intermediate accounting principles and analysis 2nd kieoso

He has served as president of the Financial Accounting and ReportingSection, the Financial Accounting Standards Committee ofthe American Accounting Association Chair 1995–1996,the AAA-FA

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INTERMEDIATE ACCOUNTING:

PRINCIPLES AND ANALYSIS

TERRY D WARFIELD, Ph.D.

Associate Professor Director, Andersen Center for Financial Reporting and Control

University of Wisconsin Madison, Wisconsin

JERRY J WEYGANDT, Ph.D., C.P.A.

Arthur Andersen Alumni Professor of Accounting

University of Wisconsin Madison, Wisconsin

DONALD E KIESO, Ph.D., C.P.A.

KPMG Emeritus Professor of Accounting Northern Illinois University DeKalb, Illinois

JOHN WILEY & SONS, Inc.

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E XECUTIVE P UBLISHER Donald Fowley

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E DITORIAL A SSISTANT Kathryn Fraser

D ESIGN D IRECTOR Harry Nolan

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S ENIOR P RODUCTION E DITOR Patricia McFadden

S ENIOR I LLUSTRATION E DITOR Elle Wagner

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O UTSIDE P ROJECT M ANAGEMENT Ingrao Associates

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This book was set in Times Roman by Aptara and printed and bound by R R Donnelley,

Jefferson City, MO.

The cover was printed by R R Donnelley, Jefferson City, MO.

This book is printed on acid free paper 

Copyright © 2008 John Wiley & Sons, Inc All rights reserved No part of this publication

may be reproduced, stored in a retrieval system or transmitted in any form or by any

means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as

permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without

either the prior written permission of the Publisher, or authorization through payment of

the appropriate per-copy fee to the Copyright Clearance Center, Inc 222 Rosewood Drive,

Danvers, MA 01923, website www.copyright.com Requests to the Publisher for

permis-sion should be addressed to the Permispermis-sions Department, John Wiley & Sons, Inc.,

111 River Street, Hoboken, NJ 07030-5774, (201)748-6011, fax (201)748-6008, website

Terry D Warfield, Ph.D., is associate professor of

accounting at the University of Wisconsin—Madison He

received a B.S and M.B.A from Indiana University and a

Ph.D in accounting from the University of Iowa Professor

Warfield’s area of expertise is financial reporting, and prior

to his academic career, he worked for five years in the

bank-ing industry He served as the Academic Accountbank-ing Fellow

in the Office of the Chief Accountant at the U.S Securities

and Exchange Commission in Washington, D.C from

1995–1996 Professor Warfield’s primary research interests

concern financial accounting standards and disclosure

poli-cies He has published scholarly articles in The Accounting

Review, Journal of Accounting and Economics, Research in

Accounting Regulation, Review of Accounting Studies, and

Accounting Horizons, and he has served on the editorial

boards of The Accounting Review, Accounting Horizons,

v

and Issues in Accounting Education He has served as

president of the Financial Accounting and ReportingSection, the Financial Accounting Standards Committee ofthe American Accounting Association (Chair 1995–1996),the AAA-FASB Research Conference Committee and theAAA Regulation Committee, and is a member ofthe Financial Accounting Standards Advisory Council tothe FASB Professor Warfield has received teachingawards at both the University of Iowa and the University ofWisconsin, and he was named to the Teaching Academy atthe University of Wisconsin in 1995 Professor Warfieldhas developed and published several case studies based onhis research for use in accounting classes These caseshave been selected for the AICPA Professor-PractitionerCase Development Program and have been published in

Issues in Accounting Education.

Jerry J Weygandt, Ph.D., C.P.A., is Arthur Andersen

Alumni Professor of Accounting at the University of

Wisconsin—Madison He Holds a Ph.D in accounting

from the University of Illinois Articles by Professor

Weygandt have appeared in the Accounting Review,

Journal of Accounting Research, Accounting Horizons,

Journal of Accountancy, and other academic and

profes-sional journals These articles have examined such

finan-cial reporting issues as accounting for price-level

adjust-ments, pensions, convertible securities, stock option

con-tracts, and interim reports Professor Weygandt is author of

other accounting and financial reporting books and is a

member of the American Accounting Association, the

American Institute of Certified Public Accountants, and

the Wisconsin Society of Certified Public Accountants He

has served on numerous committees of the American

Accounting Association and as a member of the editorial

board of the Accounting Review; he also has served as

President and Secretary-Treasurer of the AmericanAccounting Association In addition, he has been activelyinvolved with the American Institute of Certified PublicAccountants and has been a member of the AccountingStandards Executive Committee (AcSEC) of that organiza-tion He has served on the FASB task force that examinedthe reporting issues related to accounting for income taxesand as a trustee of the Financial Accounting Foundation.Professor Weygandt has received the Chancellor’s Awardfor Excellence in Teaching and the Beta Gamma SigmaDean’s Teaching Award He is on the board of directors of

M & I Bank of Southern Wisconsin He is the recipient ofthe Wisconsin Institute of CPA’s Outstanding Educator’sAward and the Lifetime Achievement Award In 2001 hereceived the American Accounting Association’sOutstanding Accounting Educator Award

A B O U T T H E A U T H O R S

Donald E Kieso, Ph.D., C.P.A., received his

bache-lor’s degree from Aurora University and his doctorate in

accounting from the University of Illinois He has served

as chairman of the Department of Accountancy and is

cur-rently the KPMG Emeritus Professor of Accounting at

Northern Illinois University He has public accounting

experience with Price Waterhouse & Co (San Franciscoand Chicago) and Arthur Andersen & Co (Chicago) andresearch experience with the Research Division of theAmerican Institute of Certified Public Accountants (NewYork) He has done postdoctorate work as a VisitingScholar at the University of California at Berkeley and is a

recipient of NIU’s Teaching Excellence Award and four

Golden Apple Teaching Awards Professor Kieso is the

author of other accounting and business books and is a

member of the American Accounting Association, the

American Institute of Certified Public Accountants, and

the Illinois CPA Society He has served as a member of the

Board of Directors of the Illinois CPA Society, the

AACSB’s Accounting Accreditation Committees, the State

of Illinois Comptroller’s Commission, as

Secretary-Treasurer of the Federation of Schools of Accountancy,and as Secretary-Treasurer of the American AccountingAssociation Professor Kieso served as a charter member

of the national Accounting Education ChangeCommission He is the recipient of the OutstandingAccounting Educator Award from the Illinois CPA Society,the FSA’s Joseph A Silvoso Award of Merit, and the NIUFoundation’s Humanitarian Award for Service to HigherEducation

Intermediate Accounting: Principles and Analysis, Second Edition, provides a solid

foun-dation for instructors whose goal is to help accounting students build an understanding of

the principles, concepts, and methods of financial accounting and reporting To that end,

we address the following key themes that users have identified as important in their

inter-mediate accounting courses

The importance of accounting to the capital market and the business community in general

has never been more important In Intermediate Accounting, Second Edition, boxed stories

entitled “What Do the Numbers Mean?” convey the excitement and ever-changing nature of

accounting, highlighting its importance We have found that when introduced to the issues

in-volved in the financial reporting of real companies, students genuinely enjoy the subject area

• “What’s the principle?”

