1.1 The accrual basis of accounting requires that all expenses that are incurred by the company should be recorded in the period in which they are incurred irrespective of when they are actually paid by the company.
In the given case, a former employee of the company has filed a lawsuit against the company and has claimed that the company had wrongfully stolen his intellectual property. If the judgment awarded by the court is in favor of the person who filed the lawsuit, then the company will have to pay the amount of claim that has been made by the former employee. This means that even though the amount is not required to be paid now, there is a high possibility that the company will have to pay it in the future as there is a strong probability that the judgment will be in favor of the plaintiff. As this amount shall be payable by the company in near future, this will need to be recorded in accounts Further, as this amount is payable in the near future, the company will have to record it as a liability in its books of accounts.
Thus, the elements of financial statements that are present in this scenario are – Expenses and Liabilities.
1.2 As per the definition provided by the International Accounting Standards Board, a liability is a current obligation that takes place due to past events related to the entity and the payment of that obligation would result in an outflow of monetary resources of the organization (International Accounting Standards. n.d.b). As per the recognition criteria for recognition of liabilities that have been provided in the International Accounting Standard 37 – Provisions, Contingent Liabilities and Contingent Assets, an obligation must lead to the outflow of economic benefits and the such an outflow is probable, not uncertain (Accounting Simplified.com, n.d.). Further, for an obligation to satisfy the recognition criteria so as to be recognized as a liability, it should be possible to measure the amount of liability or obligation in a reliable way.
Thus, an entity should recognize a liability only when it has become certain that the company will have to pay off or settle that obligation. Secondly, it should be possible to measure the amount of those liabilities in an objective manner (International Accounting Standards, n.d. a). The IAS 37 further says that it is not mandatory that the obligation to settle a liability should arise due to legal provisions or law only. An obligation that does not arise due to law and is not legal in nature may also be recognized as a liability when the obligation is based on previous practices of the company that has given rise to expectations in the minds of relevant persons, that the obligation shall be settled by the company in future.
The revised conceptual framework has provided the new definition of expenses which says that expenses are a decline in economic resources of the entity during the particular accounting period and can be in the form of decline in value of assets or outflow of monetary resources of the entity or increase in liabilities of the entity that lead to a decrease in the equity of the organization (International Accounting Standards. n.d.b). The definition of expenses provided by the revised conceptual frame of accounting says that the expenses not include those items which take place in the course of regular business actions of the organization but also includes the other items which are of the nature of losses but do not take place in the ordinary course of activities carried out by the company. As per the recognition criteria for expenses that has been provided in the revised conceptual framework, expenses should be recorded when there is decrease in financial benefits of the organization in relation to the decline or reduction in the value of an asset or enhancement in the value of liability and it is possible to measure the outflow of resources or benefits in an objective manner (International Accounting Standards. n.d a.
1.3 The two main criteria’s that must be met for a liability to be presented in the financial statements of the organization are that it should be likely that (1) an outflow of resources or financial benefits will take place and (2) it should be possible to measure the amount of outflow with a certain degree of reliability.
In the given situation, it is evident from the facts of the case that it is probable that the judgments of the court will be provided in favor of the former employee who has sued the company and filed a claim of R10-million. Thus, the first condition of recognition criteria that there should be a strong likelihood of payment or settlement of liability is satisfied as there is a high chance that the party who has filed a legal suit against the company will win. The second condition of recognition criteria of liability is that it should be possible to measure the amount of liability in a reliable way (International Accounting Standards, n.d.a). It is available from the facts of the case, that the other party has claimed an amount of R-10 million.
Thus, the amount of outflow of funds that will take place to settle this obligation is known and can be measured reliably. As both the requirements for recognition criteria of liabilities are met, this event should be recorded as a liability.As per the recognition criteria of expenses, two main conditions must be satisfied. The first condition is that it should lead to a decrease in resources or an increase in liability or a decrease in the value of assets. The second condition is that it should be possible to measure the outflow of resources or an increase in liability in a reliable way. In the given situation, both these conditions are met because the said claim would increase the liability of the company and the amount is known to be R-10 million so it can be measured reliably as well.
Thus, the recognition criteria for expenses are also met. Hence, the amount of R-10 million should be shown as an expense and a liability in the financial statements of the organization.
2.1 A small business may face many challenges for calculating depreciation of its fixed assets. The first and the greatest challenge faced by it in determining the correct and actual cost of the asset. It is required to make sure that only absolute costs are included in the total cost of the asset and no life cycle cost estimates are included.
