exceed R150 000 62 677 29,4 26,9

Where the value of the vehicle exceeds R150 000:

a) the fixed cost shall be R62 677 plus R3 874 for every R10 000 or part thereof by which the value
exceeds R150 000
b) the fuel cost shall be 29,4 cents per kilometre
c) the maintenance cost shall be 26,9 cents per kilometre
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SOLUTION

TOE409-X

APPLIED TAXATION
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QUESTION 1 – Suggested solution

PART 1

Calculation of taxable capital gains for Carl for the 2005 tax year

Description Calculation Capital

gain/(loss)
R
1985 Porsche 928 Personal use asset – exclusion i.t.o. par 53 - (1)
Yacht – 11 meters Proceeds R350 000 (½)
Less: Base cost (300 000) (½)
Capital gain R50 000 x 50% 25 000 (½)
Paintings Personal-use asset – exclusion i.t.o. par 53 - (1)
Listed shares Proceeds to be included as gross income (the share - (1)
portfolio is held for speculative purposes) and would
therefore not be subject to CGT as well (par 35(3)(a))
Kruger Rands Proceeds R100 000 (½)
Less: Base cost (75 000) (½)
Capital gain R25 000 x 50% 12 500 (½)
Stamp collection Personal-use asset – exclusion i.t.o. par 53 - (1)
Deemed disposal - donation (1)
Listed shares R75 000 x 50% (Megan) 37 500 (½)
Small business Proceeds R900 000 (½)
Less: Base cost (350 000) (½)
Less: Exclusion (par 57(3)) (500 000) (1)
Capital gain 50 000 50 000
The requirements for selling small business assets were
met, and therefore the exclusion of R500 000 can be
utilised.
Total capital gain 125 000
Less: Annual exclusion 10 000 (½)
Net capital gain 115 000
Inclusion rate @ 25 % (½)
Taxable capital gain for 2005 28 750
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Calculation of taxable capital gains for Megan for the 2005 tax year

Description Calculation Capital

gain/(loss)
R
Sea Cottage Proceeds R950 000 (½)
(Note: Less: Base cost R800 000 (½)
Capital gain R150 000 150 000
Excluded from joint estate i.t.o. the last will of Megan’s
father (1)
Yacht – 11 meters R50 000 x 50% 25 000 (1)
Kruger Rands R25 000 x 50% 12 500 (1)
Listed shares Proceeds R275 000 (½)
Less: Base cost 200 000 (½)
Capital gain R 75 000 x 50% 37 500 (½)
Persian carpets Personal-use asset – exclusion i.t.o. par 53 Nil (1)
Total capital gain 225 000
Less: Annual exclusion 10 000 (½)
Less: Assessed capital loss from 2004 7 500 (1)
Net capital gain 207 500
Inclusion rate @ 25% (½)
Taxable capital gain for 2005 51 875

Total 20

PART 2

(a) Calculation of the taxable income of Mr. JX for the 2005 tax year
R R
Basic salary 360 000 (½)
Incentive bonus 120 000 (½)
Vesting of equity instruments – -
Section 8B is not applicable as this share option plan is not part
of a broad-based employee share plan. The total market value of
the shares to be acquired would exceed the R9 000 threshold
stipulated
in section 8B(3).

Mr. JX is not taxed on the option to acquire shares in Broad

Based Technologies Limited. When he exercises the option on
31 January 2005, he is not allowed to sell the shares for a period
of 4 years. Because the shares are restricted equity instruments,
the option is (1)
also a ‘restricted equity instrument’. Section 8C(3)(b) stipulates
that when one restricted equity instrument (the option) is
disposed of for another restricted equity instrument (the share),
this does not
constitute a vesting (of the option). The option was also acquired
after 26 October 2004, being the implementation date of section
8C.
Long-service award
Cost to the company 8 000
Less: Amount allowed i.t.o. par 5 of the Seventh Schedule 5 000 3 000 (1)
INCOME 483 000
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R R
INCOME (brought forward) 483 000
Pension fund contribution (section 11(k))
Current contributions made 28 000
Maximum = greater of R1 750 or R360 000 x 7,5% 27 000 (27 000) (1)
Sub-total 456 000
Entertainment allowance – nothing allowed as a deduction in (½)
terms of sections 11(a) and 23(m) since Mr. JX earns only fixed 12 000 (½)
remuneration
Sub-total 468 000
Income protection policy contributions – The proceeds of the
policy will be income in the hands of the recipient and is therefore
deductible (Section 23(m)) ( 2 750) (1)
Travel allowance received 68 000 (½)
Travel claim = Value of the vehicle is R251 500
Fixed costs R105 291 / 27 000 km x 365/365 390,0 (1)
Fuel cost 29,4
Maintenance cost 26,9 (½)
446,3
Actual logged business km’s = 15 500 x R4,463 69 177 (½)
Claim limited to allowance received (68 000) (½)
Loss made on part-time business:
The loss made on the exotic bird breeding will be ring-fenced
i.t.o. section 20A for the following reasons:
 Mr. JX pays tax at the marginal rate of 40% (½)
 There seem no reasonable prospects to make profits in the (½)
foreseeable future.
 The trade carried on is a suspect trade, being animal Nil (½)
breeding carried on otherwise than on a full-time basis
 The loss will be carried forward (½)
Sub-total 465 250
RAF Contribution
Actual 25 000
Maximum = greater of R1 750, R3 500 – R27 000, or 15% x (½)
(R120 000 + R68 000 + R12 000 – R68 000+ R3 000
– R2 750) 19 838 (19 838) (1)
Sub-total 445 412
Capital gain
Proceeds on disposal of platinum coin 12 500 (½)
Less: Base cost (8th Schedule, par 20(l)(h)(ii)(bb)) (3 000) (½)
9 500
Less: Annual exclusion (9 500) Nil (½)
Sub-total 445 412
Donations – Section 18A - maximum = 5% x R445 412 22 271 (½)
Always limited to the actual donation for which a tax certificate
was obtained ( 5 000) (½)
Sub-Total 440 412
Medical expenses
Actual (R27 500 + R8 890) 36 390 (½)
Less: 5% x R440 412 22 021 (14 369) (½)
Taxable income for 2005 426 043 (½)
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Maximum 15

(b) Calculation of the donations tax payable by Mr. JX for the 2005 tax year

Date Reason Amount Donations

subject to tax payable
donations X 20%
tax
R R
Exempt i.t.o. section 56(1)(h)
– exempt entity Nil (1)
31 March 2004 Exempt i.t.o. section 56(1)(b) Nil Nil (1)
31 May 2004 Exempt i.t.o. section 56(2)(b) 30 000
Donation made (20 000) Nil (1)
Amount available for set-off 10 000
30 June 2004 Part exemption i.t.o. section 56(2)(b) 15 000
Donation made (10 000)
Less: Section 56(2)(b) 5 000 1 000 (1)
30 September 2004 Exempt i.t.o. section 56(1)(h) Nil Nil (1)
31 December 2004 Exempt i.t.o. section 56(1)(h) Nil Nil (1)
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QUESTION 2 – Suggested solution

Part 1

(a)
Section 24M will apply to the sale as the property is sold for unquantifiable future amounts in a
year of assessment commencing after 24 January 2005. (1)

The commercial property was held as trading stock by Apricot (Pty) Ltd and therefore section 24M
must be read in conjunction with sections 23F(2), (2A) and (2B). (1)

Only consideration that is quantified in a specific year of assessment will therefore accrue to
Apricot (Pty) Ltd (the seller). Initial deductions for the trading stock sold are limited to the initial
ordinary income quantified. (2)

Apricot (Pty) Ltd

2006 2007
R R
Accrued proceeds (2007: R1 850 000 x 15%) 350 000 277 500 (2)
Less: Opening stock value (R1 200 000 limited to accrued (350 000) - (1)
proceeds)
Section 23F(2A) - (277 500) (1)
Add: Rental income received (R195 000 x 2 months) 390 000 (1)
Less: Repairs (section 11(d)) (80 500)
Less: Electricity and water (section 11(a)) (42 300) (1)
Less: Legal expenses (revenue nature – in business of buying and (90 400) (1)
selling of property)
Taxable income 176 800 Nil
Suspended section 23F(2) (2006: R1 200 000 – R350 000) (850 000)
(2007: R850 000 – R277 500) (572 500)
11 marks
(b)
The definition of “goods” includes fixed property. The supply of fixed property by a vendor in the
course of or furtherance of an enterprise carried on by him must be charged with VAT unless the
supply is an exempt supply.

The supply of commercial property by a vendor is subject to VAT at 14% or 0%. No transfer duty is
payable in respect of any property disposed of where the transaction is subject to VAT at 14% or
0%.

The transaction can only be zero-rated if Apricot (Pty) Limited (the seller) and Melon (Pty) Limited
(the purchaser) agreed in writing that:
- the enterprise (commercial property) is disposed of as a going concern. (1)
The going concern criteria will only be met if:
- Apricot (Pty) Limited and Melon (Pty) Limited intend that the commercial property will
constitute an income-earning activity on the date of transfer thereof. (1)
The commercial property is sold with existing lease agreements in place and therefore
will constitute an income-earning activity. (1)
- The assets necessary for carrying on such enterprise are disposed of by Apricot (Pty)
Limited to Melon (Pty) Limited. This is the case. (1)
- Apricot (Pty) Limited and Melon (Pty) Limited must agree in writing at the time of conclusion
of the agreement, that the supply is inclusive of VAT at zero percent. (1)
5 marks
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If all the above requirements are met, the commercial property can be sold as a going concern.

Part 2

(a)
- The proceeds on the sale of the patent will be capital in nature despite the fact that it
was held for such a short time. The original intention with buying the patent was capital
and there is no intention that a change in intention took place. (1)
- A patent is an asset as defined in paragraph 1 of the 8 th Schedule (“an asset includes
property of whatever nature, whether movable or immovable, corporeal or incorporeal, …”
- The American patent is disposed of during the year of assessment, and therefore the 8 th
Schedule will be applicable.
- The asset (American patent) is replaced with a replacement asset (RSA patent) and we
have to determine if paragraph 66 of the 8th Schedule will be applicable.
- No par 66 cannot be selected (1)
- Paragraph 66 is only applicable to assets which qualified for an allowance in terms of
sections 11(e), 12B, 12C, 14 or 14 bis (paragraph 66(1)(a)). This is not the case as (1)
section 11(gC) will be used. (1)
Therefore the capital gain cannot be spread over a number of years (include full capital (1)
gain in calculation of taxable income)
- The recoupment must therefore be included once-off in gross income in terms of
section 8(4)(a) as paragraph 66 of the 8th Schedule can not be elected. (1)
Maximum: 3 marks

(b)
R R
Net profit before tax 295 000
American patent - sec 11gC: R284 000 ($40 000 x R7,10) x 5% (14 200) (2)
Sec 24I realised exchange loss ($40 000 x (R7,25 – R7,35)) (4 000) (2)
Sec 8(4)(a) recoupment 14 200 (1)
New RSA patent – sec 11gC: R380 000 x 5% (19 000) (1)
272 000
Capital gains tax
Capital gain on disposal of American patent 35 500
Proceeds - $45 000 x R7,10 (par 43(4) 8th Sch) 319 500 (1)
- Recoupment (14 200) 305 (1)
300
Base cost - $40 000 x R7,10(par 43(4) 8th Sch) 284 000 (1)
- Section 11gC allowance (14 200) 269 (1)
800
Capital loss on disposal of delivery vehicle (15 000) (1)
Net capital gain 20 500
Taxable capital gain @ 50% inclusion rate 10 250 (1)
Taxable income 282 250

Normal tax payable @ 29% 81 852,50 (1)

13 marks
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Part 3

The required part of the English version of the question is capable of being interpreted in two ways,
namely:

- “income” as defined in section 1 of the Income Tax Act

- “income” nature as opposed to capital nature as per the meaning ascribed to it in cases such
as Natal Estates and Vissers case.

Whichever way the required part is interpreted (it does not matter that the word “income” is in
inverted commas) the required answer is ultimately the same.

If the first interpretation is used by the student, then he would have to indicate that “income” as
defined means “gross income” less “exempt” income. He would then indicate that there is no
exemption for theft of moneys and he would thereafter discuss whether the receipt of the stolen
monies is included in “gross income”, namely,

(a) any amount – not necessary to discuss

(b) received by or accrued to – “accrued to” not necessary to discuss but “received by” imperitive
to discuss to discuss
(c) in cash or otherwise – money stolen therefore not necessary to discuss
(d) during year of assessment – not necessary to discuss
(e) not of a capital nature – imperative that it is discussed

Thus if the first interpretation is used, only those of elements “received by” and “not of a capital
nature” need to be discussed in detail.

If the second interpretation is used, then in terms of Vissers case (this interpretation is described in
Huxam & Haupt), the nature of income is discussed as follows: “if we take the economic meaning of
capital and income, the one excludes the other”. The answer then would have to discuss:

- whether the theft of the money is of a capital nature

- if not of a capital nature then it is of an “income” nature.

In order to meet the “income” nature test we would then have, once again, to look at the
requirements of “gross income”.

Thus it can be seen that the only point of difference between the two interpretations is the aspect of
whether there is an exemption in the Act for the theft of moneys.

The Afrikaans version stipulates that a discussion is necessary in regard to whether the theft of
monies is of a capital or revenue nature. This is obviously a more defined requirement and therefore
it is clear that only the alternative interpretation is possible.