An important instructional objective in Intermediate Accounting, Second Edition, is to

reinforce students’ understanding of the principles and concepts that are fundamental to

financial reporting Most students quickly forget procedural details, but they can internalize

principles and concepts that will serve as important cornerstones for decision making

throughout their careers Concepts are especially important in a world in which the details

are frequently changing Furthermore, a conceptual orientation is consistent with the

evolv-ing orientation toward principles-based, as opposed to rules-based, accountevolv-ing standards

• Active learning _“Try it out!”

Students learn best when they are actively engaged An overriding pedagogical approach

for the book is to provide students opportunities for active learning Each chapter contains

strategically placed “Try it out!”exercises (with worked-out solutions) that give added

op-portunities for active learning

• “You need to decide”

All business people and accounting professionals must make decisions Decision making

involves critical evaluation and analysis of information A new review exercise in each

chap-ter, titled “Accounting, Analysis, Principles,” helps students evaluate and analyze

informa-tion from the chapter They review the accounting introduced in the chapter (“Accounting”),

consider how the information provided by the accounting is useful to investors and

credi-tors (“Analysis”), and reflect on how the accounting is related to accounting principles and

concepts (“Principles”) Such exercises, reinforced with end-of-chapter homework

activi-ties, give students the practice they will need to build decision-making skills using the

accounting concepts and procedures they are learning

Students need to develop competencies that will be useful in their careers As described

above, the book provides multiple opportunities for students to develop the critical thinking

and analysis skills that will be the backbone of career competency In addition, explicit

writ-ing components in end-of-chapter assignments require students to practice communication

skills Other assignments for use by students working in groups help develop facility in group

problem solving, a skill useful in the working world

In addition, for those students who will eventually sit for the CPA exam, we offer

in-teractive integrative problems at the book’s companion website that mirror the new

com-puterized exam Finally, each chapter also contains stand-alone financial accounting

re-search cases using the Financial Accounting Rere-search System (FARS) database

vii

P R E F A C E

BOOK RATIONALE AND ORGANIZATION

Some instructors have expressed a desire for a slightly different type of book for theintermediate accounting course They asked for something that would enable them to havemore time to develop various professional competencies, such as analysis and communi-cation skills, and to place more emphasis on applying accounting concepts in various set-tings, such as in oral and written presentations and with introduction of more technologyand other enhancements Still others have expressed a need for a book that will better help

students cope with the complexity and rigor of the intermediate course Intermediate

Accounting: Principles and Analysis, Second Edition, is intended to address those stated

needs

With 18 chapters, this book meets the needs of various audiences Instructors whointend to use the textbook over two semesters can enhance the book with additional read-ings, cases, exercises, or other professional-competency activities Instructors who wish tocover the book in a single semester can do so, by omitting some subject material, but stillhave complete treatment of the topics covered Because the book provides the core conceptsthat must be covered in intermediate accounting, instructors can use this textbook in gradu-ate, masters, and MBA courses The 18-chapter book also provides additional flexibility toinstructors who are interested in teaching a corporate reporting course For an overview ofthe chapter sequence, see the Brief Contents list on page xxi

The underlying theme around which each chapter is based is to learn the accounting forvarious transactions (accounting), to use the accounting in various decision-making contexts(analysis), and to develop understanding of the concepts or principles underlying theaccounting treatment (principles)

Organization

The book’s organization offers an integrated framework in which to study the essentialconcepts of intermediate accounting The first two chapters discuss the standard-settingprocess, starting with the institutional structure and following with the conceptual frame-work A review of the accounting process then follows in Chapter 3, as a refresher on basicunderstanding of the recording process, which is intended to bring all students up to thesame level

The next three chapters address the three major financial statements—the balancesheet, the income statement, and (in a separate chapter) the statement of cash flows.Revenue recognition is moved up in the “batting order” (relative to its position in

Kieso, Intermediate Accounting, Twelfth Edition) and appears next, as Chapter 7.

Chapters 6 and 7 represent a change from the first edition, where cash flows and revenuerecognition were covered in a single chapter (Chapter 6) Separation of these importanttopics into two chapters makes possible a more complete discussion of the statement ofcash flows and income measurement concepts that are important to subsequent chaptertopics

What then follows, in Chapters 8 through 14, is a discussion of the basic issues

relat-ed to cash and receivables, inventories, plant assets, intangible assets, liabilities, holders’ equity, and investments Following these basic-issues chapters are chapters(Chapters 15 through 17) on the important topics of income taxes, compensation (includ-ing pensions and stock options), and leases We complete the chapter-length coverage withdiscussion in Chapter 18 of other reporting and disclosure issues, including accountingchanges and earnings per share

stock-Two end-of-book appendices address time value of money concepts and applications(Appendix A) and reporting cash flows (Appendix B) Another seven appendices dealingwith more specialized accounting topics are available at the book’s companion website Seethe Brief Contents on page xxi for the complete list of online appendices

viii Preface

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Preface ix

Throughout all chapters, we balance discussion of concepts and applications so that

these elements are mutually reinforcing In addition, we focus discussion on explaining the

rationale behind business transactions before addressing the accounting and reporting for

those activities

Distinctive Content Areas

The following are the distinctive content areas of the book

Separate Chapters on Cash Flows and Revenue Recognition

Many users requested earlier discussion of the statement of cash flows and revenue

recognition Intermediate Accounting, Second Edition, provides us the opportunity to

address both these desires In Chapter 6, we present a substantive discussion of the cash

flow statement We transition from the discussion of cash flows in Chapter 6 to revenue

recognition in Chapter 7 with its accrual concepts, to provide a perspective on the use

of various performance measurements Given that many companies report pro-forma

earnings numbers that range from cash flow per share to earnings before interest and

taxes, the logic of discussing cash flow and revenue recognition in sequence seemed

appropriate

Chapter on Compensation

Intermediate Accounting, Second Edition, features a chapter on compensation, including

the topics of payroll, stock options, and pensions The content in the area is very similar

to the treatment in Kieso, Intermediate Accounting, Twelfth Edition.