As per the accounting rules, the total cost of a fixed asset is made up of the correct purchase price of the asset and those costs which are related to transportation and installation of the asset so as to bring it in its present working condition. The total cost of the fixed asset should not include those expenses which are in the nature of overheads. It takes a lot of time and effort of the small business to determine the correct cost of the fixed asset and ensure that no overheads are considered in the total cost of fixed assets. Another major challenge that is faced by small businesses when doing depreciation accounting is the determination of revenue or capital nature of the expense in relation to the repair and maintenance expenses incurred by the company (Lohrey, .n.d.). Only those repairs which are of capital nature can be added to the cost of a fixed asset. At times, it becomes quite challenging to decide whether particular expenses should be considered as a revenue expense or as capital expenses because these decisions are of a subjective nature (Lohrey, .n.d.).
The estimation of the useful life of the fixed asset and selection of the suitable method of depreciation is another challenge that is faced by the entity. It is not possible for businesses to estimate the expected useful life of the fixed asset with certainty. Moreover, it is very challenging to find out the accurate residual value of the fixed asset as it is based on the fair market value of the fixed asset at the end of its useful life (Lohrey, .n.d.). Further, a lot of time is spent in taking decisions as to whether to select the straight-line method of depreciation or the written down value method of depreciation. The calculations, workings and estimates required to be made in relation to computation of depreciation can be quite complex and it is quite challenging for small businesses to perform these lengthy and complex calculations as it has limited resources.
Thus, it is concluded that a small business faces a number of challenges while accounting for depreciation, and the greatest challenge faced by it is calculation of cost of the asset.
2.2 The residual value of an asset is the estimate of the fair value of the asset when its useful life is about to end. The residual value of an asset is actually the value that the owner of the asset will receive when the asset is disposed off after its expected useful life. The residual value of an asset is also known as its salvage value or scrap value (CFI, .n.d.).
The residual value is used for calculation of depreciation to be charged on the asset. The residual value is reduced from the total cost of the asset to find out the total depreciable amount of the asset. This total depreciable amount is then divided by the effective useful life of the asset to arrive at the amount of depreciation to be charged by the company it its income statement of every period. It is very important that the salvage value of the asset is estimated correctly else it would affect the figure of depreciation calculated by the company (CFI, .n.d.). There should neither be overestimation nor underestimation of the residual value as both will be harmful to the company. If the residual value is overstated, then it would cause the amount of depreciation to be understated which would lead to an overstatement of the income. On the other hand, if this is understated, the amount of depreciation would be overstated, and the net income would be understated.
The estimated useful life is the estimate of the time period for which the asset can be used, before its fully depreciated and cannot be used anymore. It is the estimate of the lifespan of the asset during which it will be used by the company for carrying out its operations (Accounting Tools, 2019). As the estimate of useful life directly affects the amount of depreciation that can be recorded by the company in its profit and loss statement, it is important that the estimate of useful life that is formed by the management of the company is reasonably accurate else the figure of depreciation will be incorrect (Accounting Tools, 2019). Thus, just like residual value, the useful life of the asset is also an important factor for the calculation of depreciation. If there is a change in the estimated useful life of the asset, the figure of depreciation will also get changed but it is only the depreciation that is related to future years that will get changed. There will be no impact on the depreciation of prior accounting periods.
However, there is a major difference between these two terms. While the residual value is expressed in terms of money, the useful life of the asset is stated in terms of no. of years (or days). Secondly, while the residual value is the value that the asset will generate at the end of its life, the estimated useful life is the number of years for which the asset can be used by the company. Thirdly, for arriving at the amount of depreciation, while the residual value is reduced from the total cost, the depreciable amount (i.e. Total cost less residual value) is divided by useful life, to arrive at the amount of depreciation. Fourth, since the residual value of an asset is a monetary concept, it is a cash item and it will have an effect on the cash flow statement of the company when this value is received by the company. However, the useful life of an asset is a non-monetary item and will have no effect on the cash flow statement of the company.
(All the relevant calculations have been provided in appendix 1).
When the project is evaluated using the NPV method, it has a present value of R 0.76 million. As per the NPV method of capital budgeting, a project should be accepted if it has a positive net present value. Since this project has a positive net present value of 0.76 million, the project should be accepted. Thus, when the decision to undertake this project is considered as per the NPV method, the project is commercially feasible.
If the project is evaluated using the Payback period method, then also the project should be accepted. As per the policy of the company, a project should be selected if its payback period is 3 years or less. In this case, the project period is 1.96 years only which is much below the limit of 3 years. As the project has a very short payback period, it is recommended that the project should be accepted.