The following then, is the suggested mark plan for the solution.

If the first interpretation is taken, it is necessary to state that there is no exemption for theft of
moneys.

No mark is awarded for this statement.

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Thereafter, the solution follows the same format for both interpretations and also for the Afrikaans
answer.

In terms of COT v G, the theft of monies is regarded as an “unilateral taking” and is therefore
neither capital or revenue in nature. (1)

Please note that a mark is not awarded for the name of the case, but for the principle which comes
from the case.

However, G’s case is an old Zimbabwean case and is merely persuasive authority. We therefore
need to look at the relevant SA cases. Geldenhuys v CIR attributed to “receipt” the following
meaning “received by him on his own behalf and for his own benefit”. In Geldenhuys case it was
held that a person who only has an “usufructary” interest does not hold or receive an amount for his
own benefit. It is received and held for the benefit of the “bare domminium” holders. (1)

There can now be a divergence between the answers.

In the context of the question, there appears to be little doubt that the theft of monies constitutes an
amount “received on his own behalf and for his own benefit”. The theft of the monies was not for
anyone else’s benefit – it was totally for the benefit of the thief – there was no fiduciary duty to hold it
for someone else.

The two cases appear to be at odds with one another and therefore, there is no certainty in the
matter as to whether the theft of monies is in the nature of income or not.

However, ITC 1624 throws some further light on the matter. In that case the overcharging of a
client constituted an amount received. Overcharging is similar, in many ways, to theft. Perhaps
more decisive and persuasive is ITC 1545, a case dealing with the theft of diamonds. It was
accepted by the appellant that receipts from the theft and sale of diamonds constituted gross
income. (2)

(The only question which arose in that case was whether a deduction could be claimed for the
possible return or damages claim for the diamonds stolen. The court held that there was only a
contingent claim for damages and therefore was not allowable as a deduction).

Accordingly, the better view is that the theft of monies does constitute a receipt.

Alternative: Students could also have discussed capital vs revenue in depth. Stating that the
R180 000 will be revenue in nature as it has been designedly sought for and worked for. (2)

Mentioning of the name of a court case together with the correct principle. (1)

One mark allocated for a conclusion supported by the reasoning.

(1)

The waiver of the debt will give rise to capital gains tax implications (par 12(5)). (1)

Note that although marks are awarded as indicated above, discresionary bonus marks can be
awarded, e.g. stating that according to the Delagoa Bay case illegal receipts can be taxable.

Maximum: 5 marks
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Part 4

The dog has been purchased for trade purposes (to perform the duties of a watchdog - security).

The R2 800 paid for the purchase of the dog is a capital expense - a one-time expense from which
an enduring benefit should flow (also more closely linked to the income earning structure rather
than the income earning operations - New State Areas) - and is not deductible per the general
deduction formula. The cost of the dog may be written-off over a period of time in terms of section
11(e). (4)

The monthly cost of maintaining the dog (R50 to feed him each month) is an expense which is a
necessary concomitant of the taxpayer’s trade (in the production of income - PE Electric
Tramways, Joffe) and of a non-capital nature (New State Areas) and therefore deductible. (3)

The R20 paid for the dog’s licence and the R3 500 veterinary surgeon’s account are also expenses
which are likely to recur from time to time (in the production of income) and do not lead to an
enduring benefit and therefore will also be deductible for normal tax purposes. (1)

8 marks
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QUESTION 3 - Suggested solution

Part 1

R R

Dividend declared 90 000

Dividends exempt in terms of section 64B(5) from secondary tax on
companies Nil
Total dividend declared 90 000 (1)
Dividends that accrued during the cycle 1/10/2004 to 31/3/2004
1. RSA listed companies – dividend accrued (36 000) (1)
2. Liquidation distribution
-Repayment of share capital – not a dividend Nil (1)
-Profits before 31 March 1993 must be disregarded –
refer to section 64B(3A)(a) Nil (1)
-Profits after 31 March 1993 (6 500) (1)
-Profits of a capital nature prior to 1 October 2001
must be disregarded – refer to section 64B(3A)(d) Nil (1)
-Profits of a capital nature after 1 October 2001 (1 800) (1)
3. Subsidiary – must be disregarded – refer to section 64B(3A) Nil l (1)
(a)
4. Collective investment scheme:
-Section 11(s) – must be disregarded – refer to section
64B(3A)(a) Nil (1)
-Interest component – not a dividend Nil (1)
-Dividend component = dividend accrued (6 700) (1)
-Foreign dividend – must be disregarded – refer to
section 64B(3A)(a) Nil (1)
Total of dividends accrued (51 000)
Excess from previous cycle – refer to section 64B(3)(a) (9 000) (1)
Total of dividends accrued and excess (60 000)
Net amount 30 000 (1)
Secondary tax on companies at 12,5% 3 750 (1)

15

Part 2

(a)(i) The Share Trust

As the beneficiary has a vested right to all the income in the trust, (1)
the trust will never have any taxable income (1)
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(a)(ii) Father

The fact that the loan carries no interest would mean that there was a settle-ment or (1)
other disposition and therefore that section 7 applies. As Grandchild is entitled to it, it is (1)
deemed in terms of section 7(3) to accrue to Father. (1)
R
Rent deemed to accrue to Father 600 000
Administration (6 000) (1)
Repair (54 000) (1)
Net rental 540 000
5

(a)(iii) Grandchild
R R
Dividends on shares inherited from Grandfather 45 000 (1)
Exempt in terms of section 10(1)(k)(i) (45 000) (1)
Calculation of the dividend that will be received on liquidation:
The capital gain made on the sale of the property in the company is:
R1 300 000 - R750 000 550 000 (1)
The company does not quality for the primary residence exclusion.
The tax thereon is then: R550 000 x 50% (1)
(inclusion rate for a company) * 30% = 82 500 (1)
(R550 000 – R82 500) (Mark given for gain less tax) 467 500 (1)
The secondary tax on the dividend at deregistration is then: x
12,5/112,5 = 51 944 (1)
In terms of section 25B this is deemed to accrue to Grandchild
The capital gain consequences (for the shareholder) is then as (1)
follows:
Cash received 1 165 556
Less: Dividend 415 556
Capital distribution (also = proceeds) 750 000 (1)
The market value of the shares at the date of death is the base
cost 1 200 000 (1)
Capital loss (450 000) Nil
Dividend received on deregistration 415 556 (1)
Dividend exempt in terms of section 10(1)(k) (415 556) (1)
Interest received 5 800
Exempt in terms of section 10(1)(i)(xv) (5 800) (1)
Patent: royalties 42 000 (1)
Deduction in terms of section 11(gC) – 5% of R800 000 (40 000) (1)
Taxable income 2 000
15

(b) Shares

The loan that was made on 1 March 2004:

is deemed to be an amount distributed (1)
As it was made to a shareholder (or connected person). (1)
It does not qualify for the exemptions (section 64C(4)) as it:
- is interest free and as there is sufficient reserves (1)
- was not repaid within 12 months (1)
4
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QUESTION 4 – Suggested solution

Query 1

Since there is no employer/employee relationship, the free use of the flat cannot be taxed under
the fringe benefit legislation - Seventh Schedule. (1)

Rather there is a contractor/contractee relationship and services are being performed.

Therefore, any receipt, in cash or otherwise, must be taxed in terms of paragraph (c) of the
definition of “gross income”. (1)

A complicating factor, is how to value such free use of a flat, as and when required, in view of the
case law which we have on the matter. (In cash or otherwise). (1)

The Stander case (Appellate Division), confirmed the principle that even where services are
rendered, the question to be asked is whether something given in kind is “money’s worth or
something which can be turned into money” - if the something in kind is not money’s worth or
cannot be turned into money, then the receipt is not taxable. (Value of any form of property
earned – Lategan’s case) (2)

The fact that the architect is not entitled (in fact he is prohibited) to rent the flat to any other
person, means that it cannot be turned into money. (1)

Whether the free use of the flat is something which is money’s worth, is debatable. What happens if
the architect decides never to use the flat or only uses it once in 20 years? (1)

Accordingly, the better view is that the free use of the flat, where the taxpayer is not entitled to rent
the flat to third parties or anyone else for that matter, would not constitute a ‘receipt’ for the purposes
of ‘gross income’ and is therefore not taxable (any conclusion). (1)
8

Note (not required from student, but if mentioned a bonus mark may be awarded)

Using a subjective test as the correct test, there can be no value attributable to the free use of the
flat in return for the designing of the block of flats. Even using an objective test, it is difficult to see
any value attributable because there is no way to value such use.

If, on the other hand, Mr Archie Techt was entitled to rent the flat out to third parties, then the free
use of the flat, even if he decides not to rent it out, would be regarded as a receipt for the purpose of
“gross income” and the value of the receipt would be based on the market value of rental income
which could be earned.

The object of this question was not so much to obtain a so-called ‘correct’ answer but to establish
whether the candidate could identify the problem and apply well-known and important case law, to
answer it.

Query 2

The party that has benefitted from the reduction in the amount of the outstanding loan is the Shaik
Family Trust. The amount will, however, not form part of its gross income as it will be capital in
nature due to its fortuitous nature. (1)
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A normal donation of cash will not have any capital gains tax implications as currency is
excluded from the definition of an asset for the purposes of the Eighth Schedule (i.e. no disposal of
an asset). But in terms of paragraph 12(5) of the Eighth Schedule, such reduction of a debt owed to
a creditor will be treated as a disposal as it is not otherwise taxable (for example, as part of a
recoupment (section 8(4)(m)) or a compromise with creditors (section 20(1)(a)(ii))). (2)

The capital gain of the debtor (the Shaik Family Trust) will be equal to so much of the debt that
was reduced (R30 000) and in terms of the attribution rules (paragraph 70) such gain will have to be
taken into account by the person who made the gratuitous disposition that is subject to the
stipulation or condition that beneficiaries do not acquire any vested right thereto until the trustees
have exercised their discretion. On the other hand, the creditor (Mr Shaik) will be allowed to
claim his capital loss (of R30 000) arising from such reduction in the outstanding loan, against
such capital gain (paragraph 56(1) read with paragraph 56(2) as well as paragraph 39(2))
notwithstanding the connected person-relationship. No aggregate capital gain or aggregate
capital loss will arise (capital gain equal to capital loss) and there will be no inclusion in taxable
income by way of a taxable capital gain (conclusion). (4)
7

Query 3

(a) Section 8(8) of the Value-added Tax Act will normally deem any indemnity payment under a
contract of insurance to be received for a supply of services rendered to the extent that it relates
to a loss incurred in the course of carrying on an enterprise. This will, however, not apply to the
extent that such payment relates to
 the total reinstatement of goods stolen or damaged beyond economic repair; and
 where the vendor was denied a deduction of input tax in respect of its acquisition (motor
car, as defined). (2)

As both requirements have been met, his employer need not account for any deemed output tax
in respect of such indemnity payment (alternative for one mark: eemed output tax accounted for). (1)

The replacement vehicle does not fall within the definition of a motor car and the claiming of an
input tax deduction will not be prohibited by section 17(2)(c). As it will be used solely to make
taxable supplies and it was further acquired in terms of an installment credit agreement, the full
input tax deduction can be claimed in its two-month tax period ending 30 June (14/114 x
R319 200 = R39 200). This is due to the time-of-supply rule as contained in section 9(3)(c), stating
this will be the earlier of the time of delivery or the time any payment is received (no further
implications on subsequent payment of installments). (2)

The payment of finance charges by way of the monthly installments will not give rise to any VAT-
charge as this relates to a financial service, which will constitute an exempt supply (section 12(a)).
No input tax can be claimed in this regard. (1)

The supply of fuel levy goods will be zero rated (section 11(1)(h)) and his employer will,
therefore, not be able to claim any input tax in this regard. But the insurance premiums and charge
for its service will be charged with VAT at the standard rate. Seeing that the vehicle will be used
solely for the making of taxable supplies, an input tax deduction of 14/114 x (R8 550 + R3 876) =
R1 526 can be claimed in total over the two-month tax periods commencing on 1 May and ending
on 28 February. (2)
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The employer will also have to account for a deemed output tax in respect of the supply of the fringe
benefit in the form of the right to use the vehicle (section 18(3)). Due to the fact that the employer
had been entitled to an input tax deduction in respect of the acquisition of the vehicle, the monthly
deemed output tax will be equal to 14/114 x (100/114 x R319 200) x 0,6% = R206,31 (each
individual two-month tax period from June to February thus having R412,62 by way of output tax to
be accounted for).

