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Fundamentals of Financial Accounting
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Elsevier UK CIMA Series Chapter: 0FFaprelims 13-6-2006 2:00p.m. Page:1
CIMA’S Official
Learning System
Fundamentals of
Financial Accounting
CIMA Certificate in Business
Accounting 2006
Henry Lunt
AMSTERDAM • BOSTON • HEIDELBERG • LONDON • NEW YORK • OXFORD
PARIS • SAN DIEGO • SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO
Elsevier UK CIMA Series Chapter: 0FFaprelims 13-6-2006 2:00p.m. Page:2
CIMA Publishing is an imprint of Elsevier
Linacre House, Jordan Hill, Oxford OX2 8DP, UK
30 Corporate Drive, Suite 400, Burlington, MA 01803, USA
First edition 2006
Copyright © 2006 Elsevier Ltd. All rights reserved
No part of this publication may be reproduced, stored in a retrieval system
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No responsibility is assumed by the publisher for any injury and/or damage to persons
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or operation of any methods, products, instructions or ideas contained in the material
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British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
ISBN 13: 978 0 7506 8033 2
ISBN 10: 0 7506 8033 4
For information on all CIMA publications
visit our website at books.elsevier.com
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Elsevier UK CIMA Series Chapter: 0FFaprelims 13-6-2006 2:00p.m. Page:iii
Contents
The CIMA Learning System xi
How to use your CIMA Learning System xi
Guide to the icons used within this text xii
Study technique xii
Planning xiii
Tips for effective studying xiv
Computer-based assessment xiv
The Fundamentals of Financial Accounting Syllabus xv
CIMA Certificate in Business Accounting 2006 Syllabus xvii
Syllabus Outline xvii
Assessment Strategy xviii
1 The Accounting Scene 3
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 financial statements? 5
1.4 The qualitative characteristics of financial statements 6
1.5 Terminology 7
1.5.1 Bookkeeping 7
1.5.2 Financial accounting 7
1.5.3 Management accounting 8
1.6 The differences between external and internal information 8
1.7 What is a business organisation? 9
1.7.1 Profit-making organisations 9
1.7.2 Non-profit-making organisations 9
1.8 Summary 10
Revision Questions 11
Solutions to Revision Questions 13
2 The Framework of Financial Statements 17
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
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iv FUNDAMENTALS OF FINANCIAL ACCOUNTING C2
2.4 The accounting equation and the balance sheet 22
2.4.1 The contents of a balance sheet 22
2.4.2 Vertical presentation of a balance sheet 24
2.5 The income statement 25
2.5.1 The cost of goods sold 27
2.6 Profit and cash 30
2.7 Capital and revenue 30
2.7.1 Capital transactions 30
2.7.2 Revenue transactions 31
2.8 Summary 31
Revision Questions 33
Solutions to Revision Questions 37
3 The Accounting System in Action 43
Learning Outcomes 43
3.1 Introduction 43
3.2 What is a ledger account? 43
3.3 What is double-entry bookkeeping? 44
3.4 Bookkeeping entries for expenses and revenue 48
3.4.1 Bookkeeping entries for purchases and sales 48
3.4.2 Nominal ledger accounts 53
3.5 Balancing the accounts 53
3.5.1 Calculating the balance on the account 53
3.6 Summary 54
Revision Questions 57
Solutions to Revision Questions 65
4 Summarising the Ledger Accounts 73
Learning Outcomes 73
4.1 Introduction 73
4.2 Preparing the trial balance 73
4.2.1 Does the trial balance prove the accuracy of the ledger accounts? 74
4.3 Preparing a statement of profit 76
4.3.1 The trading account 76
4.3.2 The income statement 80
4.3.3 The balance on the income statement 82
4.3.4 Dealing with drawings 83
4.4 Preparing the balance sheet 83
4.5 Balancing off the ledger accounts 84
4.6 Columnar ledger accounts 89