Combined Chapters

One differentiating feature of Warfield, Intermediate Accounting, Second Edition, is that it

combines selected chapters that in Kieso, Intermediate Accounting, Twelfth Edition, are

sep-arate chapters We carefully planned and executed this combination of related topics, which

makes possible a textbook that can be covered in a single semester, in order to provide

ad-equate topic coverage for the second course in financial reporting The combined chapters

are as follows

Inventories

Kieso, Intermediate Accounting, Twelfth Edition, covers inventories in two chapters because

of the many complexities associated with the topic In order to distill coverage of

invento-ries to one chapter, Warfield, Intermediate Accounting, Second Edition, omits certain

top-ics related to managerial accounting In addition, online appendices discuss specialized

in-dustry topics like the retail inventory method, but still permit adequate discussion of the

key concepts related to inventories in the chapter

Property, Plant, and Equipment

Warfield, Intermediate Accounting, Second Edition, combines two chapters—Property,

Plant, and Equipment, and Depreciation—from the longer book In order to achieve a

single chapter of manageable length, we streamlined discussions related to interest

cap-italization and special depreciation methods We moved the important topic of

impair-ments to the intangibles chapter, so that this subject can be discussed fully in one place

The subject matter related to depletion appears in an online appendix

Liabilities

For Warfield, Intermediate Accounting, Second Edition, we streamlined and rewrote the two

chapters on liabilities for presentation in a single chapter on this topic

OTHER FEATURES

Intermediate Accounting: Principles and Analysis, Second Edition, is packaged with

many pedagogical tools to help students learn more effectively and to help instructorsrespond to the changing needs of the course We developed the following pedagogicalfeatures based on extensive reviews, focus groups, interactions with intermediate ac-counting instructors and students, and our own experiences with the intermediateaccounting course

Textbook Features

Chapter-Opening Vignettes

We have updated or added new chapter-opening stories to provide a real-world context thathelps motivate student interest in the chapter topic

“What Do the Numbers Mean?” Boxes

As described earlier, What Do the Numbers Mean? boxes help students think about the

real-world consequences of accounting In this edition of the book, we have added critical

think-ing questions (Beyond the Numbers) at the end of each box These questions encourage

stu-dents to stretch their thinking about the boxed story and to relate it to underlying accountingtopics and concepts Guideline answers at the end of the chapter provide immediately avail-able feedback to students’ efforts

Should the accounting profession have principles-based standards or rules-based standards? Critics of the profession today say that over the past three decades, standard-setters have moved away from broad accounting principles aimed at ensuring that companies’ financial statements are fairly presented.

Instead, these critics say, standard-setters have moved toward drafting voluminous rules that, if technically followed in “check-box” fashion, may shield auditors and companies from legal liability That has resulted in companies creating complex capital structures that comply with GAAP but hide billions

of dollars of debt and other obligations To add fuel to the fire, the chief accountant of the enforcement division of the SEC recently noted, “One can violate SEC laws and still comply with GAAP.”

In short, what he is saying is that it is not enough just to check the boxes You then have to step

back and determine whether the overall impression created by GAAP financial statements fairly

portrays the underlying economics of the company It is a tough standard, but one that auditors and corporate management should strive to achieve.

Sources: Adapted from S Liesman, “SEC Accounting Cop’s Warning: Playing by the Rules May Not Head Off

Fraud Issues,” Wall Street Journal (February 12, 2002), p C7 See also “Study Pursuant to Section 108(d) of the

Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a

Principles-Based Accounting System,” SEC (July 25, 2003).

Beyond the Numbers

Do you believe that standard-setters should issue principle-based standards or rule-based standards?

“What’s the Principle?”

These marginal notes relate topics covered within each chapter back to the tual principles introduced in the beginning of the book This continual reinforcement

concep-of the essential concepts and principles illustrates how the concepts are applied in

practice and helps students understand the why, as well as the how

WHAT’S THE PRINCIPLE?

Providing a supplemental schedule

with expense detail helps meet the

objectives of the full disclosure

principle.

“Try It Out” Exercises

New in the Second Edition, strategically placed Try It Out exercises, with accompanying

solutions, engage students in active learning as they work their way through a chapter

Preface xi

Try it out! Sloan Corporation reported the following income-related information for

$240,000 The following irregular items have not yet been considered by Sloan: tax) $35,000; restructuring charge $45,000

Extraor-Instructions

Determine the amounts for: (a) income from continuing operations and (b) net income.

Sloan’s tax rate is 30%.

Solution

a Income from continuing operations

 $240,000 less restructuring, adjusted for taxes

 $240,000  [$45,000  (1  30)]  $208,500

b Income from continuing operations $208,500 Discontinued operations 35,000 Extraordinary loss (20,000) Net income $223,500

“Convergence Corners”

Accounting is going global, led by the FASB and the IASB who are working on an

ambi-tious convergence project to result in one set of high-quality accounting standards Students

need to be informed of this important project Thus, each chapter of the second edition

con-tains a single-page discussion, called Convergence Corner, of the international

account-ing issues related to the chapter topics

Each Convergence Corner consists of four sections: (1) An introduction which

typi-cally lists the current international pronouncements related to the chapter topic; (2)

“Rele-vant Facts,” which explains similarities and differences of U.S GAAP and international

standards (referred to as iGAAP); (3) “About the Numbers,” which provides an example of

application of iGAAP (in many cases, using real international companies); and (4) “On the

Horizon,” which discusses the convergence progress and plans related to that topic

C O N V E R G E N C E C O R N E R

Most agree that there is a need for one set of international accounting standards Here is why:

Multinational corporations Today companies view the entire world as their market For example, Coca-Cola,

Intel, and McDonald’sgenerate more than 50 percent of their sales outside the United States, and many foreign companies find their largest market to be the United States.

Mergers and acquisitions The mergers that led to international giants DaimlerChryslerand Vodafone/Mannesmann

suggest that we will see even more such mergers in the future.

Information technology As communication barriers continue to topple through advances in technology,

compa-services from one another

Financial markets Financial markets are some of the most significant international markets today Whether it is

these types of instruments

Both the IASB and the FASB are hard at work developing standards that will lead to the elimination of major standards will become effective until 2009 The major reason for this policy is to provide companies time to translate and implement iGAAP into practice.

differ-The international standard-setting environment is changing rapidly differ-The task will not be easy, but conditions are conducive to convergence As Mary Barth, a member of the IASB noted, “There is still a lot to do, but I would never have dreamed we would be working as closely with the FASB as we do today.”

• iGAAP includes the standards, referred to as national Financial Reporting Standards (IFRS), devel- oped by the IASB The predecessor to the IASB issued International Accounting Standards (IAS) Both IFRS and IAS are considered iGAAP.

Inter-• The fact that there are differences between U.S.

GAAP and iGAAP should not be surprising because standard setters have developed standards in response to different user needs In some countries, the primary users of financial statements are private investors; in others, the primary users are tax authorities or central government planners In the United States, investors and creditors have driven accounting-standard formulation.