(3)
(b) The value of the fringe benefit to be included in Mr Mattheus’ gross income is calculated as
follows:

1,8% x (100/114 x R319 200) x 10 months = R50 400 (3)

14

Query 4

Big Heart Limited

This company will have to account for output tax on the supply of such property as it is a registered
vendor (no transfer duty as VAT will be levied). The fact that it relates to a transaction between
connected persons for a consideration lower than open market value, will not affect the
consideration in money to be used as the recipient (Prime Land (Pty) Limited) will be entitled to
a full input tax deduction (section 10(4)) as it solely makes taxable supplies. The total output tax
eventually to be accounted for will therefore be 14/114 x R5,7 million = R700 000. (2)

Section 16(4)(a)(ii), however, prescribes that Big Heart Limited only has to account for output tax to
the extent that payment of any consideration which has the effect of reducing or discharging any
obligation, has been made. As only R285 000 of the loan has been repaid, the output tax for the
year will amount to 14/114 x R285 000 = R35 000. (1)

The interest relates to a financial service, which will be an exempt supply (section 12(a)) and no
output tax needs to be accounted for in this regard. (1)

Prime Land (Pty) Limited

The VAT implications for this company, are a mirror image of that for the supplier company. VAT will
be levied on the supply of the property and there is thus no transfer duty payable, nor deemed input
tax credit to be claimed. The consideration in money will once again be the actual selling price (not
the market value) and the total input tax credit eventually to be claimed amounts to R700 000.
(1)

Section 16(3)(a)(iiA) will limit the deduction of input tax to the extent that payment of any
consideration which has the effect of reducing or discharging any obligation, has been made. As
only R285 000 of the loan has been repaid, the input tax to be claimed for the year amounts to
R35 000.

(1)

No VAT will be charged on the interest (financial service – exempt supply) and, correspondingly, no
input tax can be claimed. 6
35
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QUESTION PAPER

TOE412-S

APPLIED AUDITING
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QUESTION 1 35 marks

You are an audit manager employed by the audit firm, Creative Inc, which provides the following
services:

 external audits
 management consulting services
 taxation services to audit clients
 internal audit services to clients
 IT systems services to audit clients
 legal services to audit clients
 corporate financial and similar services

Below are three cases related to audit clients of Creative Inc.

CASE 1

Creative Inc are the external auditors of VData Ltd, a leading supplier of audio and video
communication solutions to the South African market. The company is listed on the JSE Securities
Exchange SA in the IT sector. VData Ltd developed a videoconferencing system (VS) that is an
extremely popular product. The turnover of VData Ltd has improved dramatically after the
introduction of the VS. However, the directors are concerned because the company could eventually
lose its market share for video conferencing due to intense competition.

CASE 2

PLATO Ltd is listed on the JSE Securities Exchange SA. This company developed and
manufactures patented fizzy cola drink. During the financial year ending on 30 November 2005,
PLATO Ltd acquired 80 per cent of the issued share capital of Jupiter (Pty) Ltd, a competitor that
focuses on the development and manufacture of a generic substitute for the fizzy cola drink.
Creative Inc was appointed as the auditor of both companies. Both audits are nearing completion
and the following issues require your urgent attention:

 The administration department of PLATO Ltd deals with capital expenditure and has to obtain
three quotes for all expenditure in excess of R500 000. These quotes are subsequently
submitted to a tender committee that awards the contract. The board of directors must
approve tenders in excess of R4 million. Three of the five directors must be present at a
directors’ meeting to constitute a quorum.

 One of the contracts you have reviewed shows that no alternative quotes had been obtained.
In addition, no documents could be presented to support the approval of the contract.

A R4,5 million contract had been awarded to Big Builders (Pty) Ltd for the construction of a site office
at the Johannesburg plant. You directed an enquiry to the financial director who is a chartered
accountant (SA). He referred you to the minutes of the directors’ meeting during which the contract
was approved. The minutes reflect that the financial director and two other directors were present.
However, an accounting clerk has told you that Big Builders (Pty) Ltd is controlled by the financial
director’s wife because she is the majority shareholder in the company.
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CASE 3

Tile Anglo (Pty) Ltd is a leader in the market for tiles and sanitary ware. The company operates a
chain of shops throughout South Africa. Tile Anglo (Pty) Ltd proposes to open outlets in Durban and
Cape Town over a three-year period. Once these outlets have been successfully established, the
company intends to seek a listing on the JSE Securities Exchange SA.

Mr Sam Bucks, the financial director of the company, is concerned about the processes being
implemented by the board of directors in order to comply with the King II Code requirements. He also
indicated that the two issues outlined below were discussed during a recent meeting of the board of
directors. All four company directors were present at the meeting:

 Mr Jacques Chirac, Managing Director and Chairman of the Board

 Mr Sam Bucks, Financial Director
 Mr Gerhard Schroder, Marketing Director
 Mr George Bush, Operations and Personnel Director

(1) Internal audit

The board decided to establish an internal audit function. As some board members were not
convinced that the benefits of establishing such an internal audit function would outweigh its
costs, it was decided to appoint one individual initially to minimise salary expenses. This
person had to hold a BCom or equivalent qualification and Mr Bucks, the financial director,
was given the task of finding a suitable candidate. Mr Bucks would also have to supervise the
work of this person who would report directly to him.

Mr Bucks had great difficulty finding someone suitable for the position as the maximum salary
the board offered was relatively low. He eventually decided to appoint a recent BCom
graduate who, whilst having very little practical business experience, obviously had potential
for development. Mr Seeker was subsequently appointed as the company’s internal audit
clerk.

(2) Statement on directors’ responsibilities

During the meeting referred to above, the directors expressed concern about the King Code
requirement that boards of directors had to state the following in their companies’ annual
reports:

 adequate accounting records and an effective internal control system had been
maintained

 the internal control system was regularly reviewed for effectiveness

 an ongoing process existed for identifying, evaluating and managing significant risks
facing the company.

The directors also expressed concern about all the new reporting and disclosure requirements of
King. Mr Chirac, the chairperson, expressed the view that less disclosure was sometimes better. Mr
Bucks asked for advice on steps the directors could take to meet their responsibilities regarding the
annual financial statements in terms of the King II Code.
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REQUIRED
Marks
(a) Name five practices that could be implemented to ensure sound information
technology-related corporate governance at board level (CASE 1). (5)

(b) Comment, by referring to the Companies Act, code of conduct and corporate
governance, on the validity of the contract to Big Builders (Pty) Ltd. Submit
recommendations to management regarding potential corrective actions (CASE 2). (15)

(c) Indicate what the company can do to enhance the status of its internal audit
department (CASE 3). (6)

(d) Prepare a list of additional disclosures (apart from those set out above) that the board
of directors have to make in the company’s annual report to meet all the relevant
requirements (CASE 3). (6)

Presentation (3)
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QUESTION 2 75 marks

On 1 July 2005 you were appointed as the head of the internal audit division of Zimbani Ltd, a
diversified company operating in the security industry. Zimbani Ltd is listed on the JSE Securities
Exchange SA with its financial year ending on 30 June 2005. Ms Zuma is chairperson of the audit
committee of Zimbani Ltd.

The previous head of the internal audit division of Zimbani Ltd, Mr Morocco, resigned due to
significant differences with the chairperson of the audit committee of Zimbani Ltd. According to Mr
Morocco, the chairperson of the audit committee cannot be regarded as independent, because she
is a former executive director of Zimbani Ltd.

(A) FRANCHISE

On 1 August 2004 the board of directors of Zimbani Ltd entered into a franchise agreement
with a British company, Alert Systems plc. According to this agreement, Zimbani Ltd has the
right to manufacture, distribute and market Alert alarm systems in South Africa. Alert
Systems plc has already entered into similar franchise agreements with parties in various
European countries. The Alert alarm system is a revolutionary, affordable security system,
which grants access based on retinal identification. The board of directors of Zimbani Ltd is of
the opinion that this unique feature of Alert alarm systems will be the contributing factor in the
significant appreciation of the value of this right.

The franchise agreement makes provision for the following:

1. An initial lump sum of £5 million has to be paid to Alert Systems plc, on conclusion of the
agreement with it to acquire the franchise.

2. A further payment of £2 million is required for the franchise which is payable to Alert
Systems plc as soon as the new Alert alarm systems are launched on the SA market.

3. A monthly royalty payment of 2% to Alert Systems plc is required, based on the revenue
(turnover) of trading in Alert alarm systems by Zimbani Ltd.

4. Alert Systems plc is responsible for high profile advertising campaigns, including the
sponsoring of the European Soccer Series for five years, and research and
development to improve the current security systems.

(B) MANUFACTURING OF ALERT ALARM SYSTEMS

(i) Wage system

The manufacturing division of Zimbani Ltd manufactures the Alert alarm systems in a
factory situated in Benoni. The systems are sold to retailers.

Wages represent the largest single expenditure item of the factory. The system
description of the wages function is as follows:

The factory is divided into two production sections, each under the control of a
production manager. A factory manager is in overall control of the factory. The wage
function is computerised and all factory workers clock in and out daily using their
personnel cards. This is done by way of a clocking machine which is situated in the
middle of the factory and is thus easily accessible to all wage workers. Supervision of
the clocking procedures is carried out by the security guard, who is also responsible for
control over finished products leaving the factory.
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Wage workers are appointed by the respective foremen of each production section.
The foremen are also responsible for determining the initial wage scale of employees.
All times worked by individual wage workers are captured in real time from the clocking
machine on a wage-time transaction file. Each week, the system runs the wage-time
transaction file against the wage master file (which contains the wage rate and the
deductions per wage worker), and a wage sheet is then produced by the system. The
computerised controls have already been tested and have been found to be effective.
The wage sheet specifies the normal time and overtime worked per employee, per
section. Overtime is worked as the need arises and is the responsibility of each
foreman. The foreman signs the wage sheet and then sends it back to the accounting
section for further processing.

Every Thursday, the approved wage sheet for the previous week is taken to the cash
book clerk, who makes out a cash cheque for the total wage amount for the week for
all sections. The cash book clerk hands the cheque to the financial director, who signs
it and then gives it to one of the three wage clerks who then cashes the cheque so that
the wage packets can be made up on the Thursday afternoon.

Payment of the wages of each section is done every Friday afternoon by the foreman
of that section. After each wage-payment session, the foreman hands over the
unclaimed wages to the wage clerks, after which one of the wage clerks locks such
wages in a cash deposit box until they are claimed by the wage workers concerned.

(ii) Production cycles

Mr Mkasi, the managing director of Zimbani Ltd, is a qualified engineer who values
operational systems. The following production cycle was thus implemented at the
factory in Benoni:

Prenumbered production reports are prepared as soon as production begins for each
Alert alarm system production order. The prenumbered production reports are
continually updated with raw materials used and direct labour hours worked, as work-
in-process moves from one phase of production to the next. At the end of the
production cycle when it is regarded as completed, the production foreman signs the
production report.

Zimbani Ltd maintains a perpetual inventory record system for all raw materials and
finished goods in stock. At the end of every month the company does inventory cycle
counts. Company policy requires that at least 20% (based on R-value) of all perpetual
inventory records should be reconciled with the physical inventory on hand at the end
of each month. Work-in-process stages are estimated at the end of the month by the
respective production managers at the factory. At year-end, Mr Nkosi, the director of
production at Zimbani Ltd, prepares a schedule of work-in-process with the help of the
production managers. The stage of completion of each incomplete Alert alarm system
production order is stated in the year-end schedule of work-in-process. Cost
accounting records are maintained by Mr Nkosi to allocate direct and indirect expenses
to work-in-process for the calculation of unit cost prices of finished goods.

All inventories are valued on a FIFO basis.

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(iii) Internal audit work performed on inventories

The internal audit division has attended three of the cycle inventory counts at the
Benoni factory during the year under review. It includes the counts that were performed
at year-end, 30 June 2005. According to the internal audit report, the cycle counts were
conducted satisfactorily and perpetual inventory records were reliable. Transaction
work on raw material purchases, sales and transfers as well as on direct and indirect
expenses has also been performed during the year under review. The results were
satisfactorily.

REQUIRED
Marks

(a) Discuss the composition and functions of the audit committee in terms of the
requirements of King II. (10)

(b) Describe how all payments which arise from the franchise agreement made to Alert
Systems plc should be accounted for, measured and recognised in the books of
Zimbani Ltd up to year-end. (7)

(c) Discuss the audit procedures your internal audit team has to perform to assess the
likelihood of economic benefits arising from the franchise with regard to the Alert
alarm systems up to year-end. (10)

(d) Draft a report to the audit committee of Zimbani Ltd listing the weaknesses in its
wages system, as evident from the question. You are not required to list any
weaknesses on unclaimed wages. (18)

(e) Describe the substantive procedures that the internal audit division would carry out
after year-end to verify that the inventory figure of Alert alarm systems which
appears in the financial statements of Zimbani Ltd for the year ended 30 June 2005
is fairly presented. No audit procedures are required on the presentation and
disclosure assertion. You can assume that the internal auditor does not make use of
CAATS in the performance of his duties. (30)
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QUESTION 3 50 marks

You are the auditor of Rightprice Hardware Suppliers (Pty) Ltd, a company which sells building
material and hardware items at discounted prices at its stores throughout South Africa.

The company utilises a network of IBM AS/400 minicomputers for its transaction processing
systems. The transaction processing system architecture includes an expenditure cycle which
processes financial information pertaining to the acquisition of inventory items (i.e. building material
and hardware) as well as the processing of payments to settle the related obligations.

The purchase requisitions are manually prepared and batched in the Inventory Control Department.
Purchase requisition batches are sent on a daily basis to the Buying Department where buyers enter
requisition information into on-line terminals situated in their department. By making inquiries by
means of an on-line system supplier reference and history file, which contains evaluation data, the
buyers either confirm the suggested suppliers listed on the purchase requisitions or select more
suitable suppliers for which certain data (e.g. name) is then entered into the system. The purchase
order processing module has been designed to produce purchase orders using purchase requisition
information and standing data.

All goods received from suppliers are first counted and inspected by a receiving clerk who then
enters the receipt information into an on-line terminal. The inventory receipt recording module then
edits input data pertaining to goods received, updates the master files and prints goods received
notes (GRNs).

