CIMA CO2 Official Learning System - Fundamentals of Financial Accounting

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FUNDAMENTALS OF FINANCIAL ACCOUNTING C2

(iv) explain the need for ﬁ nancial controls;

(v) explain the purpose of audit checks and audit trails;

(vi) explain the nature of errors, and be able to make accounting entries for them;

(vii) explain the nature of fraud and basic methods of fraud prevention.

Indicative Syllabus Content

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External audit and the meaning of fair presentation.

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Internal audit.

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Financial controls, audit checks on ﬁ nancial controls, audit trails.

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Errors and fraud.

D Preparation of Accounts for Single Entities – 45%

Learning Outcomes

n completion of their studies students should be able to:

(i) prepare accounts using accruals and prepayments;

(ii) explain the difference between bad debts and allowances for receivables;

(iii) prepare accounts for bad debts and allowances for receivables;

(iv) calculate depreciation;

(v) prepare accounts using each method of depreciation and for impairment values;

(vi) prepare a non-current asset register;

(vii) prepare accounts for inventories;

(viii) prepare income statements, statement of changes in equity and statements of ﬁ nan-

cial position from trial balance;

(ix) prepare manufacturing accounts;

(x) prepare income and expenditure accounts;

(xi) prepare accounts from incomplete records;

(xii) interpret basic ratios;

(xiii) prepare statements of cash ﬂ ows (previously known as a cash ﬂ ow statement).

Indicative Syllabus Content

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Adjustments to the trial balance; accruals and prepayments.

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Bad debts and allowance for receivables.

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Accounting treatment for depreciation (straight line, reducing balance and revaluation

methods) and impairment.

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Non-current asset register.

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Accounting for inventories (excluding construction contracts); methods of inventory

measurement (FIFO, LIFO and average cost).

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Income statements and statements of ﬁ nancial position from trial balance; statement of

changes in equity.

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Manufacturing accounts.

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Income and expenditure accounts.

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Production of accounting statements from incomplete data.

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Ratios: return on capital employed; gross and net proﬁ t margins; asset turnover; trade

receivables collection period and trade payables payment period; current and quick

ratios; inventory turnover; gearing.

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Statement of cash ﬂ ows.

CIMA CERTIFICATE IN BUSINESS ACCOUNTING

The Accounting Scene

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LEARNING OUTCOMES

When you have completed this chapter, you should be able to:

䉴 identify the various user groups who need accounting information and the qualitative

characteristics of ﬁ nancial statements;

䉴 explain the function of, and differences between, ﬁ nancial and management

accounting systems.

1.1 Introduction

This chapter provides an introduction to the accounting framework and introduces the

function of accounting systems. Much of the chapter relates to the ﬁ rst syllabus area ‘ con-

ceptual and regulatory framework ’ , which is also continued in Chapter 10. This chapter

covers the objectives of accounting, an essential feature of which is a discussion of who

uses accounts. This raises the question of how we can measure the usefulness of accounting

information to those who use accounts.

1.2 What is accounting?

Accounting can be described as being concerned with measurement and management .

Measurement is largely concerned with the recording of past data, and management with

the use of that data in order to make decisions that will beneﬁ t the organisation.

The measurement process is not always easy. One of the most common problems is that

of when to recognise a transaction. For example, if we are to obtain goods from a supplier

with payment to be due 60 days after the goods are received, when should the transaction

be recorded?

The following possibilities may be considered:

●

when we place the order;

●

when we take delivery of the goods;

The Accounting Scene

STUDY MATERIAL C2

THE ACCOUNTING SCENE

●

when we receive the invoice from the supplier; or

●

when we pay the supplier for the goods.

Accounting, therefore, involves the exercising of judgement by the person responsible for

converting data into meaningful information. It is this that distinguishes accounting from

bookkeeping.

Accounting may be deﬁ ned as:

●

the classiﬁ cation and recording of monetary transactions;

●

the presentation and interpretation of the results of those transactions in order to assess

performance over a period and the ﬁ nancial position at a given date;

●

the monetary projection of future activities arising from the alternative planned courses

of action.

Note the three aspects considered in this deﬁ nition: recording, reporting and forecasting:

1. Accounting is partly a matter of record-keeping. The monetary transactions entered

into by a business need to be controlled and monitored, and for this a permanent

record is essential. For an efﬁ cient system of record-keeping, the transactions must ﬁ rst

be classiﬁ ed into categories appropriate to the enterprise concerned.