4.7 Summary 90
Revision Questions 91
Solutions to Revision Questions 97
5 Further Aspects of Ledger Accounting 103
Learning Outcomes 103
5.1 Introduction 103
5.2 Accounting for specialised transactions 103
5.2.1 Carriage costs 103
5.2.2 Discounts 104
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FUNDAMENTALS OF FINANCIAL ACCOUNTING v
5.3 Accounting for sales tax 106
5.3.1 Sales tax on non-current assets and expenses 110
5.3.2 Sales tax in separate ledger accounts 110
5.3.3 Non-registered businesses 110
5.3.4 Zero-rated and exempt supplies 111
5.4 Accounting for wages and salaries 111
5.4.1 Gross pay and net pay 111
5.4.2 Other deductions 113
5.4.3 Pension contributions 114
5.5 Accruals and prepayments 114
5.5.1 Recording accruals and prepayments in
the ledger accounts 116
5.6 Bad debts and allowance for receivables 117
5.6.1 Accounting for bad debts 117
5.6.2 Bad debts recovered 118
5.6.3 Allowance for receivables 120
5.7 The exchange of goods 124
5.8 Summary 125
Revision Questions 127
Solutions to Revision Questions 137
6 Accounting for Non-current Assets 147
Learning Outcomes 147
6.1 Introduction 147
6.2 Capital and revenue expenditure 147
6.3 Depreciation 149
6.4 Calculating depreciation 150
6.4.1 The straight-line method 150
6.4.2 The reducing-balance method 151
6.4.3 The machine-hour method/units of production method 153
6.4.4 The revaluation method 153
6.4.5 Depreciation in the year of acquisition and disposal 154
6.5 Accounting for the disposal of a non-current asset 154
6.6 A comprehensive example 156
6.7 Controlling tangible non-current assets 158
6.8 Accounting for intangible non-current assets 159
6.8.1 What is goodwill? 160
6.9 Summary 161
Revision Questions 163
Solutions to Revision Questions 179
7 Preparation of Financial Statements with Adjustments 193
Learning Outcome 193
7.1 Introduction 193
7.2 The trial balance 193
7.3 The adjustments 194
7.4 Step 1: Labelling the trial balance 195
7.5 Step 2: Preparing workings 196
7.6 Step 3: Preparing the financial statements 198
7.6.1 Workings 206
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vi FUNDAMENTALS OF FINANCIAL ACCOUNTING C2
7.7 Summary 208
Revision Questions 209
Solutions to Revision Questions 223
8 Organising the Bookkeeping System 235
Learning Outcomes 235
8.1 Introduction 235
8.2 Organising the ledger accounts 236
8.2.1 Advantages of dividing the ledger 236
8.3 Supporting books and records 236
8.3.1 Source documents 237
8.4 Sales, purchases and returns daybooks 237
8.4.1 Recording transactions in the daybooks 238
8.4.2 Making the ledger entries 239
8.4.3 Extending the use of daybooks 245
8.5 The cash books 245
8.5.1 The banking system 245
8.5.2 The cash book 246
8.5.3 The petty-cash book 249
8.6 The journal 250
8.6.1 The layout of the journal 251
8.6.2 Using the journal for miscellaneous transactions 251
8.6.3 Using the journal for end-of-year transactions 252
8.7 Inventory records and methods of inventory measurement 253
8.7.1 The process of inventories measurement 255
8.7.2 Application of methods of inventory measurement
(also known as cost formulas) 256
8.7.3 Issues and receipts 259
8.8 Summary 261
Revision Questions 263
Solutions to Revision Questions 273
9 Controlling the Bookkeeping System 283
Learning Outcomes 283
9.1 Introduction 283
9.2 Preventing errors 283
9.2.1 Authorisation procedures 284
9.2.2 Documentation 284
9.2.3 Organisation of staff 284
9.2.4 Safeguarding assets 285
9.3 Detecting errors 285
9.3.1 Spot checks 285
9.3.2 Comparison with external evidence 285
9.3.3 Reconciliations 285
9.3.4 Carrying out an audit 286
9.4 Bank reconciliation statements 286
9.5 Reconciliation of suppliers’ statements 290
9.6 Control accounts 292
9.6.1 The status of the control account 295
9.6.2 Contra entries 298
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FUNDAMENTALS OF FINANCIAL ACCOUNTING vii