The following system documentation pertaining to the expenditure cycle was compiled by the audit
manager on the audit:

Figure 1: Purchase requisition form.

Figure 2: A flowchart of the purchase order processing and inventory receipts recording computer
modules.

Figure 3: A set of standard system flowcharting symbols.

From discussion sessions held with the managing director (Mr Brown) of the company, you have
established that the company is considering linking their purchase order processing module with
their suppliers’ Electronic Data Interchange (EDI) system which utilises a Value Added Network
(VAN). This link will enable your client to transact with its suppliers electronically. Mr Brown has
asked you to investigate the control techniques that can be utilised in a VAN environment to ensure
that the integrity of data messages and transaction data to, from and over the VAN are maintained.
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REQUIRED
Marks

(a) Briefly state the control objectives (relating to validity, completeness and accuracy) for
transaction processing performed by the purchase order processing module.
Discuss the programmed controls which that should be implemented to achieve the
control objectives. You should ignore general controls and present your answer in
tabular format as follows: (35)

Control objectives Expected programmed controls

(b) Describe the controls which will ensure that the integrity of your client’s data
messages and transaction data sent via (to, from and over) the VAN is maintained. (15)
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SOLUTION

TOE412-S

APPLIED AUDITING
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QUESTION 1

(a) Five practices be implemented to ensure sound IT corporate governance at board level

 Constitute an IT committee/steering committee as part of the overall board structure. (1)

 Educate board members on IT issues both global IT issues and company-specific IT

issues. (1)

 Appoint a board member with a good IT background or understanding. (1)

 Appoint an IT technical advisor to the board. This person need not be a full board
member but can be called upon when the board considers IT-related issues. (1)

 Make sure that IT issues are examined at board level. The board has to review how IT
risk is determined, analysed and managed. (1)

 Consult both the internal and external auditors to highlight IT risks and how these risks
are to be addressed (policies and procedures). (1)
6
Maximum 5

(b) Validity of contract to Big Builders (Pty) Ltd and potential corrective actions

1. The contract awarded to Big Builders (Pty) Ltd represents a contract in which a director
is materially interested as Big Builders (Pty) Ltd is controlled by the financial director
(FD) of Plato Ltd’s wife. (2)

For this contract to be valid, the following is required:

 the FD should have declared his interest, in writing, prior to the passing of any
resolution awarding the contract; (1)

 the FD’s interest should have been minuted; (1)

 the FD’s interest should have been noted in the register of directors’ interest in
contracts; (1)

 the FD should not have voted on the contract/recussed himself from the meeting;
(1)

 the FD should not have formed part of the quorum awarding the contract. (1)

2. The contract was thus not awarded in compliance with the requirements of the
Companies Act and is violable at the option of Plato Ltd’s members. (1)

3. However, in terms of Sec. 36 this contract is not void only because the directors did not
have the power to enter into this contract. (2)

4. Non-compliance with the code of ethics and the corporate governance principles will not
affect the validity of the contract. (2)
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5. Plato Ltd can do the following to correct the situation:

5.1 FD should disclose his interest to the members (in the notice convening the
members meeting); (1)

5.2 the members should ratify the contract; (2)

5.3 the interest should be minuted and noted in the register of directors’ interests in
contracts; (1)

5.4 disclosure of the related party should be made in the AFS; (1)

5.5 as members of SAICA should be free of conflicts of interest, the FD’s interest
should be disclosed to the audit committee of Plato Ltd; (2)

5.6 the board of Plato Ltd should design and comply with its own code of conduct
dealing with conflicts of interest; (1)

5.7 the board of Plato Ltd should ensure that the company complies with all relevant
statutory requirements; (1)

5.8 the members of Plato Ltd may hold the directors liable for any losses incurred. (1)
22
Maximum 15

(c) Status of internal audit department

To enhance the status of internal audit the board should:

 designate the head of internal audit as a senior member of the company. (The existing
title of Internal Audit Clerk does not convey this.) (1)

 allocate the same perks to the head of internal audit as other managers of a similar
status enjoy (own office, secretary, company car) (1)

 change the persons to whom the head of internal audit reports (Internal audit should
report to the audit committee on its work, and to the chief executive officer on
administrative issues.) (2)

 allow the head of internal audit to attend audit committee meetings (1)

 ensure that the head of internal audit has direct access to the chairman of the board (1)

 appoint a suitably qualified (technically proficient, independent and forceful) person to

head the internal audit department (1)

 educate the directors and managers to view internal audit as an important control
mechanism that can assist them in carrying out their own functions (1)
8
Maximum 6
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(d) Additional reporting

 The financial statements are the directors’ responsibility and fairly reflect the affairs of the
company. (2)

 The auditor is responsible for auditing and reporting on the financial statements. (1)

 Appropriate accounting policies, supported by sound decisions, judgments and

estimates, were consistently applied in compiling the financial statements. (1)

 Appropriate accounting standards were adhered to. If a deviation occurred in the

interests of fair presentation, such deviation was not only disclosed and explained but
quantified. (1)

 There is no reason to believe that the business would not remain a going concern in the
year to come. An explanation of reasons to the contrary is required. (1)

 The codes of corporate governance and conduct were adhered to. An explanation is
required if these codes were not adhered to. (1)
7
Maximum 6
Total 45
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QUESTION 2

(a) COMPOSITION AND FUNCTIONS OF THE AUDIT COMMITTEE

1. Composition

 The majority of members should be non-executive directors. (1)

 The chairperson should be a non-executive director, and not the same person as
the chairperson of the board. (1)

The concerns of the previous head of the internal audit division may therefore
have merit, because the chairperson of the audit committee cannot be regarded
as independent, being a former executive director of Zimbani Ltd. (1)

 The audit committee should be an efficient working group, consisting of 3 to 5

members. (1)

 All members should:

- have a sound mind and good, independent power of judgement; (1)
- be trained in accounting/auditing; and (1)
- have sufficient time to perform their duties and sound knowledge of the
business; (1)
- have sufficient knowledge of the company’s business and industry; (1)
- have a sound business background; (1)
- have sufficient time. (1)

 The following persons should not be members of the audit committee:

- external auditor; (1)
- internal auditor; (1)
- financial/administrative manager. (1)

 The above persons may, however, attend the audit committee meetings on
invitation. (1)

 Internal auditors, external auditors, financial and administrative managers should

not be part of the audit committee. (1)

 The audit committee members should be elected by the full board of directors. (1)

2. Functions

The audit committee is a compulsory subcommittee of the board of directors and

assists the board of directors. The audit committee makes recommendations to the
board of directors on the following:

 Review the appointment and remuneration of the external auditor. (1)

 Evaluation of the findings of the external auditors. (1)

 Review the fair presentation of the annual financial statements and half-yearly
interim reports. (1)
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 Evaluation of the effective functioning of accounting and internal control systems.

(1)

 Evaluation of the findings of the internal auditors. (1)

 Other diverse matters, e.g.:

- material irregularities;
- special investigations by the board of directors;
- social responsibilities;
- legal actions/lawsuits; and
- compliance with statutory requirements. (limit to 1)

 Review the independence of external auditors and review the scope of their work.
(1)

 Reviewing of the appointment and remuneration of the external auditor to be

submitted to the board of directors for approval. (1)

 Revision and approval of management advisory services rendered by the external

auditor. (1)

 Consideration of the fair presentation of the half-yearly interim reports and other
published financial information. (1)

 The monitoring of the company’s compliance to certain statutory requirements. (1)

Total 26
Maximum 10

(b) ACCOUNTING FOR, MEASURING OF AND RECOGNISING PAYMENTS MADE TO ALERT

ALARM SYSTEMS plc

1. An intangible asset should only be recognised if (IAS 38:21):

1.1 It is probable that expected future economic benefits that are attributable to the
asset will flow to the entity – Zimbani Ltd has the right to manufacture, distribute
and market the Alert alarm system in SA which could lead to future economic
benefits. (1)

1.2 The cost of the asset can be measured reliably – in terms of the legal agreement
£5 million and £2 million are payable. (1)

2. The initial measurement will be at cost, that is £7 million, converted to rand on the
transaction date. (1)

3. If Zimbani Ltd choose the cost model to value the intangible asset, it should be carried at
cost (£7 million converted to rand on the transaction date) less any accumulated
amortisation and any accumulated impairment losses (IAS 39:74). (1)
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4. Based on the board of directors’ opinion that, due to the unique features of the Alert
alarm system the asset will significantly appreciate in future value, they may choose the
revaluation model as the accounting policy, where the intangible asset is carried at its
fair value at date of revaluation less any subsequent accumulated amortisation and any
subsequent accumulated impairment losses (IAS 38:75). (1)
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5. IAS 38 requires that a revaluation model can only be used if the fair value of the
intangible asset can be determined by reference to an active market (where there are
willing buyers and sellers, these items are traded in the market and prices are available
to the public). The fact that Alert Systems plc already entered into similar franchise
agreements with parties in various European countries, may be indicative of an active
market, but it is questionable that prices will be available to the public and therefore the
revaluation model may not be appropriate. (2)

6. The monthly royalties payable of 2% on turnover should be accounted for as an

expense. (1)
Total 8
Maximum 7

(c) AUDIT PROCEDURES TO ASSESS THE LIKELIHOOD OF ECONOMIC BENEFITS FROM

THE FRANCHISE

1. Determine if the franchise will increase the net inflow of future economic benefits to
Zimbani Ltd by studying managements’ profit forecasts for the next five years from Alert
alarm systems. (1)

2. Review the process used to develop the profit forecasts for the franchise (in 1 above) to
obtain knowledge of the assumptions on which the profit forecasts are based, and
assess the reasonableness of these assumptions based on your knowledge obtained
during the internal audit. (2)

3. Obtain reports of feasibility studies and profit forecasts which were compiled by Alert
Systems plc for Alert alarm systems and confirm that the same assumptions are used
than in the above-mentioned profit forecasts. (1)

4. Analyse the results of actual sales of Alert alarm systems from 1 August 2004 until
30 June 2005 and confirm that it is reasonably in agreement with the profit forecasts. (1)

5. Test the mathematical accuracy of the computations made. (1)

6. Consider the effect of any public declarations, formal plans and decisions from directors’
meetings, and note any significant decisions on plans, contracts or legal agreements by
examining the minutes of directors’ meetings, making enquiries to management and
taking into account your knowledge of the Alert alarm systems. Evaluate how these
influence the profit forecast and to what extent the effect was taken into account in the
preparation of the profit forecast. (2)

7. Enquire about any assistance programmes granted by Alert Systems plc and evaluate
the influence thereof on the sales of Alert alarm systems and determine whether it was
taken into account in the preparation of the profit forecast. (1)

8. Taking the above-mentioned procedures into account, determine whether Zimbani Ltd
has the ability and intention to use the franchise and has adequate technical, financial
and other resources to obtain the expected future economic benefits. Take the following
into account: (1)

8.1 The economic conditions and trends prevailing at the balance sheet date. (1)

8.2 Results of feasibility studies on Alert alarm systems. (1)

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8.3 The presentation of a formal, board approved business plan of Zimbani Ltd which
indicates that the franchise will be used for an extended period. (1)

8.4 The availability of (internal and/or external) finance to maintain and run the project
successfully. (1)
Total 14
Maximum 10

(d) REPORT TO THE AUDIT COMMITTEE ON THE WEAKNESSES OF THE WAGES SYSTEM

Date

The Chairperson
Audit Committee
Zimbani Ltd
PO Box 1234
JOHANNESBURG
0001

Dear Ms Zuma

As requested we hereby report on certain weaknesses in the wages system to which we wish
to draw your attention (see Annexure A).

Please feel free to contact us for further information or advice.