2. At appropriate intervals, the individual transactions must be summarised in order to

give an overall picture.

3. Finally, accounting information can be the basis for planning and decision-making.

An alternative explanation is that accounting is part of the management information sys-

tem (MIS) of an organisation. In this context, the accounting element is referred to as an

accounting information system (AIS).

Accounting can thus be said to be a method of providing information to management

(and other users) relating to the activities of an organisation. In order to do this it relies on

the accurate collection of data from sources both internal and external to the organisation.

The recording of this data is often referred to as bookkeeping.

1.2.1 The objectives of accounting

The objectives of accounting are to provide ﬁ nancial information to the managers, owners

and other parties interested in an organisation. This is done by the production of ﬁ nancial

statements. You will see in Chapter 10 that the International Accounting Standards Board

(IASB) in their Framework for the Preparation and Presentation of Financial Statements

(Framework ) state that

If these objectives are to be achieved, then the information provided by the accounting sys-

tem must be reliable and easily understood, and prepared consistently not only from one

accounting period to the next but also between similar organisations so that meaningful

comparisons may be made. This need for consistency has led to a number of accounting

rules being devised. Some of these rules are contained in legislation – these rules apply par-

ticularly to companies: some are included in accounting standards; some are included in

documents such as the IASB’s Framework ; and others simply represent generally accepted

Providing useful information to investors is the main objective of ﬁ nancial

reporting.

FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE ACCOUNTING SCENE

accounting practice (GAAP). These rules are used by accountants to determine the

treatment to be adopted in respect of certain ﬁ nancial transactions and the preparation of

ﬁ nancial statements.

1.3 Who uses financial statements?

Accounting information is used by many people, both by individuals and in organisations.

To get a feel for the purpose of accounts it is useful to classify these users into groups, and

to look at the reasons why they use accounts and what they hope to get from them.

Any classiﬁ cation of this sort is somewhat arbitrary, and many users fall into more than

one classiﬁ cation. However, the following groups are commonly recognised as having par-

ticular needs for accounting information:

(a) The investor group. This group includes both existing and potential owners of shares

in companies. They require information concerning the performance of the company

measured in terms of its proﬁ tability and the extent to which those proﬁ ts are to be

distributed to shareholders. They are also interested in the social/economic policies

of the company so that they may decide if they wish to be associated with such an

organisation.

(b) The lender group. This group includes both existing and potential providers of secured

or unsecured, long- or short-term loan ﬁ nance. They require information concern-

ing the ability of the organisation to repay the interest on such loans as they fall due;

and the longer-term growth and stability of the organisation to ensure that it is

capable of repaying the loan at the agreed time. In addition, if the loan is secured,

the value of the appropriate secured assets is important as a means of recovering the

amount due.

require information concerning the ability of the organisation to pay wages and pen-

sions today. In addition, they are interested in the future of the organisation because

this will affect their job security and future prospects within the organisation.

(d) The analyst/adviser group. This group includes a range of advisers to investors, employ-

ees and the general public. The needs of these users will be similar to those of their cli-

ents. The difference is, perhaps, that in some instances, the members of this group will

be more technically qualiﬁ ed to understand accounting reports.

(e) The business contact group. This group includes customers and suppliers of the organi-

sation. Customers will be concerned to ensure that the organisation has the ability to

provide the goods/services requested and to continue to provide similar services in the

future. Suppliers will wish to ensure that the organisation will be capable of paying for

the goods/services supplied when payment becomes due.

( f ) The government. This group includes taxation authorities, and other government agen-

cies and departments. The taxation authorities will calculate the organisation’s taxation

liability based upon the accounting reports it submits to them. Other departments

require statistical information to measure the state of the economy.

( g ) The public. This group includes taxpayers, consumers and other community and spe-

cial interest groups. They require information concerning the policies of the organisa-

tion and how those policies affect the community. The public is increasingly interested

in environmental issues.

STUDY MATERIAL C2

THE ACCOUNTING SCENE

(h) Internal users. The management of the company require information to assist them in

the performance of their duties. Three different levels of management can be identiﬁ ed:

●

Strategic. This is the level of management found at the top of organisations. In a

commercial organisation it is referred to as the board of directors. These people

require information to assist them in decisions affecting the long-term future of the

organisation.

●

Tactical. This is often referred to as middle management. These people require infor-

mation to assist them in monitoring performance and making decisions to enable

the organisation to achieve its short- to medium-term targets.

