CIMA CO2 Official Learning System - Fundamentals of Financial Accounting

STUDY MATERIAL C2

10

THE ACCOUNTING SCENE

1.8 Summary

In this chapter you have learnt:

●

that ‘ accounting ’ involves recording, summarising and forecasting, to meet the informa-

tion needs of different user groups;

●

the qualitative characteristics of ﬁ nancial statements;

●

the distinction between ‘ bookkeeping ’ , ‘ ﬁ nancial accounting ’ and ‘ management accounting ’ ;

●

the differences between internal and external information; the different types of business

organisation.

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Question 1 Multiple choice

1.1 The main aim of accounting is to:

(A) maintain ledger accounts for every transaction.

(B) provide ﬁ nancial information to users of such information.

(C) produce a trial balance.

(D) record every ﬁ nancial transaction individually.

1.2 The main aim of ﬁ nancial accounting is to:

(A) record all transactions in the books of account.

(B) provide management with detailed analyses of costs.

(C) present the ﬁ nancial results of the organisation by means of recognised

statements.

(D) calculate proﬁ t.

1.3 Financial statements differ from management accounts in that they:

(A) are prepared monthly for internal control purposes.

(B) contain details of costs incurred in manufacturing.

(C) are summarised and prepared mainly for external users of accounting

information.

(D) provide information to enable the trial balance to be prepared.

1.4 Which one of the following does not apply to the preparation of ﬁ nancial statements?

(A) They are prepared annually.

(B) They provide a summary of the outcome of ﬁ nancial transactions.

(C) They are prepared mainly for external users of accounting information.

(D) They are prepared to show the detailed costs of manufacturing and trading.

1.5 Which of the following statements gives the best deﬁ nition of the objective of

accounting?

(A) To provide useful information to users.

(B) To record, categorise and summarise ﬁ nancial transactions.

(C) To calculate the taxation due to the government.

(D) To calculate the amount of dividend to pay to shareholders.

Revision Questions

1

THE ACCOUNTING SCENE

REVISION QUESTIONS C2

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1.6 Which one of the following sentences does not explain the distinction between

ﬁ nancial statements and management accounts?

(A) Financial statements are primarily for external users and management accounts

are primarily for internal users.

(B) Financial statements are normally produced annually, and management accounts

are normally produced monthly.

(C) Financial statements are more accurate than management accounts.

(D) Financial statements are audited by an external auditor and management

accounts do not normally have an external audit.

Question 2

Match the following users with their information requirements.

1. Investors A Firm’s ability to provide goods now and in future

and pay debts

2. Lenders B Performance, proﬁ tability and dividends

3. Employees C Proﬁ t levels, tax liability and statistics

4. Business contacts D Firm’s ability to pay interest and repay loans, the

value of secured assets

5. Government departments E Firm’s ability to pay wages, cash resources, future

prospects, pay pensions

Question 3

State six characteristics of useful accounting information?

(A) R … … …

(B) R … … …

(C) C … … …

(D) C … … …

(E) U … … …

(F) T … … …

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Solution 1

1.1 Answer: (B)

Maintaining ledger accounts, producing a trial balance and recording transactions

are all part of the bookkeeping system.

1.2 Answer: (C)

Recording transactions is part of the bookkeeping function. This should be capable

of providing management with internal information, but this is part of the manage-

ment accounting function. The calculation of proﬁ t also results from the bookkeep-

ing system and contributes towards the presentation of the ﬁ nancial results.

1.3 Answer: (C)

Management accounts are prepared monthly (or more frequently) for internal con-

trol purposes; they also contain detailed information such as costing ﬁ gures. The trial

balance is prepared from the bookkeeping system and is used as a basis for the prepa-

ration of ﬁ nancial statements.

1.4 Answer: (D)

Management accounts would provide detailed costs and other information regarding

manufacturing and trading.

1.5 Answer: (A)

1.6 Answer: (C)

Solution 2

1. Answer: (B)

2. Answer: (D)

3. Answer: (E)

4. Answer: (A)

5. Answer: (C)

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Solutions to Revision

Questions

THE ACCOUNTING SCENE

SOLUTIONS TO REVISION QUESTIONS C2

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Solution 3

(A) Relevant

(B) Reliable

(C) Comparable

(D) Complete

(E) Understandable

(F) Timely.

2

The Framework of

Financial Statements

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2

LEARNING OUTCOMES

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

䉴 explain and distinguish capital and revenue, cash and proﬁ t, income and expenditure,

and assets and liabilities.

2.1 Introduction

In this chapter, we begin to look at what is contained in ﬁ nancial statements and how

the information is compiled and presented. The chapter also introduces some of the basic

conventions of accounting, although these are covered in more depth in Chapter 10. In

particular, the chapter looks at the accounting equation as the basis on which accounting

systems are built, and how the equation changes as ﬁ nancial transactions are undertaken.

The chapter also considers the concept that an organisation must be regarded as an entity

completely separate from the people who own it.