Yours sincerely

HEAD OF THE INTERNAL AUDIT DIVISION (2)

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ANNEXURE A

1. Timekeeping

1.1 The clocking machine is situated in the middle of the factory and not at the
entrance or exit, and personnel can therefore leave the factory without clocking
out. (1)

1.2 There is no proper supervision of employees clocking in and out since the security
guard also has other duties to perform. (1)

2. Appointment

2.1 Segregation of duties regarding the foreman is lacking since:

 the foreman makes the appointments, determines the wage scales and
approves the time worked; (1)

 appointments are not independently authorised by the factory manager; and

(1)

 the foreman also does the paying out of wages. (1)

3. Checking of normal time and overtime worked

3.1 Normal time worked is not authorised since the foreman reviews the wage sheet
only superficially, and does not compare it with any proof of attendance. (1)

3.2 The overtime worked by the foreman is not authorised and, as a result,
unauthorised overtime wages can be paid out to him. (1)

3.3 In addition, there is no formal policy in respect of overtime work (e.g. approval by
the factory manager). This can result in inefficiency. (1)

4. Preparation of wage sheet and making up of wages

4.1 Control over the signing of the wage cheque is poor and fictitious workers could be
paid because:

 The relevant wage sheet which the foreman approved is not attached to the
wage cheque as supporting evidence; (1)

 the wage sheet is also not accompanied by other supporting documentation,

such as the wage sheet for the previous week, or resignation and
appointment forms; (1)

 the above mentioned documentation is not reviewed, checked or compared with

the information presented on the wage sheet. (1)

 only one cheque signatory is required. (1)

4.2 Control over the making up of wage packets is not independently checked and
tested, and errors may occur. (1)
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4.3 Segregation of duties is lacking because the wage clerks cash the wage cheque,
make up the wages and control unclaimed wages, therefore fictitious payments
could be made. (1)

4.4 The wages are kept at the premises of the enterprise on Thursday evenings, which
is risky because money can be stolen/misappropriated, if the cash is not safely
stored. (1)

4.5 The cheque is cashed by one wage clerk:

 supervision and control are lacking; and (1)

 the money can easily be hijacked/stolen. (1)

4.6 Supporting documentation is not cancelled once presented to the FD for signature.
(1)

5. Paying out of wages

5.1 Segregation of duties and control over wage payments are lacking since the
foreman alone makes the pay-outs and payments to fictitious workers will not be
traced. (1)

5.2 There is no indication that workers identify themselves during the paying out of
wages, that they check their wages or sign as proof of receipt. (2)

5.3 Workers do not sign payment register. (1)

Total 24
Maximum 18

(e) SUBSTANTIVE PROCEDURES AFTER YEAR-END TO VERIFY INVENTORY OF ALERT

SYSTEMS FOR THE YEAR ENDED 30 JUNE 2005

1. General

1.1 Reperform on a test basis the casts, cross-casts and calculations in the notes to
the balance sheet, ledger accounts and perpetual inventory records and agree the
amounts in the general ledger to the financial statements of Zimbani Ltd. (2)

1.2 Analytical procedures

1.2.1 Compare the Gross Profit percentage (GP%) and stock turnover ratio on a
month-to-month basis and to budgets. (1)

1.2.2 Compare the results of the year-end cycle count (30 June 2005) with those
of the other counts during the year, for example, the percentage of
adjustments required. (1)

1.2.3 Obtain further information on unusual fluctuations identified in (1.2.1) and

(1.2.2) above. (1)
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1.3 Make enquiries, inspect minutes of management and board meetings to determine
whether any events after balance sheet data have occurred which could have an
impact on inventory. (1)

2. Rights, obligations and existence

2.1 Inspect invoices to confirm that they are addressed to Zimbani Ltd. (1)

2.2 Inspect minutes, bank confirmations and correspondence for evidence of

encumbrances of inventory. (1)

2.3 Compare the uncompleted jobs from the final work-in-progress schedule of the
director of production as on 30 June 2005 with the production reports of work-in-
progress at the plants to assess the reasonableness of the director of production’s
schedule of work-in-progress. (1)

2.4 Make enquiries to management regarding any stock in transit. (1)

3. Valuation and allocation

3.1 Cost

Confirm the correctness of cost prices used on the perpetual inventory

records/work-in-progress schedule as follows:

3.1.1 Raw materials

 Trace prices to the most recent supplier invoices. (1)

 Inspect shipping/carriage-inwards documentation and confirm that such

charges have been correctly included in inventory prices. (1)

 Confirm appropriate foreign currencies from financial institutions and

determine that foreign currency fluctuations on raw material imports have
been treated in accordance with the accounting framework and reperform
calculations. (1)

3.1.2 Work-in-progress/finished goods

 Inspect the perpetual inventory records and production reports to verify

that transfers from raw material to work-in-progress are on the FIFO
basis (i.e. that the earliest relevant purchase prices are used for each
transfer). (1)

 Inspect and recalculate the most recent cost accounting records to verify
other direct and indirect costs that are attributed to WIP and finished
goods. (1)

 Inspect the cost accounting records to verify that applicable portions of

labour have been included consistently in the cost of work-in-progress,
with reference to the labour records. (1)
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 Obtain a copy of the schedule overhead allocated to work in progress and

determine whether the allocation of overheads is based on normal
production by:

- reperforming the calculations;

- making enquiry and having discussions with management on the
method used in the allocation;
- making comparison with previous years to establish past practices to
determine the consistency and reasonableness of the allocation
of overheads; and
- identifying cost not directly related to production of Alert alarm
systems to ensure that it was expensed and not capitalised. (2)

3.2 Net realisable value of finished goods and raw materials

3.2.1 Confirm that all inventories (raw materials and finished goods) are valued at
the lower of cost or net realisable value by:

 Comparing the selling prices per latest sales invoices/price lists with cost
prices per final priced stock sheets. (1)

 Comparing sales volumes just prior to year-end with sales of previous

months to assess risk of obsolescence. (1)

3.2.2 Inspect final-priced inventory sheets to verify that:

 Damaged/obsolete inventory has been clearly identified and valued

appropriately (refer to 3.2.1 above). (1)

 Inventory identified as obsolete/damaged by the internal audit team

attending the year-end cycle count, appear, as such on the final-priced
stock sheet. (1)

3.2.3 Assess the adequacy of provisions for stock obsolescence or determine

the need for such provisions by obtaining a copy of the schedule of provision
for obsolete inventory:

 Assessing the reasonableness of the assumptions. (1)

 Reperforming calculations. (1)

 Comparing the estimate with prior years and with the percentage obsolete
or damaged inventory items identified during the cycle counts. (1)

 Making enquiries and discussing the matter with management. (1)

3.3 Reconcile the totals of the general ledger inventory accounts to the perpetual
inventory records and summary of production reports. (1)

3.4 Based on the above, confirm the journals for transfer of expenses and raw
materials to the WIP account and transfer of finished goods to the finished goods
account. (1)
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4. Completeness

4.1 Establish cut-off numbers for the documents below by referring to audit work
papers for the year-end stock count:

 goods received notes;

 raw materials requisitions;

 production reports;

 sales invoices; and

 labour records. (1)

4.2 Trace the last few (say, 10) document numbers prior to the cut-off numbers to the
current year’s accounting records (i.e. before 30 June 2005) for each of the above
documents or journals. (1)

4.3 Trace the first few (say, 10) document numbers after the cut-off numbers to the
next year’s accounting records for each of the above documents or journals. (1)

4.4 Verify the completeness of the work-in-progress schedule by:

4.4.1 Comparing the related raw materials requisitions and production orders with
the production reports. (1)
4.4.2 Assessing the reasonableness of these quantities in terms of the production
schedule. (1)
4.4.3 Comparing production reports with the perpetual inventory records for
finished goods after year-end to verify that work-in-progress was ultimately
recorded as finished goods (allowances may need to be made for spoilage).
(1)
4.4.4 Tracing uncompleted jobs at year-end from the production reports for work-
in-progress at the plants to the work-in-progress schedule of the director of
production. (1)

4.5 Trace test counts of inventory determined per your audit working papers from the
year-end stock count to year-end quantities per the perpetual inventory records.
(1)
Total 37
Maximum 30
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QUESTION 3

(a) (i) Purchase order processing module

Key control objective Expected programmed control

1. Validity of (i) order information Authentication of order information received
(purchase requisitions) received
as well as (ii) data capturing  Only official and approved purchase requisi-
activity tions received (in the normal course of
business) from the Inventory Control
Department will be accepted for data
- Only valid data are ac-cepted capturing. (1)
for data capturing. (1)
Authentication of users/valid data capturing
- Logical access to the functionality
application software func-
tionality is restricted to  Logical access is only permitted by use of a
authorised users. (1) valid logon ID and password combination (i.e.
user IDs should be unique and passwords
should be specific to one ID). (1)

 Logon IDs are automatically disabled after a

prescribed number of logon failures or a set
period of inactivity. (1)

 Logical access is restricted to certain times

during the day (e.g. working hours). (1)

 Menu selections displayed and user access

rights are restricted based upon the access
privileges defined by the user ID (security
matrix). (2)

 Password confidentiality is controlled by

requiring individual passwords to be changed
at regular intervals. (1)

 An audit trail of access/activity is generated

and reviewed daily or weekly. (1)

 Changes to user IDs and privileges are

logged, reported and confirmed with
authorised documentation. (1)

 Passwords should not be displayed on

terminals while they are entered. (1)

 Any other valid point(s). (1)

Maximum for authentication of users 4
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Key control objective Expected programme control

2. Completeness of order details  Computer program calculation of batch totals
entered on terminal to be agreed with input batch totals i.r.o. (1)
- number of documents (1)
- All purchase requisitions and - hash totals (e.g. stock items and supplier
requisition details must be numbers). (1)
completely captured. (1)
 Computer program must check if the purchase
requisition batch numbers and individual
requisition numbers are in sequence.
(1)

 Computer program must check that number of

requisitions per batch received correspond
with batch header totals. (1)

 Exception reports should be automatically

generated by the computer when gaps in the
numbers are identified. (Exception reports
should be followed up by responsible official.)
(1)
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3. Accuracy of order details  The following design techniques assist to

entered on terminal ensure accurate and valid entry:
- logical screen layout, and (1)
- All purchase requisition details - prompting, ensuring the sequence of entering
must be accurately entered. is logical. (1)
(1)
 Extensive edit checks are to be carried out on
the forms captured, such as: (1)
- alphabetic check on vendor field; (1)
- numeric check on dates, item no, quantity,
unit and price fields; (1)
- existence of the stock item and supplier by
means of record confirmation checks; (1)
- limit the input of data by, for example,
retrieving unit prices directly from
masterfile information rather than retyping
requisition prices; (1)
- field size tests on input fields (e.g. item
number); (1)
- descriptive data echo tests – for example,
when an item number is entered then a
proper description of that item is retrieved
from the masterfile and displayed on the
screen. The person responsible for making
the input can then check and ensure that
the correct data is entered. (1)
- whenever unit prices are obtained from the
requisitions, the computer must
automatically agree the prices of units
keyed in with the unit price data on the
masterfile – deviations must only be
accepted by the system if these deviations
fall within preset boundaries. (1)

Key control objective Expected programme control

- requisition data are only accepted when all
the required fields are captured. (1)
- reasonableness checks e.g. order quantities
(1)
- sequence check of requisition - number from
previous day’s last number; (1)
- current stock level below re-order level; and
(1)
- order quantity to most economic order
quantity. (1)

 The system is to enable the keypunch operator

(buyers) to sight edit the details keyed in.
(1)
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4. Complete, valid, accurate and  Programmatic check to establish whether the

timely processing of purchase most suitable supplier was selected. (1)
requisition information entered
to produce the following:  Automatic generation of exception reports
where standard selection criteria in selecting
- purchase orders (1) suppliers were not followed (Exception reports
- updated transaction and must be followed up by a responsible official).
master files (1) (1)

 Input and output file identification controls. (1)

 Run-to-run totals pertaining to number of

documents processed (orders = requisitions).
(1)

 Allocation of sequential order numbers. (1)

5. Complete, accurate and timely  End of report indicators. (1)
output. (1)
 Printing of transaction report that can be used
by the IT Data Control Group to perform tests
to ensure output is reasonable (e.g. number of
documents and document number check). (1)

 Generation of error and exception reports that

should be followed-up by responsible officials
independent of the original input function.
(1)

 Printing of reports in respect of documents

(e.g. purchase orders) that were processed
which will be included in a register which
allows for “sign-off” when documents are
collected. (1)
6. Only authorised persons may  Multi-level passwords are required for
make use of enquiry facilities to enquiring and other functions. (1)
gain access to current infor-
mation (e.g. suppliers). (1) __
8 37
Maximum 5 Maximum 30

(b) Controls which will ensure the integrity of your client’s data messages and transaction
data send via (to, from and over) the VAN is maintained, include the following:

 The following controls should be used to ensure that integrity of data transmitted over the
VAN:

- Line interference protection to ensure that data are not distorted. (1)

- Transaction and system logs to facilitate recovery in the event of system failure. (1)

- Storage and forward techniques to ensure that data are not lost. (1)

- Echo tests (whereby messages are transmitted back to the transmitting device) to
ensure that individual data are complete. (1)
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- Data should be automatically retransmitted if any errors are detected to ensure

completeness of data. (1)

 Software controls should be used to monitor the integrity of outgoing and incoming data
messages and transaction data, for example: (1)

- Usage and verification of headers, trailers and record counts to ensure

completeness of data. (1)

- Usage and verification of proper identification procedures and message structures

to ensure that input is from a valid source. (1)

- Using and verifying check digits on control fields (1)

- Using and verifying control and/or hash totals (1)

- Confirming that appropriate fields which conform to message standards, are used,
including: field size checks and checks for alpha and numeric fields (1)

- Checks that data do not exceed predetermined ranges/limits (1)

- Checks on the reasonability of data (1)

- Checks on the acceptability of item codes included in the data (e.g. stock codes on
orders placed by client will be checked against the data base for validity). (1)

 Regular printouts of the audit trail of incoming and outgoing data should be generated
together with reports of exception - provide proper documentation and audit trails of
transactions. (1)

 The audit trail and exception reports must be reviewed regularly by a senior official - acts
as a managerial control. (1)

 Any errors should be corrected as soon as possible - ensures early follow-up and
correction of system problems and shortcomings. (1)
17
Maximum 15
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QUESTION PAPER

TOECTA-E

CTA INTEGRATED PAPER

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QUESTION 1 40 marks

This question consists of two independent but related parts.

Part A 30 marks

Bettie Banana, a resident of the Republic, is a newly qualified fashion designer. Unable to find
employment, she decided to start her own business.

Bettie designs a range of children’s fashion clothing. Her designs were an instant success as
affordable designer children’s clothing is not readily available. She decided to incorporate her
business as a close corporation, namely, Bananas CC. Bettie is the only member of the close
corporation and started trading as Bananas CC on 15 December 2004 (when the registration of the
close corporation was finalised). The principal business of Bananas CC is the manufacture of
designer children’s clothing. The Commissioner for the South African Revenue Service considers
this process to be a process of manufacture.