●

Operational. This is the level of management responsible for decisions concern-

ing the day-to-day activities of the organisation. It is common for the information

provided to them to be quantiﬁ ed in non-monetary units, such as hours worked,

number of components produced, and so on.

1.4 The qualitative characteristics of financial

statements

All of the above user groups, both internal and external to the organisation, require the

information provided to be useful. In this context, information should:

(a) enable its recipient to make effective decisions;

(b) be adequate for taking effective action to control the organisation or provide valuable

details relating to its environment;

(d) be produced at optimum cost;

(e) be easily understood by its recipient;

(f) be timely;

(g) be sufﬁ ciently accurate and precise for the purpose of its provision.

The IASB’s Framework also suggests that ﬁ nancial statements should have certain quali-

tative characteristics, including relevance, reliability, completeness, comparability, under-

standability and timeliness.

For decisions to be made, the information must be relevant to the decision and be

clearly presented, stating any assumptions upon which the information is based, so that

the user may exercise judgement as appropriate.

Often, better information may be provided at additional cost or after an additional time

delay. The adequacy of information is important, and factors such as the cost of the infor-

mation and the speed with which it is available may be more important than it being 100

per cent accurate.

The information provided must be communicated to the person responsible for taking

any action in respect of the information provided. In this regard it is better to distinguish

information between that which relates to controllable aspects of the business and that

which relates to non-controllable aspects. The controllable aspects may then be further

divided into those that are signiﬁ cant and an exception reporting approach applied.

Exception reporting is the technique of reducing the size of management reports by

including only those items that should be drawn to the manager’s attention, rather than

including all items.

FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE ACCOUNTING SCENE

Most organisations will set targets against which actual performance can be compared.

You will learn more about the setting of such targets in your studies of management

accounting. Their use enables exception reports to be produced to highlight the differ-

ences between the actual and target results. The use of exception reporting avoids wasting

unnecessary management time reading reports that merely advise the management that no

action is required and concentrates on those issues that do require management action.

In conclusion, therefore, internal information will be much more detailed than external

information, and will be prepared on a more regular basis.

1.5 Terminology

1.5.1 Bookkeeping

Bookkeeping can be described as the recording of monetary transactions, appropriately clas-

siﬁ ed, in the ﬁ nancial records of an entity, by either manual means or otherwise.

Bookkeeping involves maintaining a detailed ‘ history ’ of transactions as they occur.

Every sale, purchase or other transaction will be classiﬁ ed according to its type and,

depending on the information needs of the organisation, will be recorded in a logical man-

ner in the ‘ books ’ . The ‘ books ’ will contain a record or account of each item showing the

transactions that have occurred, thus enabling management to track the individual move-

ments on each record, that is, the increases and decreases.

Periodically a list of the results of the transactions is produced. This is done by listing

each account and its ﬁ nal position or balance . The list is known as a trial balance and is an

important step prior to the next stage of providing ﬁ nancial statements.

1.5.2 Financial accounting

Financial accounting can be described as the classiﬁ cation and recording of monetary

transactions of an entity in accordance with established concepts, principles, accounting

standards and legal requirements, and their presentation, by means of various ﬁ nancial

statements, during and at the end of an accounting period.

Two points in particular are worth noting about this description:

1. Financial statements must comply with accounting rules published by the various advisory

and regulatory bodies. In other words, an organisation does not have a completely free

hand. The reason for this is that the end product of the ﬁ nancial accounting process – a

set of ﬁ nancial statements – is primarily intended for the use of people outside the organi-

sation. Without access to the more detailed information available to insiders, these people

may be misled unless ﬁ nancial statements are prepared on uniform principles.

2. Financial accounting is partly concerned with summarising the transactions of a period and

presenting the summary in a coherent form. This again is because ﬁ nancial statements are

intended for outside consumption. The outsiders who have a need for and a right to infor-

mation are entitled to receive it at deﬁ ned intervals, and not at the whim of management.

1.5.3 Management accounting

Management accounting can be described as the process of identiﬁ cation, measurement, accu-

mulation, analysis, preparation, interpretation and communication of information used by

management to plan, evaluate and control within an entity and to assure appropriate use of

STUDY MATERIAL C2

THE ACCOUNTING SCENE

and accountability for its resources. Management accounting also comprises the preparation

of ﬁ nancial reports for non-management groups such as shareholders, lenders, regulatory

agencies and tax authorities.

