CIMA CO2 Official Learning System - Fundamentals of Financial Accounting
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CIMA Offi cial
Learning System
Revised edition relevant for
Computer-Based Assessments
C2 — Fundamentals of
Financial Accounting
CIMA Certifi cate in
Business Accounting
Henry Lunt
CIMA Publishing is an imprint of Elsevier
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First edition 2008
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Contents
The CIMA Learning System x i
How to use your CIMA Learning System x i
Guide to the Icons used within this text xii
Study technique xii
Planning xiii
Tips for effective studying xiv
Computer-Based Assessments xiv
The Fundamentals of Financial Accounting Syllabus xv
CIMA Certifi cate in Business Accounting xvii
Syllabus Outline xvii
Learning Aims xvii
Assessment Strategy xviii
1 The Accounting Scene 1
Learning Outcomes 3
1.1 Introduction 3
1.2 What is accounting? 3
1.2.1 The objectives of accounting 4
1.3 Who uses fi nancial statements? 5
1.4 The qualitative characteristics of fi nancial statements 6
1.5 Terminology 7
1.5.1 Bookkeeping 7
1.5.2 Financial accounting 7
1.5.3 Management accounting 7
1.6 The differences between external and internal information 8
1.7 What is a business organisation? 8
1.7.1 Profi t-making organisations 9
1.7.2 Non-profi t-making organisations 9
1.8 Summary 10
Revision Questions 11
Solutions to Revision Questions
13
2 The Framework of Financial Statements 15
Learning Outcomes 17
2.1 Introduction 17
2.2 The separate entity convention 17
2.3 The accounting equation 18
2.3.1 The accounting equation in action 19
2.4 The accounting equation and the statement of fi nancial position 2 2
2.4.1 The contents of a statement of fi nancial position 22
2.4.2 Vertical presentation of a statement of fi nancial position 24
FUNDAMENTALS OF FINANCIAL ACCOUNTING C2
iv
CONTENTS
2.5 The income statement 25
2.5.1 The cost of goods sold 27
2.6 Profi t and cash 29
2.7 Capital and revenue 30
2.7.1 Capital transactions 30
2.7.2 Revenue transactions 30
2.8 Summary 30
Revision Questions 31
Solutions to Revision Questions
35
3 The Accounting System in Action 39
Learning Outcomes 41
3.1 Introduction 41
3.2 What is a ledger account? 41
3.3 What is double-entry bookkeeping? 42
3.4 Bookkeeping entries for expenses and revenue 46
3.4.1 Bookkeeping entries for purchases and sales 46
3.4.2 Nominal ledger accounts 50
3.5 Balancing the accounts 50
3.5.1 Calculating the balance on the account 51
3.6 Summary 52
Revision Questions 53
Solutions to Revision Questions
61
4 Summarising the Ledger Accounts 67
Learning Outcomes 69
4.1 Introduction 69
4.2 Preparing the trial balance 69
4.2.1 Does the trial balance prove the accuracy of the
ledger accounts? 70
4.3 Preparing a statement of profi t 7 2
4.3.1 The trading account 72
4.3.2 The income statement 76
4.3.3 The balance on the income statement 78
4.3.4 Dealing with drawings 79
4.4 Preparing the statement of fi nancial position 79
4.5 Balancing off the ledger accounts 80
4.6 Columnar ledger accounts 85
4.7 Summary 85
Revision Questions 87
Solutions to Revision Questions
93
5 Further Aspects of Ledger Accounting 97
Learning Outcomes 99
5.1 Introduction 99
5.2 Accounting for specialised transactions 99
v
FUNDAMENTALS OF FINANCIAL ACCOUNTING
CONTENTS
5.2.1 Carriage costs 99
5.2.2 Discounts 100
5.3 Accounting for sales tax 102
5.3.1 Sales tax on non-current assets and expenses 106
5.3.2 Sales tax in separate ledger accounts 106
5.3.3 Non-registered businesses 106
5.3.4 Zero-rated and exempt supplies 107
5.4 Accounting for wages and salaries 107
5.4.1 Gross pay and net pay 107
5.4.2 Other deductions 109
5.4.3 Pension contributions 110
5.5 Accruals and prepayments 110
5.5.1 Recording accruals and prepayments in the ledger accounts 112
5.6 Bad debts and allowance for receivables 113
5.6.1 Accounting for bad debts 114
5.6.2 Bad debts recovered 115
5.6.3 Allowance for receivables 116