Bettie Banana does not hold any shares other than shares in listed companies or collective
investment schemes. Bananas CC received no investment income for the current year of
assessment. The close corporation is not a labour broker or a personal service company.

For the year of assessment ending 28 February 2005, Bananas CC had a gross income of R455 000
and made a net profit of R215 000 before tax and before taking the following into account:

1. Bettie Banana incurred the following expenses during November and up to 14 December 2004 in
preparation for trading as Bananas CC (while she waited for the registration of the close
corporation to be finalised). Bettie could not deduct these expenses in her own name.
R
Material 18 675
Scissors, needles, thread 2 045
Design paper 1 065
21 785

All the material purchased was used to produce new designs before end of the financial year.

2. On 1 January 2005 Bettie Banana registered the trademark “Bananas D”. It was her intention to
use it as the trademark of Bananas CC. This trademark is displayed on the labels on her
designs and is a good advertising tool in order to sell more of Bananas CC’s clothing lines. The
total cost incurred to register this trademark amounted to R4 595.

During January 2005, Bettie spent a great deal of time in designing a few patterns that she
intends to use for her signature line. These specific patterns will be used to manufacture the
children’s clothing for the different age groups. The cost to Bananas CC of these designs (as
defined in the Designs Act) amounted to R8 450.
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3. Bananas CC paid rental for the premises it occupied from 1 January 2005, in advance for 12
months. In the rental agreement the parties agreed on a rental of R3 400 per month. Legal
expenses of R1 500 were incurred in drawing up the rental agreement for the rental of the
premises.

On 1 February 2005, Bananas CC also paid its insurance premiums in advance for one year.
The total amount paid amounted to R19 200.

4. Since they started trading Bananas CC incurred the following selling and administration
expenses:

R
Parking fines which Bettie Banana views as a normal business expense 400
Interest on bank overdraft (to finance normal business activities) 600
Repairs to delivery vehicles 2 500
Sundry tax deductible expenses 3 300
6 800

5. On 1 January 2005 Bananas CC purchased two new sewing machines to be used to

manufacture her new clothing line. The machines cost R20 000 each. They were brought into
use on 1 January 2005.

A new computer with a cost of R12 000 was purchased to be used for accounting purposes. The
computer was brought into use on 1 January 2005. This computer was damaged beyond repairs
on 28 February 2005 (refer to note 8). The Receiver of Revenue allows a three year straight line
write-off period on computers in terms of section 11(e).

6. On 31 January 2005 Bananas CC imported material from America, which Bettie wants to use for
a “special occasions” designer line, at a cost of $4 500. The debt was paid on 15 February 2005.
(35% of the material purchased was still on hand at year-end.)

The following exchange rates are applicable:

Date Spot rate

$1 = R

31 January 2005 $1 = R6,85

15 February 2005 $1 = R7,05
Average rate for the 2005 year of assessment $1 = R7,35

7. On 15 February 2005 Bettie took one of the dresses she designed from the close corporation’s
trading stock for her private use. She plans to give this dress to her cousin as a birthday gift.
The cost price of the dress was R120 and the market value was R180 on the same date.
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8. On 28 February 2005 an electrical fault caused damage to the computer (refer to note 5). The
damage was of such an extent that it could no longer be used. The computer was, however, not
insured. Bananas CC elected to apply the section 11(o) allowance. Bettie decided that she
would only purchase a new computer for Bananas CC in April 2005, when there would be
specials available at the Rand Show.

9. Bettie decided to replace one of the sewing machines she purchased on 1 January 2005 (refer to
note 5), with a new model. The sewing machine was sold for R23 000. On 25 February 2005 a
new machine was purchased and immediately brought into use. This replacement machine cost
R25 000. Bananas CC elected to apply paragraph 66 of the Eighth Schedule.

10. On 22 February 2005 Bananas CC donated two designer outfits to an organisation registered for
the care of abandoned and homeless children, to be used in a fundraiser. The activities of this
organisation are listed in Part I of the Ninth Schedule to the Income Tax Act as qualifying public
benefit activities. Its activities are however not recognised under Part II of the Ninth Schedule to
the Income Tax Act. The donated outfits cost Bananas CC R150 each to manufacture and the
market value on 22 February 2005 was R225 each.

11. During February 2005 Bananas CC started carrying out research relating to the development of
a special process to dye materials. The special process will result in a better quality product.
Bananas CC purchased a new dying machine to be used wholly and exclusively for the purpose
of the research, at a cost of R38 000.

REQUIRED
Marks
(a) Discuss whether Bananas CC will qualify as a small business corporation. 2

(b) Calculate the normal income tax payable by Bananas CC for the 2005 year of
assessment. Start with the accounting net profit before tax of R215 000. Give
reasons to support your answers, where applicable. Round all amounts off to the
nearest Rand. All amounts, where applicable, are exclusive of VAT. Ignore the
effect of any possible VAT adjustments on the taxable income of Bananas CC. 28
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Part B 10 marks

During the 2005 year of assessment Bettie Banana disposed of the following capital assets to
finance her new business venture:

● A holiday house that was sold for R880 000 on 30 November 2004. She purchased the
house on 1 July 2000 at a total cost of R220 000. During January 2001 she made
improvements to the house at a cost of R60 000. In February 2002 she made further
improvements to the house to the value of R30 000. She failed to obtain a proper valuation
of this holiday house on 1 October 2001. You may assume that the time-apportionment base
cost, as adjusted according to paragraph 30 of the Eighth Schedule, is R485 936.

● A stand in Forest Hill was sold for R470 000 on 2 February 2005. Bettie purchased the stand
on 1 August 2001 for R475 000. During January 2004 she incurred further costs of R50 000
to remove rubble and to have the stand levelled. On 1 October 2001 the market value of the
stand was R450 000.

● Her bicycle that she used to practise for the Argus race, was sold on 12 December 2004 for
R2 500. She purchased the bicycle on 31 January 2002 for R1 500.

● On 15 December 2004, Bettie sold several Krugerrand coins for R6 500. She purchased the
coins on 30 November 2001 for R3 200.

Bettie had an assessed capital loss of R80 000 for the 2004 year of assessment.

REQUIRED Marks

Calculate Bettie Banana’s taxable capital gain (or assessed capital loss) for the 2005 year
of assessment. Round all amounts off to the nearest Rand. Give reasons to support your
answer, where applicable. 10
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QUESTION 2 30 marks

While enjoying themselves one sunny Friday afternoon in a trendy Camps Bay bar, two famous
Cape Town socialites, Karen Waldorf and Robyn Deckman, devised a plan to open a chain of bars,
called Drinks for Free Ltd. Their only problem would be how to raise the necessary capital required
for their venture, as the banks, after having researched their hectic social lifestyles, would not agree
to back them.

Fortunately, Marc Lecturer happened to sit at a table close to them. In an attempt to secure
employment, he approached them with a brilliant concept. The bar would be for members only, each
of whom would have to pay R1 200 in advance for a two-year membership. In return, each member
would be allowed to have free drinks of their choice and would not have to pay any entrance fees at
the bars, which would normally cost R10.

Market research conducted subsequent to their discussion has shown that the average person will
consume R800 (at cost) of alcoholic drinks over two years.

Wherever necessary, assume a market-related interest rate of 20% per annum.

Additional information

At 20% per period Year 1 Year 2 Year 3 Year 4 Year 5

Present Value of R1 0.833 0.694 0.579 0.482 0.402
Future Value of Rand 1.200 1.440 1.728 2.074 2.488
Present Value of Annuity of R1 0.833 1.528 2.106 2.589 2.991
Future Value of Annuity of R1 1.000 2.200 3.640 5.368 7.442

REQUIRED
Marks
(a) With reference to the Framework and the Statement on Revenue (IAS 18 (AC111)),
explain fully how the revenue arising from the above proposal should be treated in
the financial statements of Drinks for Free Ltd. Do not present any calculations. 10

(b) Prepare the journal entries of Drinks for Free Ltd’s first financial year, on the following
assumptions:

i) 1 000 members join the scheme on the first day of the financial year.

ii) The door attendant recorded 15 000 bar visits during the year.

iii) R450 000 of alcoholic drinks (at selling price) was consumed during the year.

iv) The company has a 200% mark up on the cost of alcoholic drinks. 8
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Marks
(c) Drinks for Free Ltd entered into a five year operating lease agreement for its
premises, at an initial cost of R500 000. In addition, monthly rentals of R1 640,50
would have to be paid in arrears. These lease rentals are considerably below
market rentals for similar properties.
8
Discuss how the R500 000 payment should be treated in Drinks for Free Ltd’s
financial statements.

(d) Assuming that the R500 000 payment (referred to in (c) above) was capitalised,
present the journal entries required in respect of this lease agreement during Drinks
for Free Ltd’s first year of operation. Show all workings. 4

(UCT - adapted)
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QUESTION 3 40 marks

You are the newly appointed external auditor of Meldon Ltd. Due to a recent management shake-
up, a new financial director has also been appointed. He recently received the latest report from
Meldon Ltd Pension Fund’s actuaries. The pension fund is a defined benefit fund. The report
contained the following information:

31 March
2005 2004
R’000 R’000
Plan assets

Market value – beginning of year 46 340 44 540

Employer contributions 6 600 6 000
Employee contributions 6 600 6 000
Expected return on plan assets 5 800 8 400
Pension payments (10 600) (10 000)
Actuarial loss (5 600) (8 600)
Market value – end of year 49 140 46 340

Defined benefit obligation

Balance – beginning of year 56 360 56 000

Current service cost 7 040 6 400
Interest cost 6 000 5 960
Pension payments (10 600) (10 000)
Actuarial (gain)/loss 1 000 (2 000)
Balance – end of year 59 800 56 360

Other information

Expected average remaining working life of plan participants 20 years 20 years

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The financial director found the following note in the latest annual financial statements of Meldon Ltd for the year ended
31 March 2004:

Accounting policies
Defined benefit plans
If net cumulative unrecognised actuarial gains or losses at the end of a financial year exceed the
greater of
 10% of the present value of the defined benefit obligation at that date, and
 10% of the fair value of the plan assets at that date,

the excess is recognised on a straight-line basis over the expected average remaining working life
of employees in the plan.

Meldon Ltd Pension Fund

Unrecognised net actuarial losses of R6,2 million (2003: gains of R400 000) are included in the
deficit on the defined benefit plan.

The financial director is unfamiliar with the application of IAS 19: Employee benefits, and has asked you
to assist him with passing the correct entries in the 2005 financial statements. The only entry passed so far in respect of
the defined benefit plan for 2005 was:

Dt Contributions paid R13 200 000

Ct Bank R13 200 000
Payment of employee and employer contributions to the pension fund.

REQUIRED Marks

(a) Prepare journal entries to record the movement in the defined benefit liability or asset
arising from the Meldon Ltd Pension Fund in the financial statements of Meldon Ltd for
the year ended 31 March 2005. Narrations are not required. Show all supporting
workings. 11

(b) Reconcile the defined benefit liability or asset as disclosed in the annual financial
statements of Meldon Ltd at 31 March 2005 to the plan assets and defined benefit
obligations of Meldon Ltd Pension Fund at that date.
7

(c) Describe the audit procedures that the external auditor of the Meldon Ltd Pension Fund
would follow for auditing the defined benefit obligation.
14

(d) In your audit of the defined benefit liability (asset) in the financial statements of Meldon
Ltd, you intend to rely on the external auditors of the pension fund to provide you with a
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closing market value of the plan assets. Describe the procedures you would follow in
relying on the other auditor’s work. 8
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QUESTION 4 50 marks

Since 2000 you have been the external auditor of Auto Spares (Pty) Ltd, a company that
manufactures and distributes radiators to the automotive industry. In your planning meeting with the
financial director he discussed two issues that bothered him, namely a change in the way the
materials purchases accounts payable system operates and a problem with the integrity of the
management information.

Issue 1: Materials purchases accounts payable system

Materials purchases constitute a substantial part of the company’s cost structure. In the 2004
financial year the materials purchases system operated as follows:

 The authorised materials buyer would identify the need for stock, using the Economic
Order Quantity (EOQ) model, to replenishment the stock. Based on EOQ report an order
would be placed with an authorised supplier. The receiving department would take
delivery of the goods and prepare a multicopy, sequentially numbered goods received
note (GRN).

 On arrival of the invoice the materials clerical staff would post the invoice to the creditors’
ledger and the purchase journal. On arrival of the creditor’s statement, the materials
accounts payable clerks would reconcile the statement with the creditor’s ledger account.

 The senior payments clerk would prepare a remittance advice with full details of the
payment to be made to the creditor. Payments would be made by cheque, which would
be signed, by the financial accountant and the financial director after inspecting the
creditor’s statement, the reconciliation, invoices, GRN’s and copies of signed purchase
orders.

To simplify the accounting and reduce the paper work, the company made the following changes in
the 2005 financial year to the materials purchases accounts payable system:

 The company changed to a “payment on presentation of invoice” basis, which involves

dispensing with the creditors ledger altogether. When invoices are now received, they
are debited to purchases and credited to materials creditors’ control.

 The financial accountant, following the cash flow policy of the company, puts the date for
payment on the invoices and files them in a “due date” file.