Although the needs of external users of accounts are addressed in this deﬁ nition, it can

be seen that the emphasis of management accounting is on providing information to help

managers in running the business. The kind of information produced, and the way in

which it is presented, are at the discretion of the managers concerned; they will request

whatever information, in whatever format, they believe to be appropriate to their needs.

1.6 The differences between external

and internal information

External information is usually produced annually, though in organisations listed (or quoted)

on a stock exchange, information may be produced more frequently, for example quarterly.

External information is provided mainly by limited companies, in accordance with the rel-

evant company legislation. These may prescribe the layouts to be used and the information

that is to be disclosed either on the face of the ﬁ nancial statements or in the notes that accom-

pany them. For other organisations that are not regulated by such legislation, accounts may

have to be provided for other interested parties such as those dealing with taxation and

lenders. For these organisations, the requirements of legislation are not mandatory and may

not be appropriate. However, these requirements are often considered to be good accounting

practice.

External information is often available publicly and is therefore available to the com-

petitors of the organisation as well as its owners and employees. Of necessity, therefore, it

is important that the information provided does not allow the organisation’s competitors

to obtain detailed information concerning the working of the organisation. Thus external

information is summarised in order to protect the organisation from losing any competi-

tive edge that it may possess.

Internal information is produced on a regular basis in order for management to com-

pare the organisation’s performance with its targets and to make decisions concerning the

future. Accounting information is usually produced on a monthly basis, although other

non-ﬁ nancial performance measures may be produced more regularly. Whereas external

information is almost exclusively measured in monetary terms, internal information will

most likely involve reporting ﬁ nancial and non-ﬁ nancial measures together. There is a very

good reason for this: many managers, particularly those in control of operational matters,

will not feel competent to understand accounting reports. They will understand differences

in output levels and in usage of materials and labour much more readily than they will

understand the implications of these same differences upon proﬁ t.

1.7 What is a business organisation?

A business is an organisation that regularly enters into transactions that are expected to

provide a reward measurable in monetary terms. It is thus obvious from everyday life that

many business organisations exist; what is less obvious is that their organisational (legal)

structure and therefore their accounting requirements may differ.

FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE ACCOUNTING SCENE

There are two main reasons for the different organisational structures that exist – the

nature of their activities and their size .

1.7.1 Profit-making organisations

Some organisations are formed with the intent of making proﬁ ts from their activities for

their owners:

(a) Sole traders ( sole proprietors ). These are organisations that are owned by one person.

They tend to be small because they are constrained by the limited ﬁ nancial resources

of their owner.

(b) Partnerships. These are organisations owned by two or more persons working in com-

mon with a view to making a proﬁ t. The greater number of owners compared with a

sole trader increases the availability of ﬁ nance and this is often the reason for forming

such a structure.

right. Thus a company may own assets and incur liabilities in its own name.

The accounting of these organisations must meet certain minimum obligations imposed

by legislation, for example, via company law and other regulations. Some of these require-

ments constitute recommended accounting practice for other types of organisation.

Two types of limited companies can be identiﬁ ed: private limited companies; and public

limited companies.

Public limited companies can be further divided according to their size, and whether

they are ‘ listed ’ on a stock exchange. These distinctions can be important when consider-

ing the accounting requirements. A common feature of private limited companies is that

their owners are actively involved in running the business. In this way they are similar to

sole traders and partnerships. This is rarely true of public companies, where the owners

may not become involved in the day-to-day activities of the business. Listed companies

may have many thousands of owners (shareholders) who are even further removed from

the running of the business.

1.7.2 Non-profit-making organisations

Other organisations are formed with the intent of providing services, without intending to

be proﬁ table in the long term:

(a) Clubs and societies. These organisations exist to provide facilities and entertainments

for their members. They are often sports and/or social clubs and most of their revenue

is derived from the members who beneﬁ t from the club’s facilities. They may carry out

some activities that are regarded as ‘ trading ’ activities, in which proﬁ ts are made, but

these are not seen as the main purpose of the organisation.

(b) Charities. These exist to provide services to particular groups, for example people with

special needs and to protect the environment. Although they are regarded as non-

proﬁ t-making, they too often carry out trading activities, such as running shops.

society (including limited companies). Their ﬁ nances are used to provide the infra-

structure in which we live, and to redistribute wealth to other members of society. You

will not look at the accounts of government bodies in this Learning System.