• iGAAP tends to be simpler and less stringent in its accounting and disclosure requirements U.S GAAP is more detailed This difference in approach has resulted in a debate about the merits of “principle-based” versus “rule-based” standards.

• Regulators have stated that by 2009 they want to eliminate the need for foreign companies that trade sharees in U.S markets

to reconcile their accounting with U.S GAAP.

International Financial Reporting

“Accounting, Analysis, Principles” Review

Also new in the Second Edition, the Accounting, Analysis, Principles review exercise, as

the first feature of the chapter-review apparatus, summarizes the three important elements

of each chapter It helps students to review the accounting introduced in the chapter, to consider how the information provided by the accounting can be analyzed and used by investors and creditors, and to reflect on how the accounting is related to underlying

accounting principles and concepts A full solution is provided.

ACCOUNTING, ANALYSIS, PRINCIPLES

William Murray achieved one of his life-long dreams by opening his own business, The Caddie

He paid $6,000 cash to have a small building constructed to house the operations and spent

$1,000 per month (He paid the first month’s rent in cash.) During the first month, three nephews $400 for retrieving golf balls He deposited in the company’s bank account all use On May 31, the company received a utility bill for $100, but did not immediately pay

advertis-it On May 31, the balance in the company bank account was $15,100

Murray is feeling pretty good about results for the first month, but his estimate of itability ranges from a loss of $4,900 to a profit of $1,650

a A balance sheet for The Caddie Shack at May 31, 2008, would be:

Assets Liabilities and Capital

Cash $15,100 Advertising payable $ 150 Building 6,000 Utilities payable 100 Equipment 800 Original capital 20,000

Change in capital 1,650 Total assets $21,900 $21,900 Murray might conclude that income was $1,650 based on the change in capital from the beginning of the month to the end of the month.

b If Murray focused on the change in cash or the balance in the bank account, he would

measured on a cash basis.

Analysis

c The income measure of $1,650 is most relevant for assessing the future profitability

Review Exercise

Following the list of Key Terms and the Summary of Learning Objectives, a Review

Exer-cise, with solution, gives students another chance to check their understanding of chapter

concepts before they begin end-of-chapter homework assignments

REVIEW EXERCISE

Presented below are ten income statements items from Ritter Corporation for the year ended December 31, 2008.

Sales $3,200,000 Cost of goods sold 1,650,000 Interest revenue 10,000 Loss from abandonment of plant assets 60,000 Gain from extinguishment of debt 100,000 Selling expenses 340,000 Administrative expenses 280,000 Effect of change in estimated useful

lives of fixed assets 50,000 Loss from earthquake (unusual and infrequent) 40,000 Gain on disposal of a component of

Ritter’s business 90,000

Instructions

Using the information above, prepare a condensed multiple-step income statement Assume

a tax rate of 30% and 100,000 shares of common stock outstanding during 2008.

Solution

Ritter Corporation Income Statement For the Year Ended December 31, 2008

Sales $3,200,000

Questions, Brief Exercises, Exercises, and Problems

A full complement of homework materials of varying lengths and difficulty levels gives

instructors a wide variety of class-tested and time-proven materials from which to make

as-signment selections Numerous exercises and problems are adapted from professional

ex-ams, to give students practice in the type of materials they will encounter in these testing

situations Special icons identify problems that are good for group work or for writing

assignments Homework materials that can be solved using the Excel Problems supplement

are identified by a spreadsheet icon In addition, end-of-chapter Brief Exercises, Exercises,

and Problems are now classified by learning objective

Preface xiii

Exercises

E2-1 (Qualitative Characteristics) SFAC No 2 identifies the qualitative characteristics that make

account-ing information useful Presented below are a number of questions related to these qualitative characteristics and

underlying constraints.

(a) What is the quality of information that enables users to confirm or correct prior expectations?

(b) Identify the two overall or pervasive constraints developed in SFAC No 2.

(LO 4, 8)

We have carefully chosen all homework materials to reflect key chapter content and

have triple-checked them for accuracy Also, new in this edition, we have added a set of

Additional Exercises, which are available at the book’s companion website These

addi-tional materials give instructors an alternate set of exercises to assign

“Accounting in Action” Section

The Accounting in Action section at the end of each chapter groups problems that require

students to apply their accounting knowledge while expanding student competencies in

analysis and decision-making contexts

Included in the Accounting in Action section are three sub-sections: Financial

Report-ing and Analysis, Concepts for Analysis, and Professional Tools Homework materials in

each sub-section are as follows

A C C O U N T I N G I N A C T I O N

Financial Reporting and Analysis

䊏 Financial Reporting Issues: The Procter & Gamble Company

AIA3-1 The financial statements of Procter & Gamble (P&G)can be accessed at the book’s website.

Instructions

Refer to P&G’s financial statements and the accompanying notes to answer the following questions.

(a) What were P&G’s total assets at June 30, 2006? At June 30, 2005?

(b) How much cash (and cash equivalents) did P&G have on June 30, 2006?

(c) What were P&G’s research and development costs in 2004? In 2006?

(d) What were P&G’s revenues in 2004? In 2006?

The Financial Reporting and Analysis section includes a Financial Reporting Problem

(focused in this edition on Procter & Gamble), Comparative Analysis (comparing The

Coca-Cola Company to PepsiCo, Inc.), Financial Statement Analysis Cases (using a variety of

real-world companies), and in some chapters, an International Reporting Case The

inter-national cases, based on real companies, are designed to illustrate interinter-national accounting

differences A particular emphasis is on the implications of these differences for analysis,

which reinforces the user orientation of the Accounting in Action elements

The Concepts for Analysis section contains numerous conceptual cases that focus on

reporting concepts and principles Many of these cases are adapted from professional exams

Students entering the accounting profession must demonstrate not only accountingknowledge but also the ability to apply that knowledge and to use the tools that are used in

practice to solve accounting problems To address these new demands, the Professional

Tools section in the Second Edition includes one or more Ethical Decision Making cases,

Financial Accounting Research (FARs) exercises, and an online Professional Simulation.

Professional Tools

䊏 Ethical Decision Making

AIA4-11 (Presentation of Property, Plant, and Equipment) Andrea Pafko, corporate comptroller for Nicholson Industries, is trying to decide how to present “Property, plant, and equipment” in the balance sheet She realizes that the statement of cash flows will show that the company made a significant investment in pur- chasing new equipment this year, but overall she knows the company’s plant assets are rather old She feels that she can disclose one figure titled “Property, plant, and equipment, net of depreciation,” and the result will be a low figure However, it will not disclose the age of the assets If she chooses to show the cost less accumulated depreciation, the age of the assets will be apparent She proposes the following.