9.6.3 Credit balances in the sales ledger; debit balances
in the purchase ledger 299
9.6.4 The control account and allowance for receivables 300
9.6.5 Advantages of control accounts 300
9.6.6 Reconciling control accounts and ledger accounts 301
9.7 Suspense accounts and the correction of errors 302
9.8 Computers in accounting 305
9.8.1 Aspects of computerised accounting systems 306
9.9 Accounting coding systems 306
9.10 Summary 308
Revision Questions 309
Solutions to Revision Questions 325
10 The Regulatory Framework of Accounting 337
Learning Outcomes 337
10.1 Introduction 337
10.2 Accounting conventions 338
10.2.1 The business entity convention 338
10.2.2 The money measurement convention 338
10.2.3 The historical cost convention 339
10.2.4 The objectivity convention 339
10.2.5 The dual aspect convention 339
10.2.6 The realisation convention 339
10.2.7 The periodicity convention 340
10.2.8 The accruals and matching conventions 340
10.2.9 The materiality convention 341
10.2.10 The stable monetary unit convention 341
10.2.11 The going concern convention 342
10.2.12 The consistency convention 342
10.2.13 The prudence convention 342
10.3 Accounting policies and estimation techniques 343
10.4 The historical cost convention and its alternatives 344
10.4.1 The theory of capital maintenance 344
10.4.2 Current purchasing power (CPP) accounting 345
10.4.3 Current cost accounting (CCA) 346
10.4.4 Fair value 346
10.4.5 Value to the business (or deprival value) 346
10.4.6 The valuation of intangible assets 347
10.5 Regulations in accounting 350
10.5.1 Company law 350
10.5.2 The accountancy profession 350
10.5.3 International accounting standards 350
10.5.4 The IASB Framework for the Preparation and Presentation of
Financial Statements (the ‘Framework’) 352
10.6 The role of the auditor 352
10.6.1 Fair presentation or true and fair 353
10.6.2 The role of the external auditor 354
10.6.3 The role of the internal auditor 355
10.6.4 The value-for-money audit 355
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viii FUNDAMENTALS OF FINANCIAL ACCOUNTING C2
10.7 The role of management 355
10.8 Summary 356
Revision Questions 357
Solutions to Revision Questions 365
11 Incomplete Records; Income and Expenditure Statements 371
Learning Outcomes 371
11.1 Introduction 371
11.2 Calculating ‘missing figures’ 372
11.2.1 Sales figures 372
11.2.2 Purchases figures 373
11.2.3 Expenses figures 373
11.2.4 Opening capital 374
11.2.5 Cash and bank summaries 374
11.3 Financial statements of non-profit-making bodies 380
11.3.1 Accounting terminology for non-profit-making bodies 380
11.3.2 Accounting for membership fees and subscriptions 381
11.3.3 The financial statements of non-trading organisations 384
11.4 Summary 389
Revision Questions 391
Solutions to Revision Questions 407
12 The Manufacturing Account 421
Learning Outcome 421
12.1 Introduction 421
12.2 Why is a manufacturing account needed? 421
12.2.1 Inventories in manufacturing organisations 422
12.3 Costs to include in the manufacturing account 422
12.3.1 Other direct costs 423
12.3.2 Prime cost 423
12.3.3 Indirect costs 423
12.3.4 Factory cost of production 423
12.3.5 Work in progress 423
12.3.6 Factory cost of goods completed 424
12.4 Layout of manufacturing and trading accounts 424
12.5 Income statement for manufacturing organisations 425
12.6 Balance sheets for manufacturing organisations 425
12.7 The accounting system for manufacturing
organisations 425
12.8 Summary 428
Revision Questions 431
Solutions to Revision Questions 435
13 The Financial Statements of Limited Companies and
Cash Flow Statements 439
Learning Outcomes 439
13.1 Introduction 439
13.2 Limited companies 440
13.2.1 The financial statements of companies 440
13.2.2 Presentation of company financial statements 441
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FUNDAMENTALS OF FINANCIAL ACCOUNTING ix
13.2.3 Taxation in company financial statements 441