5.7 The exchange of goods 120
5.8 Summary 122
Revision Questions 123
Solutions to Revision Questions 133
6 Accounting for Non-current Assets 141
Learning Outcomes 143
6.1 Introduction 143
6.2 Capital and revenue expenditure 143
6.3 Depreciation 145
6.4 Calculating depreciation 146
6.4.1 The straight-line method 147
6.4.2 The reducing-balance method 148
6.4.3 The machine-hour method/units of production method 149
6.4.4 The revaluation method 149
6.4.5 Depreciation in the year of acquisition and disposal 150
6.5 Accounting for the disposal of a non-current asset 150
6.6 A comprehensive example 152
6.7 Controlling tangible non-current assets 154
6.8 Accounting for intangible non-current assets 155
6.8.1 What is goodwill? 156
6.9 Summary 157
Revision Questions 159
Solutions to Revision Questions 177
7 Preparation of Financial Statements with
Adjustments
189
Learning Outcome 191
7.1 Introduction 191
7.2 The trial balance 191
FUNDAMENTALS OF FINANCIAL ACCOUNTING C2
vi
CONTENTS
7.3 The adjustments 192
7.4 Step1: Labelling the trial balance 193
7.5 Step2: Preparing workings 194
7.6 Step3: Preparing the fi nancial statements 196
7.7 Summary 205
Revision Questions 207
Solutions to Revision Questions
219
8 Organising the Bookkeeping System 229
Learning Outcomes 231
8.1 Introduction 231
8.2 Organising the ledger accounts 232
8.2.1 Advantages of dividing the ledger 232
8.3 Supporting books and records 232
8.3.1 Source documents 233
8.4 Sales, purchases and returns daybooks 233
8.4.1 Recording transactions in the daybooks 234
8.4.2 Making the ledger entries 235
8.4.3 Extending the use of daybooks 240
8.5 The cash books 241
8.5.1 The banking system 241
8.5.2 The cash book 242
8.5.3 The petty cash book 245
8.6 The journal 246
8.6.1 The layout of the journal 247
8.6.2 Using the journal for miscellaneous transactions 247
8.6.3 Using the journal for end-of-year transactions 248
8.7 Inventory records and methods of inventory measurement 249
8.7.1 The process of inventories measurement 251
8.7.2 Application of methods of inventory measurement
(also known as cost formulas) 252
8.7.3 Issues and receipts 255
8.8 Summary 257
Revision Questions 259
Solutions to Revision Questions
269
9 Controlling the Bookkeeping System 277
Learning Outcomes 279
9.1 Introduction 279
9.2 Preventing errors 279
9.2.1 Authorisation procedures 280
9.2.2 Documentation 280
9.2.3 Organisation of staff 280
9.2.4 Safeguarding assets 281
9.3 Detecting errors 281
9.3.1 Spot checks 281
9.3.2 Comparison with external evidence 281
vii
FUNDAMENTALS OF FINANCIAL ACCOUNTING
CONTENTS
9.3.3 Reconciliations 281
9.3.4 Carrying out an audit 282
9.4 Bank reconciliation statements 282
9.5 Reconciliation of suppliers ’ statements 285
9.6 Control accounts 287
9.6.1 The status of the control account 290
9.6.2 Contra entries 293
9.6.3 Credit balances in the sales ledger; debit balances in
the purchase ledger 294
9.6.4 The control account and allowance for receivables 295
9.6.5 Advantages of control accounts 295
9.6.6 Reconciling control accounts and ledger accounts 295
9.7 Suspense accounts and the correction of errors 296
9.8 Computers in accounting 299
9.8.1 Aspects of computerised accounting systems 300
9.9 Accounting coding systems 300
9.10 Summary 302
Revision Questions 303
Solutions to Revision Questions
317
10 The Regulatory Framework of Accounting 327
Learning Outcomes 329
10.1 Introduction 329
10.2 Accounting conventions 330
10.2.1 The business entity convention 330
10.2.2 The money measurement convention 330
10.2.3 The historical cost convention 331
10.2.4 The objectivity convention 331
10.2.5 The dual aspect convention 331
10.2.6 The realisation convention 331
10.2.7 The periodicity convention 332
10.2.8 The accruals and matching conventions 332
10.2.9 The materiality convention 333
10.2.10 The stable monetary unit convention 334
10.2.11 The going concern convention 334
10.2.12 The consistency convention 334