䊏 Professional Simulation

AIA4-13 Go to the book’s companion website, at www.wiley.com/college/warfield, to find an interactive

prob-lem that simulates the computerized CPA exam The professional simulation for this chapter asks you to address questions related to the balance sheet.

?

help standards sheet calculator paste copy

Balance Sheet

The Accounting in Action section concludes by referring students to the book’s panion website where they can purchase a Professional Simulation related to the chapter

com-content This exercise provides students with an interactive integrative context in which toapply the concepts introduced in the chapter The exercises are patterned after the comput-erized CPA exam that tests a candidate’s ability to read, digest, research, and respond to both

a numeric problem and a short-answer essay, and they expand on the professional tency elements that students will need to apply their accounting knowledge in the profes-sional workplace (For more on developing professional competencies, see the next section,

compe-Gateway to the Profession Portal.)

Gateway to the Profession Portal

The Gateway to the Profession supplement to the textbook content is an electronic gateway at the book’s companion website (www.wiley.com/college/warfield), to a comprehensive set of additional materials These materials include: the Professional Simulation exercises; a database

of annual reports of real companies; professional-competency tools on writing, group work,and ethics; discussion of additional topics not included in the printed textbook; and student tu-

torials, self-tests, and a comprehensive glossary The Gateway to the Profession portal enables

instructors to enrich and custom-design course content using easy-to-access materials

In addition to the material available via the Gateway to the Profession portal,

WileyPLUS offers students a suite of online homework, with access to an online version of

the text All Brief Exercises, Exercises, and select Problems are available within

WileyPLUS Instructor resources include a wealth of presentation and preparation tools,

easy-to-navigate assignment and assessment tools, and a complete system to administer andmanage your course

Supplementary Materials

Accompanying this textbook is an improved and expanded package of student learning aids

and instructor teaching aids The Gateway to the Profession portal provides expanded

ma-terials, as discussed above, including WileyPLUS, whose resources can help you prepare

class presentations, create assignments, offer help to students, and track student progress

Other teaching and learning aids to supplement the textbook are described below

Instructor Teaching Aids

The following teaching aids are available to support instructors using Warfield, Intermediate

Accounting: Principles and Analysis, Second Edition.

Instructor’s Manual

The online Instructor’s Manual is designed to assist professors in preparing lectures and

assignments It contains chapter reviews, study objectives for each chapter, sample syllabi,

lecture outlines, and printed teaching transparency masters Each chapter also provides

quizzing exercises, a Bloom's taxonomy table, and much more

Solutions Manual

The Solutions Manual provides answers to all end-of-chapter Questions, Brief Exercises,

Exercises, Problems, and Accounting in Action materials Classification tables categorize

solutions by topic, and the new solutions manual also categorizes solutions by textbook

learning objective The estimated time to complete exercises, problems, and cases is

pro-vided Print is large and bold for easy readability in lecture settings

Test Bank

The Second Edition Test Bank contains over 500 new testing questions Exercises,

prob-lems, true/false, multiple choice, and conceptual short-answer questions help instructors test

students’ knowledge and communication skills The Test Bank is designed to allow

in-structors to tailor examinations according to study objectives, learning skills, and content

The Test Bank provides a final exam in addition to chapter tests, achievement tests, and

comprehensive tests

Computerized Test Bank

This easy-to-use program allows instructors to create multiple versions of the same test

This computerized test bank also has authoring capabilities and randomizing functions

Solutions Transparencies

These acetate transparencies contain solutions to textbook end-of-chapter material (brief

exercises, exercises, problems, and Accounting in Action materials) The transparencies

con-tain large, bold type for classroom presentation

PowerPoint™ Presentations

The PowerPoint™ presentations are designed to enhance classroom presentation of

chap-ter topics and examples by emphasizing the key concepts in each chapchap-ter The Second

Edition templates have a new design with review questions and many examples

illus-trating textbook content Available for download from the companion website or in CD

/c

e g

/w arfield

Teaching Transparencies

These four-color acetates provide illustrations of key concepts for classroom viewing

Checklist of Key Figures

Available for download from the website or the Instructor’s Resources CD (IR-CD), thecheck figures are partial and complete answers (not solutions) to select end-of-chaptermaterials

Instructor’s Resource CD (IR-CD)

This CD-ROM contains the Instructor’s Manual, Solutions Manual, Test Bank, teachingtransparencies, text art, computerized test bank, PowerPoint™ presentations, Excel Work-book solutions, and check figures

Companion Website

At www.wiley.com/college/warfield, the book’s companion website offers a wealth of

con-tent and teaching aids

Solutions to Rockford Practice Set

This supplement provides solutions to the Rockford Practice Set, which is available in print

form or electronically on a CD-ROM

Solutions to Excel Workbook Templates

Available for download from the website, these are solutions to the Excel problem

tem-plates discussed in the Warfield, Intermediate Accounting Excel Workbook.

Course Management Resources

Course content cartridges are available from both WebCT and Blackboard to support thistextbook

Student Learning Aids

Working Papers

The working papers are printed templates that can help students correctly format their book accounting solutions Working paper templates are available for all end-of-chapterBrief Exercises, Exercises, and Problems

text-Excel Working Papers

An electronic version of the printed working papers, these Excel-formatted templates helpstudents properly format and present end-of-chapter textbook solutions

Problem-Solving Survival Guide, with Excel Working Papers

This study guide provides exercises and problems that will develop students’

problem-solving skills in intermediate accounting Accompanying the Problem-Solving Survival

Guide is a CD containing the Excel working papers.

Rockford Corporation: An Accounting Practice Set

This revised practice set has been designed as a student review and update of the ing cycle and the preparation of financial statements

account-Rockford Corporation: A Computerized Accounting Practice Set

This computerized practice set is a general ledger software version of the printed practice

set The new computerized Rockford Practice Set is available on CD-ROM.