13.2.4 Directors of limited companies 441
13.2.5 Sources of finance for a limited company 441
13.2.6 Dividends 444
13.2.7 Reserves 446
13.2.8 Statement of changes in equity 446
13.3 Cash flow statements 454
13.3.1 What is a cash flow statement? 454
13.3.2 Why does the profit earned not equal the change in bank
and cash balances? 454
13.3.3 Cash flows from operating activities – cash generated
from operations 455
13.3.4 Cash flows from operating activities – net cash from
operating activities 456
13.3.5 Cash flows from investing activities 457
13.3.6 Cash flows from financing activities 457
13.3.7 Cash flow statements for sole traders 460
13.4 Summary 460
Revision Questions 461
Solutions to Revision Questions 489
14 The Interpretation of Financial Statements 509
Learning Outcome 509
14.1 Introduction 509
14.2 What is meant by ‘interpretation of financial statements’? 509
14.3 Calculating ratios 511
14.3.1 Using the ratios 511
14.4 Types of ratios 511
14.5 Profitability ratios 512
14.5.1 Gross profit margin 513
14.5.2 Gross profit mark-up 513
14.5.3 Operating profit margin 514
14.5.4 Return on capital ratios 514
14.6 Liquidity ratios 515
14.6.1 The current ratio 516
14.6.2 The quick ratio 516
14.7 Efficiency ratios 517
14.7.1 Asset turnover ratios 517
14.7.2 Inventories days 517
14.7.3 Receivables days 518
14.7.4 Payables days 519
14.7.5 Total working capital ratio 519
14.8 Capital structure ratios 520
14.8.1 The gearing ratio (or leverage ratio) 520
14.8.2 Interest cover 520
14.9 Ratio analysis for sole traders 520
14.10 Summary 521
Revision Questions 523
Solutions to Revision Questions 547
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x FUNDAMENTALS OF FINANCIAL ACCOUNTING C2
Preparing for the Computer-Based Assessment (CBA) 563
Revision technique 563
Planning 563
Getting down to work 564
Tips for the final revision phase 564
Format of the Assessment 565
Structure of the assessment 565
Weighting of subjects 565
Revision Questions 567
Solutions to Revision Questions 655
Mock Assesment 699
Index 725
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The CIMA Learning System
How to use your CIMA Learning System
This Financial Accounting Fundamentals Learning System has been devised as a resource for
students attempting to pass their CIMA computer-based assessment, and provides:
• a detailed explanation of all syllabus areas;
• extensive ‘practical’ materials;
• generous question practice, together with full solutions;
• a computer-based assessment preparation section, complete with computer-based
assessment standard questions and solutions.
This Learning System has been designed with the needs of home-study and distancelearning candidates in mind. Such students require very full coverage of the syllabus
topics, and also the facility to undertake extensive question practice. However, the Learning
System is also ideal for fully taught courses.
The main body of the text is divided into a number of chapters, each of which is organised
on the following pattern:
• Detailed learning outcomes expected after your studies of the chapter are complete. You
should assimilate these before beginning detailed work on the chapter, so that you can
appreciate where your studies are leading.
• Step-by-step topic coverage. This is the heart of each chapter, containing detailed explanatory text supported where appropriate by worked examples and exercises. You should
work carefully through this section, ensuring that you understand the material being
explained and can tackle the examples and exercises successfully. Remember that in
many cases knowledge is cumulative: if you fail to digest earlier material thoroughly,
you may struggle to understand later chapters.
• Activities. Some chapters are illustrated by more practical elements, such as comments
and questions designed to stimulate discussion.