 Each day the invoices which are due for payment are removed by the senior payments
clerk from the due date file, a remittance advice is prepared for the invoice amount and
the invoice, GRN and purchase order are attached.
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 Since August, payments are generally made by electronic fund transfers (though some
creditors still insist on cheque payments). The senior payments clerk prepares the
transaction file of payments to be made. The financial director and financial accountant
inspect the supporting documentation and authorise the EFT payment, by each entering
their distinctive PIN numbers.

Issue 2: Integrity of the management information

Budget and actual for 2005

As part of the accountant’s preparations for the 2005 budget, a breakeven analysis was performed
and it was concluded that the budgeted breakeven production and sales volumes would amount to
20 700 units. The fact that the company only sold 20 000 units, but is reporting a profit of R540 500
for the year ended 31 December 2005, has raised a concern in the mind of the managing director
about the integrity of the management accounting information generated by the finance department.

The following information was provided:

1. The income statement for the year ended 31 December 2005 was as follows:

R
Sales 4 000 000
Cost of sales 3 400 000
Production costs
Inventory at beginning of year -
Materials 1 000 000
Direct labour costs 1 200 000
Production overheads absorbed 2 050 000
Inventory at end of year: finished products (850 000)

Gross profit 600 000

Production overheads – over-recovery 180 000
Administration costs (59 500)
Selling costs (180 000)
Net income before tax 540 500

2. Sales and production had been budgeted for the 2005 year at 22 000 units. The budgeted
selling price for the 2005 financial year was R200 per unit.

3. The company has access to reliable suppliers of materials and therefore does not carry any
materials inventory. There were no work-in-progress inventories at the beginning or end of
the year.
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4. Actual production volumes amounted to 25 000 units.

5. The actual unit costs and selling prices, as well as fixed costs, were all equal to budgeted
amounts.

6. Production overheads and selling costs comprise both fixed and variable costs. Selling costs
would have amounted to R190 000 at budgeted sales volumes of 22 000 units.

7. Administration costs are fixed.

8. Fixed production overhead absorption rates were budgeted at R60 per unit at the beginning
of the 2005 financial year. This was based on planned production volumes of 22 000 units.

9. Production volumes of 25 000 units per annum represents the maximum capacity.

Budget for 2006

As a result of the unexpected profit, the financial director deemed a review of the 2006 budget
necessary. Based on a discussion with the managing director and the sales and production
managers, the following assumptions were agreed upon:

1. Units sales prices are expected to increase by 8%.

2. Sales volumes are expected to be 22 000 units.

3. Material costs are expected to increase by 20%. All other unit variable costs are expected to
increase by 10%.

4. A key objective in the forthcoming financial year is to achieve a net income before tax of 10%
of turnover.

5. All fixed costs are expected to increase by 5%.

6. Production volumes of 21 000 units are forecast.

Special order

As a result of the supply disruptions caused by the recent liquidation of one of its competitors, Auto
Spares (Pty) Ltd has been invited to quote for a special order of 7 000 units, which is to be supplied
during the course of the 2006 financial year. Product specifications vary from the existing radiators
that are produced and will accordingly require different machine settings. Therefore labour and
variable production overhead costs are expected to be 50% higher for the first batch of 1 000 units
than for the existing product. Thereafter expected unit costs will return to the previous levels.
Material costs are not expected to differ from the existing product. No variable selling costs will be
incurred.
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This special order was not taken into account in the 2006 budget.

Because of current industry conditions, bidding for this order is likely to be highly aggressive. Auto
Spares (Pty) Ltd regards this order as an opportunity to gain a foothold in that market, which offers
great expansion opportunities. As a consequence the managing director wants to quote the
minimum price that can be charged.

REQUIRED
Marks
(a) Briefly discuss:

(i) your audit approach for accounts payables relating to material 7

purchases in the current financial year; and

(ii) the advantages and disadvantages of the new method of handling materials
purchases and related accounts payables.
8

(b) Using the budget assumptions provided for 2005, determine whether the accountants’
breakeven production and sales volumes were correct. 14

(c) Calculate the budgeted profit before tax for the 2006 financial year. Ignore the effect
of the special order. 13

(d) What is the minimum selling price that should be quoted for the special order? Take
into account that the company would have to accept or reject the whole order. 8

SAICA 2003 - Adapted

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SOLUTION

TOECTA-E

CTA-INTEGRATED
PAPER
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QUESTION 1

Part (a)

Establish if Bananas CC is a small business corporation:

 Bananas CC has a gross income of R455 000 for three months. The R5 million gross
income limit must be apportioned. (1)
- R5 million x 3/12 = R1 250 000 or
- R455 000 x 12/3 = R1 820 000.
 Bananas CC is not a labour broker / personal services company
 The entire members’ interest is held by a natural person
 Less than 20% of the total receipts and accruals consists of investment income
 Bettie does not hold any shares other than shares in listed companies or collective
investment schemes
Bananas CC therefore meets all the requirements of a small business corporation. (1)
2
Part (b)
R R
Net profit before tax 215 000
1. Section 11A Pre-trade expenditure (21 785) (1)
Section 12E(3A) double deduction limited to (20 000) (1)

2. Section 11B(2)(b) registration of trademark (4 595) (1)

Section 11B(2)(a) designing cost (8 450) (1)

3. Section 23H prepaid expenses (not within 6 months after

year end OR aggregate of prepaid amounts not less than
R50 000 [(R3 400 x 10) + (R19 200/12 x 11) = R51 600] (1)
- Rental: R3 400 x 2 (6 800) (1)
- Insurance: R19 200 x 1/12 (1 600) (1)
Legal expenses (drawing up a contract – capital exp) - (1)

4. Selling and administration expenses:

 Parking fines (not in the production of income,
thus not deductible) - (1)
 Interest paid (sec 11(a)) (600) (½)
 Repairs (sec 11(d)) (2 500) (½)
 Sundry tax deductible expenses (3 300)

5. Section 12E allowance: (R20 000 x 2) x 100% (40 000) (1)

Section 11(e) allowance: R12 000 /3 x 2/12 (667) (1)

6. Section 11(a): Materials purchased ($4 500xR7,35)

Section 25D (33 075) (1)
Closing stock: 35% still on hand at year-end 11 576 (1)
Debt: $4 500 x R6,85 30 825
Settlement of debt: $4 500 x R7,05 31 725
Foreign exchange loss (900) (2)

7. Trading stock – section 22(8) 180 (1)

8. Section 11(o) allowance: R12 000 – R667 (11 333) (1)
Carried forward 71 151
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Brought forward 71 151

9. Section 8(4)(e) recoupment (R20 000 (limited to cost

price) – Rnil (tax value)) 20 000 (2)
The recoupment cannot be deferred (refer section 8(4)
(eB)) as section 12E allows for a 100% allowance. The
full recoupment (limited to cost) must therefore be
included in taxable income in the current year when the
new asset is written off – R20 000 x 100%
Section 12E allowance: R25 000 x 100% (25 000) (1)

10. Trading stock donated (R225 x 2) – recoupment @ MV 450 (1)

11. Section 11B(3) – capital research expenditure

(R38 000 x 40%) (15 200) (1)
Taxable income before capital gains tax 51 401

Capital gains tax

Proceeds 23 000
Less: Section 8(4)(e) recoupment (20 000) 3 000

Less: Base cost

Cost price 20 000
Less: Wear & Tear claimed (20 000) -
Capital gain 3 000
The capital gain cannot be deferred as section 12E allows for a 100%
allowance. The full capital gain must therefore be included in taxable
income in the current year.
X 50%
Section 26A - Taxable capital gain 1 500 (3)
52 901
Less: Donation of R450 to a public benefit organisation
– not recognised under Part II of the Ninth Schedule,
no deduction permitted in terms of section 18A - (1)
52 901
Calculation of income tax payable for the 2005 tax
year

R52 901 x 15% 7 935.15 (1)

Total 28
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Part B

Calculation of capital gains tax

R R
Holiday house (see note 1)
Proceeds > Expenditure (before & after 1/10/01) therefore par
26 of the Eighth Schedule must be applied to determine the
base cost of the asset (½)
Option 1: 20% x (Proceeds – cost after 1/10/01)
= 20% x (R880 000 – R30 000)
= R170 000 OR (½)
Option 2: Time-apportionment base cost as adjusted
according to par 30 of the Eighth Schedule
= R485 936
Option 3: Market value: not available

Proceeds 880 000

Less: Base cost – Choose option 2 - the highest 485 936 (1)
Plus improvements after 1/10/01 30 000 (515 936) (1)
Capital gain on holiday house 364 064

Stand
Proceeds < Expenditure (before & after 1/10/01) therefore par
27 of the Eighth Schedule must be applied to determine the
base cost of the asset. (½)
-The market value (R450 000) is less than the expenditure
before 1/10/01 (R475 000) AND
- The proceeds (R470 000) is less than or equal to the
expenditure before 1/10/01 (R475 000), therefore:

The valuation date value of the asset = Higher of

 Market value – R450 000 OR
 Proceeds – Expenditure after 1/10/01
= R470 000 – R50 000 = R420 000 (½)
Proceeds 470 000
Less: Base cost (450 000) 20 000 (1)
384 064
Bicycle
Personal use asset – disregard capital gain - (1)

Gold coins
Proceeds 6 500
Less: Base cost (3 200) 3 300 (1)
387 364
Less: Annual exclusion (10 000) (1)
Aggregate capital gain 377 364
Less: Assessed capital loss of previous year (80 000) (1)
Net capital gain 297 364
X 25% (1)
Taxable capital gain to be included in taxable income 74 341
10
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Note 1
Pre-valuation date asset
Proceeds > Expenditure therefore par 26
Proceeds = R880 000
Cost before 1/10/01 = R220 000 + R60 000
= R280 000
Cost after 1/10/01 = R30 000
Total cost = R310 000
Market value 1/10/01 = Not available
Base cost: Adjust P according to par 30
P = R x B/(A+B)
P = R880 000 x R280 000/R310 000
P = R794 839
Thus Y = B + [((Adjusted P – B) x N)/(T + N)]
= R280 000 + (R794 839 – R280 000) x 2
3+2
= R485 936
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QUESTION 2 – SUGGESTED SOLUTION

a) The issues examined in this question are the treatment of the advance payment received in
respect of the membership fees, the imputed interest, the revenue recognition of the bar
sales, entrance fees, as well as membership fees.

 Advance payments of membership fees

- In substance, the advance receipts represent a liability. (½)

- A liability is an obligation of the entity as a result of a past event, the settlement of

which will result in an outflow of resources embodying economic benefits. (½)

 This loan is an obligation to the entity as future services have to be provided to

the customers. (½)
○ The past event has been the acceptance of membership fees paid in advance.
(½)
○ The settlement of this liability will result in an outflow of resources as future
services will have to be provided to the members. (½)

- The items should be recognised as a liability as it is probable that future economic

benefits will flow from the entity and as the liability has a cost (i.e. membership fees
received) which can be measured reliably. (2)

 Interest expense

- Since the advance membership fees represent a loan, interest should be imputed at
20% pa on the outstanding capital amount and the loan should subsequently be
“amortised” over a period of two years, as the services are rendered. (1)

 Revenue Recognition of bar sales, entrance fees

- In return for the loan received, services are rendered to customers. Revenue in respect of
the above stated services rendered can be recognised if :

○ the amount of revenue can be measured reliably. This is the case as it can be
established how many people have visited the bar as well as how much alcoholic
drinks at market value was consumed. (1)

○ it is probable that economic benefits will flow to the enterprise. This is the case as
the membership fees have been received in advance. (1)

○ the stage of completion can be measured reliably. This is also the case as market
research has indicated that not more than R800 (at cost) of alcoholic drinks per
person will be consumed. (1)
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○ the cost incurred and to be incurred to complete the transaction can be measured
reliably. This is the case as it is possible to measure the costs incurred via internal
control systems. The future costs can thereafter be extrapolated and thus also
measured. (1½)

Revenue Recognition of membership fees

- The membership fees recognised from the residual balance between revenue for
sales and entrance fees, and the amortised portion of the loan. (½)
10(½)
Max 10

b) Bank 1 200 000 (½)

Liability - Membership fees 1 200 000 (1)
Membership fees received in advance, which
Effectively amounts to a loan (1 000 x 1 200)

Interest expense 240 000 (1)

Liability - Membership fees 240 000 (½)
Interest expense imputed on loan (1 200 000 x 20%)

Liability - Membership fees *785 (1½)

454
Sales 450 000 (½)
Entrance Fees 150 000 (1)
Membership fees 185 454 (½)
Reduction of loan by recognising services offered to
members

Cost of Sales 150 000 (1)

Inventory 150 000 (½)
Matching of cost of sales to revenue recoupment
(450 000 x 100/300)

*WORKINGS
PV = 1 200 000
FV = 0
n=2
i = 20
Compute PMT

PMT = R785 454

Schedule
Payment Received 1 200 000
Interest Expense 240 000
Sales, Entrance Fees, etc. ( 785 454)
Liability at end of first financial year 654 546
Interest Expense (654 546 x 20%) 130 909
Sales, Entrance Fees, etc next year ( 785 454)
-
__
8
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c) This question is aimed at whether the initial payment should be recognised as an asset or
expensed straight away.