Excel Workbook and Templates

This workbook contains Excel templates that help students complete selected end-of-chapter

exercises and problems identified by a spreadsheet icon in the margin of the main text A

use-ful introduction to Excel, this package details how students can work with preprogrammed

spreadsheets, and it explains to students how they can design their own spreadsheets

Web Quizzing

The Web Quizzes are online true/false and multiple-choice quizzes with grading and feedback

They can be found at the book’s companion website at http://www.wiley.com/college/warfield

Acknowledgments

We thank the users of the First Edition and the many instructors who contributed to the

revision through their comments and instructive criticism Special thanks are extended to

the focus group participants and the primary reviewers of and contributors to our Second

Utah State University

Paul (Jep) Robertson

Henderson State University

Ancillary Authors, Contributors, Proofers, and Accuracy Checkers

Mary Ann BensonMargaret Blais

Rhode Island College

Borough of Manhattan Community College

Paul (Jep) Robertson

Henderson State University

Green River Community College

Perspectives and “From Classroom to Career” Interviews

Stuart Weiss

Stuart Weiss Business Writing, Inc., Portland, Oregon

Practicing Accountants and Business Executives

From the fields of corporate and public accounting, we owe thanks to the following

prac-titioners for their technical advice and for consenting to interviews

Acknowledgments xix

In addition, we appreciate the exemplary support and professional commitment given

us by the editorial, marketing, production, and design staffs of John Wiley & Sons, cluding the following: Chris DeJohn, Mark Bonadeo, Amy Scholz, Julia Flohr, Ed Brislin,Allie Morris, Kathryn Fraser, Trish McFadden, Maddy Lesure, Anna Melhorn, and DorothySinclair Thanks to Ann Torbert for her editorial assistance in pulling together the variouspieces of the manuscript Thanks, too, to Suzanne Ingrao for her production work, to SteveIngle for his indexing, to the management and staff, particularly Jane Shifflet, at Aptara fortheir work on the textbook, and to Kim Nichols and the management and staff at Elm StreetPublishing Services for their work on the solutions manual

in-We also appreciate the cooperation of the American Institute of Certified Public countants and the Financial Accounting Standards Board in permitting us to quote fromtheir pronouncements We thank The Procter & Gamble Company, The Coca-Cola Com-pany, and PepsiCo, Inc for permitting us to use their 2006 annual reports for our specimenfinancial statements We also acknowledge permission from the American Institute of Cer-tified Public Accountants, the Institute of Management Accountants, and the Institute of In-ternal Auditors to adapt and use material from the Uniform CPA Examinations, the CMAExaminations, and the CIA Examination, respectively

Ac-If this book helps teachers instill in their students an understanding of the accountingfor various transactions, prepares students to use this accounting in various decision-makingsituations, and helps students understand the basic concepts and principles involved infinancial accounting and reporting, then we will have attained our objective

We will appreciate suggestions and comments from users of this book You can send

comments to us by email at AccountingAuthors@yahoo.com.

䊏 Official Accounting Pronouncements P-1

C h a p t e r 1

FINANCIAL ACCOUNTING AND ACCOUNTING

STANDARDS 2

The Size of the New York Phone Book, if Necessary 2

Financial Statements and Financial

Reporting 4

Parties Involved in Standard Setting 7

American Institute of Certified Public

Generally Accepted Accounting Principles 14

Issues in Financial Reporting 15

Ethics in the Environment of Financial

First Level: Basic Objectives 38

xxiii

Second Level: Fundamental Concepts 39

Qualitative Characteristics of Accounting

Convergence Corner The Conceptual Framework 57

C h a p t e r 3

THE ACCOUNTING INFORMATION SYSTEM 76

Needed: A Reliable Information System 76

Accounting Information System 78

The Accounting Cycle 83

Identifying and Recording Transactions and

Financial Statements for a Merchandising

Usefulness of the Income Statement 200

Format of the Income Statement 202

Reporting Irregular Items 208

Special Reporting Issues 218

Convergence CornerIncome Statement 225

C h a p t e r 6

STATEMENT OF CASH FLOWS 250

Don’t Take Cash Flow for Granted 250

The Statement of Cash Flows: Purpose and Format 252

Preparation of the Statement of Cash Flows 257

Summary of Conversion to Net Cash Provided by

Using Cash Flows to Evaluate a Company 269

Assessing Liquidity and Solvency Using Cash

Convergence Corner Statement of Cash Flows 273

Using Reversing Entries 115

Behind the Numbers: Appendix 3B 117

Using a Worksheet: The Accounting Cycle

Revisited 117

Preparing Financial Statements from a

C h a p t e r 4

BALANCE SHEET 144

“There Ought to Be a Law” 144

Use and Limitations 146

Classification in the Balance Sheet 148

Additional Information Reported 162

Behind the Numbers: Appendix 6A 276

Ratio Analysis _A Reference 276

Using Ratios to Analyze Financial

C h a p t e r 7

REVENUE RECOGNITION 302

It’s Back 302

The Current Environment 304

Revenue Recognition at Point of Sale

(Delivery) 307

Revenue Recognition before Delivery 310

Convergence Corner Revenue Recognition 323

Behind the Numbers: Appendix 7A 326

Revenue Recognition Procedures 326

Valuation of Accounts Receivable 365

Recognition of Notes Receivable 371

Valuation of Notes Receivable 376 Disposition of Accounts and Notes Receivable 377

Presentation and Analysis 382

Convergence Corner Cash and Receivables 384

Behind the Numbers: Appendix 8A 388

Cash Controls 388

C h a p t e r 9

ACCOUNTING FOR INVENTORIES 418

Inventories in the Crystal Ball 418

Inventory Classification and Systems 420

Basic Issues in Inventory Valuation 423

Special Issues Related to LIFO 432

Comparison of LIFO Approaches 437

Lower-of-Cost-or-Market 442

Methods of Applying

Convergence Corner Inventories 450

Behind the Numbers: Appendix 9A 454

Gross Profit Method 454

C h a p t e r 1 0

ACCOUNTING FOR PROPERTY, PLANT,

AND EQUIPMENT 486

Where Have All the Assets Gone? 486

Acquisition and Valuation of Property, Plant,

Costs Subsequent to Acquisition 496

Use of Property, Plant, and Equipment:

Depreciation 500

Dispositions of Plant Assets 509

Presentation and Analysis 516

Presentation of Property, Plant, and

Convergence Corner Property, Plant,

Types of Intangible Assets 558

Research and Development Costs 574

Presentation of Intangibles and Related Items 578

Presentation of Research and Development

Convergence Corner Intangible Assets 582

C h a p t e r 1 2

ACCOUNTING FOR LIABILITIES 604

Now You See It, Now You Don’t 604

Section 1 Current Liabilities 606

Bonds Issued at Discount or Premium on Interest

Presentation and Analysis 631

Convergence Corner Liabilities 636

Behind the Numbers: Appendix 12A 640

Effective-Interest Amortization 640

C h a p t e r 1 3

STOCKHOLDERS’ EQUITY 670

Everything Else Equal? 670

The Corporate Form of Organization 672

Corporate Capital 674

Preferred Stock 684

Accounting for and Reporting Preferred

Convergence Corner Stockholders’ Equity 701

Behind the Numbers: Appendix 13A 705

Accounting for Financial Instruments with Both Debt and Equity Characteristics 705