10.2.13 The prudence convention 334
10.3 Accounting policies and estimation techniques 335
10.4 The historical cost convention and its alternatives 336
10.4.1 The theory of capital maintenance 337
10.4.2 Current purchasing power (CPP) accounting 337
10.4.3 Current cost accounting 338
10.4.4 Fair value 338
10.4.5 Value to the business (or deprival value) 338
10.4.6 The valuation of intangible assets 339
10.5 Regulations in accounting 342
10.5.1 Company law 342
10.5.2 The accountancy profession 342
FUNDAMENTALS OF FINANCIAL ACCOUNTING C2
viii
CONTENTS
10.5.3 International accounting standards 342
10.5.4 The IASB Framework for the Preparation and
Presentation of Financial Statements (the ‘ Framework ’ ) 344
10.6 The role of the auditor 344
10.6.1 Fair presentation or true and fair 345
10.6.2 The role of the external auditor 346
10.6.3 The role of the internal auditor 347
10.6.4 The value-for-money audit 347
10.7 The role of management 347
10.8 Summary 348
Revision Questions 349
Solutions to Revision Questions
357
11 Incomplete Records; Income and
Expenditure Statements
361
Learning Outcomes 363
11.1 Introduction 363
11.2 Calculating ‘ missing fi gures ’ 364
11.2.1 Sales fi gures 364
11.2.2 Purchases fi gures 365
11.2.3 Expenses fi gures 365
11.2.4 Opening capital 366
11.2.5 Cash and bank summaries 366
11.3 Financial statements of non-profi t-making bodies 373
11.3.1 Accounting terminology for non-profi t-making bodies 373
11.3.2 Accounting for membership fees and subscriptions 374
11.3.3 The fi nancial statements of non-trading organisations 376
11.4 Summary 381
Revision Questions 383
Solutions to Revision Questions
399
12 The Manufacturing Account 411
Learning Outcomes 413
12.1 Introduction 413
12.2 Why is a manufacturing account needed? 413
12.2.1 Inventories in manufacturing organisations 414
12.3 Costs to include in the manufacturing account 414
12.3.1 Other direct costs 415
12.3.2 Prime cost 415
12.3.3 Indirect costs 415
12.3.4 Factory cost of production 415
12.3.5 Work in progress 415
12.3.6 Factory cost of goods completed 416
12.4 Layout of manufacturing and trading accounts 416
12.5 Income statement for manufacturing organisations 417
12.6 Statements of fi nancial position for manufacturing organisations 417
ix
FUNDAMENTALS OF FINANCIAL ACCOUNTING
CONTENTS
12.7 The accounting system for manufacturing organisations 417
12.8 Summary 420
Revision Questions 423
Solutions to Revision Questions
427
13 The Financial Statements of Limited
Companies and the Statement of Cash Flows
429
Learning Outcomes 431
13.1 Introduction 431
13.2 Limited companies 432
13.2.1 The fi nancial statements of companies 432
13.2.2 Presentation of company income statements 433
13.2.3 Taxation in company fi nancial statements 433
13.2.4 Directors of limited companies 434
13.2.5 Sources of fi nance for a limited company 434
13.2.6 Dividends 436
13.2.7 Reserves 437
13.2.8 Statement of comprehensive income 438
13.2.9 Statement of changes in equity 440
13.3 Statement of cash fl ows 447
13.3.1 What is a statement of cash fl ows? 447
13.3.2 Why does the profi t earned not equal the change in
bank and cash balances? 447
13.3.3 Cash fl ows from operating activities – cash generated
from operations 448
13.3.4 Cash fl ows from operating activities – net cash from
operating activities 450
13.3.5 Cash fl ows from investing activities 450
13.3.6 Cash fl ows from fi nancing activities 450
13.3.7 Statement of cash fl ows for sole traders 453
13.4 Summary 454
Revision Questions 455
Solutions to Revision Questions 483
14 The Interpretation of Financial Statements 501
Learning Outcomes 503
14.1 Introduction 503
14.2 What is meant by ‘ interpretation of fi nancial statements ’ ? 503
14.3 Calculating ratios 505
14.3.1 Using the ratios 505
14.4 Types of ratios 505
14.5 Profi tability ratios 506
14.5.1 Gross profi t margin 507
14.5.2 Gross profi t mark-up 507
14.5.3 Operating profi t margin 508
14.5.4 Return on capital ratios 508