• Question practice. The test of how well you have learned the material is your ability
to tackle exam-standard questions. Make a serious attempt at producing your own
answers, but at this stage do not be too concerned about attempting the questions in
computer-based assessment conditions. In particular, it is more important to absorb the
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xii FUNDAMENTALS OF FINANCIAL ACCOUNTING C2
material thoroughly by completing a full solution than to observe the time limits that
would apply in the actual computer-based assessment.
• Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an illusion
to think that this provides the same benefits as you would gain from a serious attempt of
your own. However, if you are struggling to get started on a question you should read
the introductory guidance provided at the beginning of the solution, where provided,
and then make your own attempt before referring back to the full solution.
Having worked through the chapters you are ready to begin your final preparations for
the computer-based assessment. The final section of this CIMA Learning System provides
you with the guidance you need. It includes the following features:
• A brief guide to revision technique.
• A note on the format of the computer-based assessment. You should know what to expect
when you tackle the real computer-based assessment and in particular the number of
questions to attempt.
• Guidance on how to tackle the computer-based assessment itself.
• A table mapping revision questions to the syllabus learning outcomes allowing you to
quickly identify questions by subject area.
• Revision questions. These are of computer-based assessment standard and should
be tackled in computer-based assessment conditions, especially as regards the time
allocation.
• Solutions to the revision questions.
One mock computer-based assessment. You should plan to attempt this just before the
date of the real computer-based assessment. By this stage your revision should be complete
and you should be able to attempt the mock computer-based assessment within the time
constraints of the real computer-based assessment.
If you work conscientiously through this CIMA Learning System according to the guidelines
above you will be giving yourself an excellent chance of success in your computer-based
assessment. Good luck with your studies!
Guide to the Icons used within this Text
Key term or definition
Exam tip or topic likely to appear in the computer-based assessment
Exercise
Question
Solution
Comment or Note
Study technique
Passing exams is partly a matter of intellectual ability, but however accomplished you are
in that respect you can improve your chances significantly by the use of appropriate study
and revision techniques. In this section we briefly outline some tips for effective study
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FUNDAMENTALS OF FINANCIAL ACCOUNTING xiii
during the earlier stages of your approach to the computer-based assessment. Later in the
text we mention some techniques that you will find useful at the revision stage.
Planning
To begin with, formal planning is essential to get the best return from the time you spend
studying. Estimate how much time in total you are going to need for each paper you are
studying for the Certificate in Business Accounting. Remember that you need to allow
time for revision as well as for initial study of the material. The amount of notional study
time for any paper is the minimum estimated time that students will need to achieve
the specified learning outcomes set out below. This time includes all appropriate learning
activities, for example, face-to-face tuition, private study, directed home study, learning
in the workplace, revision time, etc. You may find it helpful to read Better Exam Results:
a Guide for Business and Accounting Students by S.A. Malone, Elsevier, ISBN: 075066357X.
This book will provide you with proven study techniques. Chapter by chapter it covers the
building blocks of successful learning and examination techniques.
The notional study time for the Certificate in Business Accounting paper Fundamentals
of Financial Accounting is 130 hours. Note that the standard amount of notional learning
hours attributed to one full-time academic year of approximately 30 weeks is 1,200 hours.
By way of example, the notional study time might be made up as follows:
Hours
Face-to-face study: up to 40
Personal study: up to 65
‘Other’ study – e.g. learning in the workplace, revision, etc.: up to 25
130
Note that all study and learning-time recommendations should be used only as a guideline
and are intended as minimum amounts. The amount of time recommended for face-to-face
tuition, personal study and/or additional learning will vary according to the type of course
undertaken, prior learning of the student, and the pace at which different students learn.
Now split your total time requirement over the weeks between now and the exam. This
will give you an idea of how much time you need to devote to study each week. Remember
to allow for holidays or other periods during which you will not be able to study (e.g.
because of seasonal workloads).
With your study material before you, decide which chapters you are going to study in each
week, and which weeks you will devote to revision and final question practice.
Prepare a written schedule summarising the above – and stick to it!