Who’s in Control Here? 730

Section 1 Investments in Debt Securities 732

Held-to-Maturity Securities 733 Available-for-Sale Securities 736

Trading Securities 740

Section 2 Investments in Equity Securities 742

Contents xxvii

Holdings of Less Than 20% 743

Holdings Between 20% and 50% 746

Holdings of More Than 50% 748

Section 3 Other Reporting Issues 749

Financial Statement Presentation of

Transfers Between Categories 756

Fair Value Controversy 756

Summary of Reporting Treatment of

Future Deductible Amounts and Deferred

Accounting for Net Operating Losses 796

Financial Statement Presentation 803

Review of the Asset–Liability Method 809

Convergence CornerIncome Taxes 814

C h a p t e r 1 6

ACCOUNTING FOR COMPENSATION 840

Where Have All the Pensions Gone? 840

Salary and Bonuses 842

Stock Compensation Plans 846

Postretirement Benefits 854

Concluding Remarks 871

Convergence Corner Compensation 873

C h a p t e r 1 7

ACCOUNTING FOR LEASES 890

More Companies Ask, “Why Buy?” 890

The Leasing Environment 892

Accounting by the Lessee 896

Comparison of Capital Lease with Operating

Accounting by the Lessor 907

Other Accounting Issues 913

Lease Accounting _Unresolved Problems 916

Convergence Corner Lease Accounting 918

C h a p t e r 1 8

ADDITIONAL REPORTING ISSUES 940

So Many Changes 940

Section 1 Accounting Changes 942

Changes in Accounting Principle 942

Section 2 Reporting Earnings per Share 959

Earnings per Share _Simple Capital

Structure 960

Weighted-Average Number of Shares

Earnings per Share _Complex Capital

Structure 964

Convergence Corner Additional Financial Reporting

A p p e n d i x A

ACCOUNTING AND THE TIME VALUE OF MONEY 1000

Applications of Time Value Concepts 1000

Single-Sum Problems 1007

Solving for Other Unknowns in Single-Sum

Contents xxix

Annuities 1012

Examples of Future Value of Annuity

Examples of Present Value of Annuity

More Complex Situations 1023

Effective-Interest Method of Amortization of Bond

Present Value Measurement 1027

A p p e n d i x B

REPORTING CASH FLOWS 1050

Section 1 Indirect Method 1050

Preparing the Statement of Cash Flows 1051

Step 1: Determining the Net Increase/Decrease

Step 2: Determining Net Cash Flow Provided/Used

Step 3: Determining Net Cash Flow Provided/Used

Special Problems in Statement Preparation 1054

Section 2 Direct Method 1060

Indirect Method 1061 Direct Method —An Example 1061

Summary of Net Cash Flow from Operating

Company Index I-1

Subject Index I-3

䊏 Official Accounting Pronouncements P-1

A p p e n d i x C

USING FINANCIAL CALCULATORS 00

Future Value of a Single Sum 00

Present Value of a Single Sum 00

Future Value of an Ordinary Annuity 00

Future Value of an Annuity Due 00

Present Value of an Ordinary Annuity 00

Useful Applications of the Financial

Calculator 00

A p p e n d i x D

RETAIL INVENTORY METHOD 00

Retail Method Concepts 00

Retail Inventory Method with Markups and

Markdowns _Conventional Method 00

Special Items Relating to Retail Method 00

Evaluation of Retail Method 00

A p p e n d i x E

ACCOUNTING FOR NATURAL RESOURCES 00

Depletion 00

Presentation of Natural Resources 00

A p p e n d i x F

ACCOUNTING FOR COMPUTER SOFTWARE COSTS 00

Diversity in Practice 00

The Profession’s Position 00

Accounting for Capitalized Software Costs 00

Reporting Software Costs 00

Setting Standards for Software Accounting 00

Basic Principles in Accounting for Derivatives 00

Differences Between Traditional and Derivative

Derivatives Used for Hedging 00

Other Reporting Issues 00

Comprehensive Hedge Accounting Example 00

Financial Statement Presentation of an Interest

Comprehensive Example: Numerous Errors 00 Preparation of Financial Statements with Error Corrections 00

This page intentionally left blank

Enron, Global Crossing, Kmart, WorldCom, Williams Cos., and Xerox are all

companies that the Securities and Exchange Commission (SEC) recently nized because of accounting issues Share prices of all these companies havedeclined substantially Investors punish any company whose quality of earnings

scruti-is in doubt

The unfortunate part of accounting scandals is that we all pay For example,Enron’s market capitalization totaled $80 billion before disclosure of its account-ing irregularities Today, it is bankrupt Employees lost their pension money andinvestors their savings Further, the entire stock market caught “Enronitis,” a distrust of accountingthat has led to substantial declines in the overall stock market At one point, at least 10 congressionalcommittees were inquiring into corporate governance issues, and Congress introduced over 30 Enron-related bills that addressed matters such as regulation of derivative securities, auditor–client conflicts,and development of an oversight body to regulate the accounting profession

Companies have also taken steps to respond to the many investor concerns about the pleteness and reliability of the accounting numbers Many companies now expand the financial dis-closures in their annual reports For example, General Electric’s CEO Jeffrey Immelt stated, “I wantpeople to think about GE as we think of GE—as a transparent company.” He noted that GE’s annualreport will be “the size of New York City’s phone book, if necessary” to provide the information needed

com-to help invescom-tors and credicom-tors make the proper investing decisions

We believe that meaningful reform will come out of these recent investigations into sloppy orfraudulent accounting Although many consider the United States to have the finest financial report-ing system in the world, we must do better As former chair of the FASB Ed Jenkins remarked recently,

“If anything positive results it may be that [these accounting issues] serve as an indelible reminder

to all that transparent financial reporting does matter and that lack of transparency imposes significantcosts on all who participate [in our markets].”

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3

Learning Objectives

After studying this chapter, you should be able to:

1. Identify the major financial statements and other

means of financial reporting.

2. Explain how accounting assists in the efficient use of

scarce resources.

3. Describe some of the challenges facing accounting.

4. Identify the objectives of financial reporting.

5. Explain the need for accounting standards.

6. Identify the major policy-setting bodies and their role

in the standard-setting process.

7. Explain the meaning of generally accepted accounting

䊏 What Do the Numbers Mean?