- An asset is a resource controlled by an entity as a result of a past event, from which

future economic benefits are expected to flow to the enterprise. (½)

 The initial payment is a resource controlled by the entity as it is Drinks for Free
Ltd’s decision as to whether or not to enter into the agreement and pay the initial
cost of R500 000. (½)

 It results from a past event, i.e. the signing of the contract. (½)

 Future economic benefits are expected to flow to the entity, in that the bar is now
able to trade and generate income by use of the leased premises. (½)

- The initial payments thus conform to the definition of an asset. (½)

- But before it can be recognised as such, it must be probable that future economic
benefits will flow to the enterprise and the item must have a cost or value which is
reliably measurable. (½)

 Since 1 000 members have signed up for this scheme, although only on a two
year basis, it seems probable that future economic benefits will flow to the
entity. (½)

 Since the asset has a cost which can be measured reliably, the initial payment
should be recognised as an asset (prepayment) and treated effectively as a loan
to the lessor. (½)

- Since the lease for its premises is an operating lease, the lease payments should be
recognised as an expense on a straight-line basis over the lease term, unless another
systematic basis is more representative of the time pattern of Drinks for Free Ltd’s
benefit (IAS 17(AC 105).33 and Circ. 7/2005). (1)

- As a result, the R500 000 initial lease payment should initially be recognised as a
prepayment (asset) and then amortised on a straight-line basis over the lease term.
This would result in matching the cost of using the premises with the earning of income
(future economic benefits) - the matching concept per FRAMEWORK. (1)

- The payment of R500 000 is not a financial asset per IAS 32(AC 125).11 as it is not an
asset comprising cash, an equity instrument of another entity or a contractual right to
receive cash or another financial asset. Furthermore, IAS 39(AC 133) does not apply to
rights and obligations to which IAS 17(AC 105) applies (IAS 39(AC 133).2(b)). (1)

- The initial payment of R500 000 can not be regarded as an initial direct cost in
negotiating or arranging the lease per IAS 17(AC 105). The initial direct costs referred
to IAS 17(AC 105) would normally include commissions, legal fees and internal costs
that are incremental and directly attributable to negotiating or arranging a lease. (1)
8
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d) Assets – Lease prepayments 500 000 (½)

Bank 500 000 (½)
Prepayment of a portion of the lease, which effectively
amounts to a loan in the hands of the lessor
Rent expense 100 000 (1)
Asset - Lease prepayments 100 000 (½)
Recognition of lease payment over lease term (500
000/5)
Rent expense 19 686 (1)
Bank 19 686 (½)
Recognition of monthly rent expense of R1 640,5 x 12
months (1 640,5 x 12)
4
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QUESTION 3 – SUGGESTED SOLUTION

(a) Journal entries for defined benefit asset

R’000 R’000

Journal 1
Dt Pension fund deficit/liability (Balance sheet) (balancing figure) 5 960,0 (1)
Dt Current service cost (Income statement) 7 040,0 (1)
Dt Interest cost (Income statement) 6 000,0 (1)
Ct Contributions paid (Employer contributions (6 600)
plus employee contributions (6 600)) 13 200,0 (1)
Ct Expected return on plan assets (Income statement) 5 800,0 (1)

Journal 2
Dt Actuarial loss (Income statement) [W1] 28,2
Ct Pension fund deficit 28,2 (1)

[W1]
Unrecognised net actuarial losses at 1 April 2004 6 200 (1)
Exceeds greater of:
10% of benefit obligation at beginning (56 360) 5 636
10% of plan assets at beginnig (46 340) 4 634
That is, 5 636 (2)
Excess (6 200 – 5 636) 564 (1)
Divided by expected average remaining working life (20 years) 28,2 (1)
11

(b) Reconciliation

R’000

Fair value of plan assets – closing 49 140,0 (1)

Present value of defined benefit obligation – closing (59 800),0 (1)
Unrecognised actuarial losses (6 200 – 28,2 + 5 600 + 1 000) 12 771,8 (4)
Defined benefit asset (balancing figure) (smaller than 12 771,8) 2 111,8 (1)
7
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(c) Audit procedures for defined benefit obligation

 Agree the opening plan obligation to the closing balance as per last year’s AFS and
working papers. (1)

 Recalculate the interest charge for the year by multiplying the opening obligation by the
discount rate. Inspect the journal entry Dt Interest expense, Cr Pension fund liability
(asset). (1)

 Request a calculation of the current service cost from the actuary. Determine whether
the assumptions that have been used in determining the current service cost are
reasonable. (1)

 On a test basis, reperform the actuary’s calculations to determine whether they are
correct. (1)

 Inspect that the current service cost per the actuary’s calculation has been transferred to
the obligation workings. Inspect the journal entry Dt Current service cost expense, Cr
Pension fund liability (asset). (1)

 Request the pension fund to confirm the amount paid to fund members during the year.
(1)

 Obtain the calculation of the actuarially determined present value of the post employment
obligation (closing balance). This should be audited as follows:

 Obtain a general understanding of the methods used by the actuary to

calculate the pension fund obligation. (1)

 Enquire of the actuary whether the projected unit credit valuation method has
been used to determine the pension fund obligation (AC116.65). If the projected
unit credit valuation method is not used, report to the management of the
enterprise that the annual financial statements will have to be qualified, as they
do not conform to generally accepted accounting practice. (2)

 Assess the actuary’s competence and objectivity by enquiring into the

following:
 formal qualifications of the actuary
 independence and objectivity of the actuary
 reputation of the actuary
 experience of the actuary
 who the actuary is employed by
 is the actuary a member of a recognised body (as this will influence
his/her independence)
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 professional rules governing the recognised body of which the actuary is

a member Maximum (5)

 Enquire of the actuary what major assumptions (AC116.76) have been used in
the estimate of the pension obligation:

 Establish whether the discount rate used to discount the future obligation is
determined by reference to market yields at the balance sheet date on
high quality corporate bonds. (1)

 Request from a financial institution what the current corporate bond yield is at
the balance sheet date and compare it to the discount rate used. (1)

 Determine that the mortality tables used by the actuary are appropriate and
most recent and enquire of the actuary how he/she has taken the impact
of AIDS on the organisation into account, and determine whether the
assumptions that he/she has used are reasonable. (2)

 Assess whether the assumptions used as regards employee turnover and

salary increases at the organisation are reasonable. Obtain statistics from
Statistics SA and consider reasonability of assumptions. (1)

 Recalculate the unrecognised gain/loss for the year, as this should be the balancing
figure. (1)

 Inspect the trust deeds i.r.o. the defined benefit fund. (1)

 Enquire from trustees as to the plans to address the shortage on the pension fund. (1)
22
Maximum 14

(d) Procedures to follow for relying on other auditor’s work

 Consider the other auditor’s professional competence in the context of the specific
assignment. Consider factors such as:
 Membership of professional organisations;
 Membership or affiliation with the same firm of auditors (as yourself); and
 Professional bodies to which the other auditor belongs. Maximum (2)

 Advise the other auditor:

 Of the independence requirements regarding both the entity and the pension fund
for which you are relying on his/her work;
 Of the use that is to be made of his/her work;
 Of the accounting, auditing and reporting requirements that apply;
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 Of the co-ordination and planning of the work; and

 Of the timetable for completion of the work. Maximum (3)

 Perform procedures to obtain sufficient appropriate audit evidence that the other
auditor’s work is sufficient for your purpose. The nature, timing and extent of the
procedures will depend on the circumstances of the engagement and your knowledge of
the other auditor’s professional competence. (1)

 The procedures to assess the other auditor’s work should entail the following:

 Direct discussion with the other auditor of the procedures performed;

 Review of questionnaires and checklists prepared by the other auditor;
 Review of the other auditor’s work papers;
 Review of a written summary prepared by the other auditor;
 Discussions with and enquires of the directors or management of the pension fund;
and
 Analytical procedures on the financial statements of the pension fund.
Maximum (3)

 Perform procedures on the other auditor’s findings:

 Discuss the findings with the other auditor and management; and
 Test the accounting records of the pension fund, if necessary. Yourself or the
other auditor can perform such tests, depending on the circumstances. (2)
11
Maximum 8
40
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QUESTION 4 – SUGGESTED SOLUTION

(a) (i) Approach for current year audit

1. Timing

Procedures should preferably be carried out at year-end because:- (1)

1.1 It is a high-risk area. (1)

1.2 “Early close” with roll forward procedures is, strictly speaking, only appropriate
under circumstances of reasonable/good internal control (which is not the case
here). (1)

2. Nature

2.1 Weaknesses in internal control and the new system increase control risk. (1)

2.2 Clearly tests of control would not be appropriate because of the absence of
good internal controls. (1)

2.3 Though some analytical review procedures will be appropriate, attempting to

judge the reasonableness of an amount, which may be full of errors, has limited
value. (1)

2.4 Thus the bulk of the auditor’s assurance should come from substantive tests of
detail. (1)

2.5 This is a clear-cut situation for the auditor to do a creditors confirmation as the
auditor clearly needs 3rd party evidence with respect to trade creditors (the
completeness thereof, in particular). (A request for statements would not be
sufficient as they are frequently dated before month end and uncertainty would,
therefore, remain with respect to the days not covered by the statements.) (2)

2.6 Use CAATS to perform selection/confirmations etc. (1)

2.7 The audit procedures will focus an understatement of accounts payable. (1)

3. Extent

There should be extensive tests of detail owing to limited reliance on controls and
analytical review. (1)
12
Maximum 7
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(ii) New system

1. Disadvantages

1.1 There is no detailed analysis of purchases (unless the payments cash book carries all the
information of a purchase journal), thus hampering efficient working capital management.
(1)

1.2 It is possible that the company is contravening the Companies Act in respect of the
keeping of statutory records (refer section 284 (1) (a)). (1)

1.3 There is a serious risk of undetected errors as no creditors’ reconciliation’s are done. (1)

1.4 Adequate checks (controls) have to be in place to ensure the accuracy of invoices before
it is paid. (1)

1.5 Credit/Refunds might not be taken into account when invoices are paid immediately. (1)

1.6 EFT associated risks (e.g. authorization) would arise and adequate controls (e.g. access
controls) need to be in place to address these risks. (1)

1.7 Increased interest cost as a result of continuous cash flow. (Not utilizing interest free
period of holding creditors.) (1)

2. Advantages of new system

2.1 It is simpler to be certain that goods were received in respect of each payment made and
EFT payments will be more efficient e.g. cheques not getting lost in the mail. (1)

2.2 Simpler recording leads to reduced bookkeeping costs. (1)

2.3 Discounts offered for immediate payment can be utilised. (1)

2.4 Decreased bank charges due to increased number of EFT payments which is cheaper
than cheques. (1)

2.5 Cost savings in terms of user preparation of cheques, obtaining signatures, posting etc.
(1)
12
Maximum 8
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(b) Budget 2005 and breakeven calculation

Unit R
costs

Raw materials (R1 000 000 / 25 000) 40 880 000 (1)

Direct labour (R1 200 000 / 25 000) 48 1 056 000 (1)
Variable production overhead
(R2 050 000 – R180 000 – R1 320 000 [W2]) / 25 000 22 484 000 (3)
Variable selling costs [W1] 5 (110 000)
Total variable cost 115 2 530 000

[W1] Selling costs: R190 000 for 22 000 units

180 000 20 000
Change 10 000 2 000
Variable: R10 000 / 2 000 = R5 per unit (2)
Fixed: R180 000 – 20 000 x R5 = R80 000 (1)

[W2] Fixed production cost = 60 x 22 000 = R1 320 000 (1)

Break-even sales (2005 budget):

Fixed cost: R1 320 000 + R80 000 + R59 500 = R1 459 000 (2)
Contribution per unit: R200 – R115 = R85 (1)
Break-even: R1 459 500 / R85 = 17 170,59 i.e. 17 171 units (1)

Reconciliation
[(20 000 – 17 171) x R85] + (5 000 x R60) = R540 465 (rounding)

Thus the breakeven calculation of 20 700 units was wrong. (1)

14
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(c) Budgeted profit before tax – 2006

Budget 2006
Volume Per unit
(units) R R
Sales (R200 x 1,08) 22 000 216 4 752 000 (1)
Cost of sales 4 097 000
Opening inventory (115 – 5 + 60) as per (b) 5 000 170 850 000 (2)
Materials (R40 x 1,2) 21 000 48 1 008 (1)
Direct labour (R48 x 1,1) 52,8 000 (1)
Variable overhead (R22 x 1,1) 24,2 1 108 (1)
Fixed overhead [W1] 66 800
Closing inventory (5 000 + 21 000 – 22 000) (4 000) 191 508 200 (2)
1 386
000
(764 000)
Gross profit 655 000
Variable selling cost (R5 x 1,1) 22 000 (121 000) (1)
Fixed selling cost (R80 000 x 1,05) (84 000) (1)
Administration cost (R59 500 x 1,05) (62 475) (1)
Net income 387 535

[W1] R1 320 000 x 1,05) / 21 000 units = (2)

R66
13

(d) Selling price for special order

Available capacity: 25 000 Units
Budgeted production: 21 000
Available: 4 000 (1)
Required: 7 000

If accepted, reduce normal production by 3 000 units. (1)

Opportunity cost R R

3 000 units x R216 – R191 – 66 + 5,5) 256 500 (2)

Production cost
7 000 x material R48 336 000 (1)
1 000 x labour variable overhead [(R52,8 + R24,2) x 1,5] 115 000 (2)
6 000 x (R52,8 + R24,2) 462 000 913 000 (1)
Minimum selling price 1 169 500 __
8
50
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