(All the relevant calculations have been provided in appendix 2).
The calculation of the payback period for both project X and project Y has been shown in the appendix, and it is evident from those calculations that the payback period of project X is of 2.5 years while the payback period of project Y is 2.18 years. The cut-off payback period that has been decided by the company is 2.5 years. Thus, both the projects meet the cut-off set by the company. However, it is recommended that even though both the projects fall within the cut-off set by the company for the payback period, Project Y should be selected as it will be more feasible for the company. The main reason why project Y should be selected over project X is that the payback period of project is longer than that of project Y. Secondly, while the cash inflows generated by project X will be spread evenly over the life of the asset, the project Y will generate all its cash inflows during the first and second year of the project. If a company selects project Y, then it will be able to quickly cover the cost of the project and the funds can then be invested in other projects. Thirdly, considering the factor of the time value of money which says that a sum of money received today has greater value than a sum of money received later, project Y is more beneficial as it would lead to the cash flows earlier than project Y.
(The calculation of all ratios has been provided in appendix 3)
4.1 The gross profit ratio of the company tells about the proportion that the cost of sales of the company bears to the total sales. This ratio is used to indicate the earning power of the organization. Also, this ratio is a useful measure to evaluate the efficiency of operations of the company. It tells the percentage of revenues that remain with the company after paying for the cost of goods sold (Wilkinson, 2013.a). This ratio tells whether the company is generating a good amount of gross profit so as to be able to cover its non-operational expenses and other administrative expenses. The gross profit ratio is a very significant indicator of the profitability of the company. The gross profit ratio of the company tells about the financial health of the company. This ratio tells that whether or not the company is efficient in using its material and labour and the production process is efficient or not (Wilkinson, 2013.a
)The gross profit ratio of KCA Limited is 37.5 percent which is quite a good level of gross margin that can be maintained by any company. The high gross profit ratio of KCA limited shows that its operational performance is good and it is able to keep the cost of goods sold under control. It also shows that the management of the organization has been capable of managing its cost of goods sold and keeps them under control so that the company can utilize its gross profit margin to cover its non-operational expenses and for generating a net profit for the company. Since the gross profit margin percentage of KCA Limited is high, it shows that the production processes of the company are efficient.
4.2 The net profit margin ratio of the organization tells about the ability of the company to make a profit after providing for all the expenses related to the business of the company (Wilkinson, 2013.b). The net profit ratio of the company tells the percentage which the net profit generated by the company bears to its total sales. If the net profit ratio of an organization is very low, this shows that the non-operating expenses of the company are excessive and shows that the management of the organization is not able to keep the earnings of the company under control. On the other hand, a high net profit margin ratio shows that the management of the organization has been efficient in keeping the expenses under control.
The net profit margin of the KCA limited is 10.04 percent which indicates a moderate level of profitability. However, the ratio is very low as compared to its gross profit margin. This indicates that the non-operating expenses of the company are very high and a big proportion of the gross margin earned by the company is consumed in meeting the non-operating expenses, resulting in a lower net profit available for the shareholders. In a nutshell, KCA Limited is able to generate a good level of net profits.
4.3 Operating profit margin ratio tells about the ability of the company to make a profit from its core operations before providing for interest and tax. The operating profit margin of this company is 15.81 percent which shows that the profit generated by the company from its core operations is quite high. However, as the net profit percentage is 5 percent lower than the operating profit percentage, this indicates that the amount of interest and taxes paid by the company is quite high.
4.4 The current ratio is used as a measure of the liquidity position of the company. This ratio tells that whether the company shall be capable to meet its current liabilities by using its current assets. It is generally considered that ideally, the current ratio of the company should be around 2:1. The current ratio of CA Limited is 2.31 which show that the liquidity position of the company is quite strong and it will be easily able to repay its current liabilities by making use of its current assets.
4.5 The acid test ratio tells that whether the company shall be able to meet its current liabilities by making use of its quick assets (Wall Street Mojo, n.d.) The value of quick assets can be found out by reducing the value of any inventory and prepaid expenses. This ratio finds out whether the company has sufficient liquid assets to pay off its current liabilities. It is believed that the ideal acid test ratio should be around 1. If the acid test ratio is less than 1, it shows that the liquidity position of the company is not strong. The acid test ratio of KCA Limited is 0.27 which shows that the organization does not have sufficient liquid assets to pay off its current liabilities.