The amount of space allocated to a topic in the Learning System is not a very good guide
as to how long it will take you. For example, the material relating to the ‘Conceptual and
Regulatory Framework’ and the ‘Accounting Systems’ both account for 20% of the syllabus,
but the latter has more pages because there are more numerical illustrations which take up
more space. The syllabus weighting is the better guide as to how long you should spend
on a syllabus topic. It is essential to know your syllabus. As your course progresses you
will become more familiar with how long it takes to cover topics in sufficient depth. Your
timetable may need to be adapted to allocate enough time for the whole syllabus.
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xiv FUNDAMENTALS OF FINANCIAL ACCOUNTING C2
Tips for effective studying
1. Aim to find a quiet and undisturbed location for your study, and plan as far as possible
to use the same period of time each day. Getting into a routine helps to avoid wasting
time. Make sure that you have all the materials you need before you begin so as to
minimise interruptions.
2. Store all your materials in one place, so that you do not waste time searching for items
around your accommodation. If you have to pack everything away after each study
period, keep them in a box, or even a suitcase, which will not be disturbed until the
next time.
3. Limit distractions. To make the most effective use of your study periods you should
be able to apply total concentration, so turn off all entertainment equipment, set your
phones to message mode, and put up your ‘do not disturb’ sign.
4. Your timetable will tell you which topic to study. However, before diving in and
becoming engrossed in the finer points, make sure you have an overall picture of all the
areas that need to be covered by the end of that session. After an hour, allow yourself
a short break and move away from your Learning System. With experience, you will
learn to assess the pace you need to work at.
5. Work carefully through a chapter, making notes as you go. When you have covered a
suitable amount of material, vary the pattern by attempting a practice question. When
you have finished your attempt, make notes of any mistakes you made, or any areas
that you failed to cover or covered only skimpily.
6. Make notes as you study, and discover the techniques that work best for you. Your
notes may be in the form of lists, bullet points, diagrams, summaries, ‘mind maps’, or
the written word, but remember that you will need to refer back to them at a later date,
so they must be intelligible. If you are on a taught course, make sure you highlight any
issues you would like to follow up with your lecturer.
7. Organise your notes. Make sure that all your notes, calculations etc. can be effectively
filed and easily retrieved later.
Computer-based assessment
CIMA uses computer-based assessment (CBA) for all subjects for the Certificate in Business
Accounting. The website says
Objective questions are used. The most common type is “multiple choice”, where you have
to choose the correct answer from a list of possible answers, but there are a variety of
other objective question types that can be used within the system. These include true/false
questions, matching pairs of text and graphic, sequencing and ranking, labelling diagrams
and single and multiple numeric entry.
Candidates answer the questions by either pointing and clicking the mouse, moving objects
around the screen, typing numbers, or a combination of these responses. Try the online
demo at http://www.cimaglobal.com to see how the technology works.
The CBA system can ensure that a wide range of the syllabus is assessed, as a predetermined number of questions from each syllabus area (dependent upon the syllabus
weighting for that particular area) are selected in each assessment.
In every chapter of this Learning System we have introduced these types of questions
but obviously we have to label answers A, B, C, etc. rather than using click boxes. For
convenience we have retained quite a lot of questions where an initial scenario leads to
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a number of subquestions. There will be questions of this type in the CBA but they will
rarely have more than three sub-questions. In all such cases examiners will ensure that the
answer to one part does not hinge upon a prior answer.
The Fundamentals of Financial Accounting Syllabus
The computer-based assessment for Financial Accounting Fundamentals is a 2 hrs
computer-based assessment comprising 50 compulsory questions, with one or more parts.
Single part questions are generally worth 1–2 marks each, but two and three part questions
may be worth 4 or 6 marks. There will be no choice and all questions should be attempted
if time permits. CIMA are continuously developing the question styles within the CBA
system and you are advised to try the on-line website demo at www.cimaglobal.com, to
both gain familiarity with assessment software and examine the latest style of questions
being used.
2006.1