2.2 The separate entity convention

In discussing limited companies in Chapter 1, it was mentioned that the law recognises a

company as a ‘ person ’ in its own right, distinct from the personalities of its owners (known

as shareholders). In other words, if a company runs up debts in its own name and then

has difﬁ culty in paying them, its suppliers may be entitled to seize the assets owned by the

company. But they have no claim against the personal assets owned by the shareholders:

it is the company that owes money, not its owners. In law, this distinction does not exist

with other forms of business entity, such as the sole proprietor. If Bill Smith is in busi-

ness as a plumber, trading under the name of ‘ Smith & Co. Plumbing Services ’ , the law

recognises no distinction between the business and the individual. If there are large debts

outstanding for plumbing supplies, and the business assets of Smith & Co. are insufﬁ cient

to pay them, the suppliers can demand payment from Bill Smith the individual, who may

The Framework of

Financial Statements

STUDY MATERIAL C2

18

THE FRAMEWORK OF FINANCIAL STATEMENTS

be forced to sell his personal assets – home, car, and so on. But in this respect accounting

conventions do not correspond with the strict legal form of the business. It is an absolutely

crucial concept in accounting that, regardless of the legal form of a business – limited

company, sole trader, partnership or whatever – the business is treated as a separate entity

from its owner(s). For accounting purposes, Bill Smith the individual is not the same as

Smith & Co. Plumbing Services. This reﬂ ects the fact that accounting information relates

only to business transactions. What Bill Smith does as an individual is of no concern to

the accountant, and his private activities must be kept quite separate from the business

transactions of Smith & Co. Students often ﬁ nd this concept hard to grasp, particularly

when they notice that, as a consequence of it, Bill Smith the individual can actually have

business dealings with Smith & Co. For example, Bill may take some copper piping from

the inventories held by Smith & Co. in order to repair the heating system in his own

home. From the accounting point of view, a business transaction has occurred: Smith & Co.

has supplied an individual called Bill Smith with some piping, and its value must be

accounted for.

Despite its apparent artiﬁ ciality, the importance of this convention will become appar-

ent in the next section, where we look at an arithmetic relationship called the accounting

equation .

2.3 The accounting equation

The accounting equation shows that

Assets Liabilities Capital

What do these terms mean?

Asset.

A resource that may be used by a business or other organisation to derive revenue

in the future.

Examples of assets are land, buildings, plant and machinery, motor vehicles, invento-

ries of goods, receivables, bank balances and cash. Assets may be described as tangible or

i ntangible . Tangible assets are those that can be physically seen or touched (e.g. land, build-

ings, equipment, inventories, etc.). Intangible assets cannot be physically seen or touched

(e.g. goodwill, which represents the value of a business as a whole compared with the sum

of the values of its individual assets and liabilities). As such, goodwill represents the value

of the organisation’s customer base, employee relationships, and so on. Other intangible

assets might include patents and trademarks. You will learn more about intangible assets in

Chapter 10.

Receivables. A person owing money to an entity.

These are assets to the business because they are eventually converted into cash, which is

a resource that can be used by the business.

Liability. An entity’s obligations to transfer economic beneﬁ ts as a result of past transac-

tions or events.

Thus a liability can be described as an amount owed by a business or organisation to

an individual or other business organisation. Examples of liabilities are payables, loans

received and bank overdrafts.

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE FRAMEWORK OF FINANCIAL STATEMENTS

Payables. A person or an entity to whom money is owed as a consequence of the receipt

of goods or services in advance of payment.

These are ﬁ nancial obligations or liabilities of a business until they are paid. These lists

of assets and liabilities are not exhaustive, and you will encounter other examples as your

studies progress.

Capital. In this context, capital is difﬁ cult to deﬁ ne, but it can be regarded as a special

kind of liability that exists between a business and its owner(s).

To return to the accounting equation, you can perhaps see that the assets of an organi-

sation have been provided, or ‘ ﬁ nanced ’ , by liabilities either to outsiders or to the owner.

This emphasises the importance of the separate entity concept described above. Because

we regard the owner as being separate from the business, we can regard the amount owed

by the business to its owner as a kind of liability. Effectively, we can restate the accounting

equation in an even simpler form:

Assets of the business Liabilities of the business

This statement is always tr

ue no matter what transactions the business undertakes. Any

transaction that increases or decreases the assets of the business must increase or decrease

its liabilities by an identical amount.

You may be wondering exactly what is meant by saying that capital is an amount ‘ owed ’

by the business to its owner. How can the business ‘ owe ’ anything in this way? How has

it incurred a debt? The answer is that when a business commences, it is common for the

owners to ‘ invest ’ some of their private resources in the business. As the business oper-

ates it generates its own resources in the form of proﬁ ts, which technically belong to the

owner. Some of the proﬁ ts may remain in the business, while some may be withdrawn by

the owner in the form of goods or cash. This withdrawal of proﬁ ts in simple organisation

structures such as sole traders is known as ‘ drawings ’ .

The equation that states that

Assets Liabilities Capital

can thus be seen to demonstrate the r

elationships that exist within any business. The equa-

tion is the basis of one of the most common accounting statements to be prepared – the

statement of ﬁ nancial position . It is worth noting here that the presentation of a statement of

ﬁ nancial position is based on the accounting equation.

2.3.1 The accounting equation in action

To see how this works, study the following example.

Example 2.A

On 31 March, Ahmed’s employment with Gigantic Stores Ltd came to an end. On 1 April, Ahmed sets up in

business by himself, trading as ‘Ahmed’s Matches ’, and selling boxes of matches from a tray on a street corner.

Ahmed puts $100 into a bank account opened in the name of Ahmed’s Matches. He persuades a supplier of

matches to let him have an initial inventory of 400 boxes, costing 5 p each, promising to pay for them next

week. During his ﬁ rst day of trading he sells 150 boxes at 12¢ each – $18 in all. Feeling well pleased, he

takes $5 from the cash tin and treats himself to supper at the local café. He also writes a cheque for $5 to his

supplier in part payment for the initial inventory of boxes. Show what happens to the accounting equation as

each of these transactions takes place.

CIMA CO2 Official Learning System - Fundamentals of Financial Accounting

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