4.6 The debt to equity ratio of a company tells about the solvency position of the company. It measures the proportion which the total liabilities of the company bear to the total value of equity of the company. The debt to equity ratio of a company should neither be too low nor should it be too high (CFI, n.d.b). If the debt to equity ratio is too low, then it shows that the company has poor financial leverage. On the other hand, if the ratio is too high, it shows that the company has been majorly financed through outside capital and indicates a solvency risk for the company. In the case of KCA Limited, the debt to equity ratio of the company is 0.38 only, which is very low. This shows that the company is majorly financed through its equity capital and the proportion of debt in the total capital structure of the company is relatively low. This also indicates that the solvency position of KCA Limited is quite strong but also points out that the company is not adequately leveraged.
The Procurement Act and Regulations are the main parts of the legislation that relates to the use of procurement and provided various policies and procedures in relation to procurement. This act introduced some major changes in the way procurement was previously carried out in South Africa and procurement was made a policy instrument. Before the introduction of the regulations related to procurement, the procurement done by the South African governments was mostly in favor of large businesses and it was very challenging for small businesses to get into the system. (Bolton, 2006:194) However, in the year 1994, there were certain changes that were introduced that were directed towards putting an end to the discriminatory practices carried out in South Africa and making the procurement policy as a policy tool in South Africa. The government in South Africa has used procurement policy as a tool to redistribute wealth among different groups.
The government in South Africa placed a lot of reliance on the tendering process which was governed by various rules relating to the assignment of contracts for the procurement of various items as well as services for public needs and interests (Smit, 2016: 2). However, after the introduction of the constitution, the procurement process in South Africa underwent big changes. Tendering is a process of making a formal written offer to someone for the supply of goods or the provision of services. The tendering process practiced in South Africa is made of six stages namely initiation to tender to call of tenders, submission of tenders, the opening of tenders, evaluation of tenders and awarding of tender (Smit, 2016: 11).
The procurement policy in South Africa has brought a lot of benefits for the country and society. Watermeyer (2000) has stated that a study done by the European Community showed that the procurement policy of the government lead to stimulation of economic activity in the country, help to protect the domestic industries against competition from companies in foreign countries, also promoted competition in certain sectors on the industry (Bolton, 2006:195). The procurement policy in South Africa helped to achieve the social objectives of creation of more jobs in the market and increase in the number of employment opportunities, promotion of safe and fair working conditions, use of local labour to contribute towards upliftment of certain communities, protection of the environment and equality of opportunities between males and females (Bolton, 2006:195).
The main challenges that are associated with the procurement process are that it involves a lot of time and extra costs. However, the government should not view the procurement policy only in a commercial sense but should also pay consideration to the social benefits brought by the current procurement policies. The government should see it as an important part of the growth of the country. The government should make efforts to –promote the participation of small enterprises in the procurement system of the government. This is because small and medium entities rely more on labour and do not involve a large amount of capital and advanced technology. As the small and medium entities are more flexible and less dependent on the use of advanced technologies in production, they contribute towards an increase in production as well as employment at a faster rate than larger firms (Bolton, 2006:201). It not only leads to more employment but also helps to reduce the poverty gap. Thus, in this manner, the procurement processes and policies lead to the sustainable development of the country.
Procurement policies can be used as a means to discourage discrimination among employees in the workplace. The government can refuse to provide contracts to those employers who adopt discriminatory practices. This will promote fair competition between the workforce and fair working conditions. It is also mandatory for all employers in South Africa to comply with the labour laws of the state. Various studies have shown that a lot of progress has taken place in the country after the implementation of the procurement policy (Bolton 2008:3). The procurement policies have helped the South African governments to direct the flow of capital into those regions and communities which are not sufficiently developed (Bolton, 2006:200).
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Accounting Tools. 2019. Useful life. Retrieved from https://www.accountingtools.com/articles/2017/5/11/useful-life
Bolton, P. (2008, February). Protecting the environment through public procurement: The case of South Africa. In Natural Resources Forum (Vol. 32, No. 1, pp. 1-10). Oxford, UK: Blackwell Publishing Ltd.
Bolton, P., 2006. Government procurement as a policy tool in South Africa. Journal of public procurement, 6(3).
CFI .n.d.a What is Salvage Value?. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/accounting/salvage-value/
CFI.n.d. b Debt Equity Ratio. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/debt-to-equity-ratio-formula/
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Wall Street Mojo. n.d. Acid test ratio formula. Retrieved from https://www.wallstreetmojo.com/acid-test-ratio-formula/
Wilkinson J. 2013. B Net profit margin analysis. Retrieved from https://strategiccfo.com/net-profit-margin-analysis/
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