“It’s not the economy anymore, stupid” (p 5)You have to step back (p 15)

The economic consequences of goodwill (p 17)

䊏 What’s the Principle? (pp 5, 6, 16, 19)

䊏 Accounting, Analysis, Principles (p 21)Identify and discuss two major entitiesinvolved in standard setting,

Indicate reasons for increase in financialinformation in annual reports

Identify concepts and principles related to theexpansion of financial reporting

Preview of Chapter 1

As our opening story indicates, companies must provide relevant and reliable

information so that our capital markets work efficiently This chapter explains the

environment of financial r eporting and the many factors affecting it, as

䊏 Governmental Accounting Standards Board (GASB)

䊏 Changing role of the AICPA

The essential characteristics of accounting are: (1) the identification, measurement, and munication of financial information about (2) economic entities to (3) interested parties.

com-Financial accountingis the process that culminates in the preparation of financial reports onthe enterprise for use by both internal and external parties Users of these financial reports in-

clude investors, creditors, managers, unions, and government agencies In contrast, managerial accounting is the process of identifying, measuring, analyzing, and communicating financial

information needed by management to plan, control, and evaluate a company’s operations.Financial statements are the principal means through which a company communicates itsfinancial information to those outside it These statements provide a company’s history quan-tified in money terms The financial statementsmost frequently provided are (1) the balancesheet, (2) the income statement, (3) the statement of cash flows, and (4) the statement of own-ers’ or stockholders’ equity Note disclosures are an integral part of each financial statement.Some financial information is better provided, or can be provided only, by means of

financial reportingother than formal financial statements Examples include the president’sletter or supplementary schedules in the corporate annual report, prospectuses, reports filedwith government agencies, news releases, management’s forecasts, and social or environ-mental impact statements Companies may need to provide such information because ofauthoritative pronouncement, regulatory rule, or custom Or they may supply it becausemanagement wishes to disclose it voluntarily

In this textbook, we focus on the development of two types of financial information:(1) the basic financial statements and (2) related disclosures

Accounting and Capital Allocation

Resources are limited As a result, people try to conserve them and ensure that they areused effectively Efficient use of resources often determines whether a business thrives Thisfact places a substantial burden on the accounting profession

Accountants must measure performance accurately and fairly on a timely basis, so thatthe right managers and companies are able to attract investment capital For example, rel-evant and reliable financial information allows investors and creditors to compare the incomeand assets employed by such companies as IBM, McDonald’s, Microsoft, and Ford.Because these users can assess the relative return and risks associated with investmentopportunities, they channel resources more effectively Illustration 1-1 shows how thisprocess of capital allocation works

The financial information

a company provides to help users with capital allocation decisions about the company.

Investors and creditors use financial reports to make their capital allocation decisions.

Users (present and potential)

The process of determining how and at what cost money is allocated among competing interests.

1AICPA Special Committee on Financial Reporting, “Improving Business Reporting—A Customer

Focus,” Journal of Accountancy, Supplement (October 1994).

Financial Statements and Financial Reporting 5

It’s not the economy anymore It’s the accounting That’s what many investors seem to be saying these

days As indicated in our opening story, even the slightest hint of any accounting irregularity at a

com-pany leads to a subsequent pounding of the comcom-pany’s stock price For example, recent editions of the

Wall Street Journal had the following headlines related to accounting and its effects on the economy.

• Stocks take a beating as accounting woes spread beyond Enron.

• Once hot Krispy Kremeousts its CEO amid accounting woes.

• Nortelunveils new accounting flubs.

• Accounting woes at AIGtake their toll on insurers’ shares.

• Bank stocks fall as investors take issue with PNC’s accounting.

It now has become clear that investors must trust the accounting numbers or they will abandon

the market and put their resources elsewhere With investor uncertainty, the cost of capital increases

for companies who need additional resources In short, relevant and reliable financial information is

necessary for markets to be efficient.

Beyond the Numbers

Explain the difference between relevance and reliability Why are these concepts important in

re-porting financial information?

What do the numbers mean? “It’s Not the Economy Anymore, Stupid”

The Challenges Facing Financial Accounting

Much is right about financial reporting in the United States We presently have the most

liquid, deep, secure, and efficient public capital markets of any country at any time in

his-tory One reason for this success is that our financial statements and related disclosures

cap-ture and organize financial information in a relevant and reliable fashion However, much

still needs to be done For example, if we move to the year 2020 and look back at

finan-cial reporting today, we might read the following:

• Nonfinancial Measurements.Financial reports failed to provide some key

per-formance measures widely used by management, such as customer satisfaction

indexes, backlog information, and reject rates on goods purchased

• Forward-looking Information.Financial reports failed to provide forward-looking

information needed by present and potential investors and creditors One individual

noted that financial statements in 2005 should have started with the phrase, “Once

upon a time,” to signify their use of historical cost and accumulation of past events

• Soft Assets.Financial reports focused on hard assets (inventory, plant assets) but

failed to provide much information about a company’s soft assets (intangibles)

The best assets are often intangible Consider Microsoft’s know-how and market

dominance, Dell’s unique marketing setup and well-trained employees, and

J Crew’s brand image

• Timeliness.Companies only prepared financial statements quarterly, and provided

audited financials annually Little to no real-time financial statement information was

available

We believe each of these challenges must be met for the accounting profession to

pro-vide the type of information needed for an efficient capital allocation process We are

con-fident that changes will occur, based on these positive signs:

• Already some companies voluntarily disclose information deemed relevant to investors

Often such information is nonfinancial For example, regional banking companies, such

as BankOne Corp., Fifth Third Bancorp, and Sun Trust Banks, now include data

on loan growth, credit quality, fee income, operating efficiency, capital management,

and management strategy

Describe some of the challenges facing accounting.

WHAT’S THE PRINCIPLE?

Relevance and reliability

are the two primary qualities that make accounting information useful for decision making Discussions in the “What’s the Principle?” boxes throughout the text highlight the essential idea or principle that you will want to remember about the topic being

studied.

• Initially, companies used the World Wide Web to provide limited financial data Nowmost companies publish their annual reports in several formats on the Web The mostinnovative companies offer sections of their annual reports in a format that the usercan readily manipulate, such as in an Excel spreadsheet format Companies also for-mat their financial reports using extensible business reporting language (XBRL),which permits quicker and lower cost access to companies’ financial information.

• More accounting standards now require the recording or disclosing of fair value tion For example, companies either record investments in stocks and bonds, debt obliga-tions, and derivatives at fair value or companies show information related to fair values inthe notes to the financial statements

informa-Changes in these directions will enhance the relevance of financial reporting and vide useful information to financial statement readers

pro-Objectives of Financial Reporting

To establish a foundation for financial accounting and reporting, the accounting professionidentified a set of objectives of financial reporting by business enterprises Financial

reporting should provide information that:

1 Is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions The information should be com- prehensible to those who have a reasonable understanding of business and eco-

nomic activities and are willing to study the information with reasonable diligence

2 Helps present and potential investors, creditors, and other users assess the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and

the proceeds from the sale, redemption, or maturity of securities or loans Since vestors’ and creditors’ cash flows are related to enterprise cash flows, financial report-ing should provide information to help investors, creditors, and others assess the amounts,timing, and uncertainty of prospective net cash inflows to the related enterprise

in-3 Clearly portrays the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and own-

ers’ equity), and the effects of transactions, events, and circumstances that change itsresources and claims to those resources.2

In brief, the objectives of financial reporting are to provide information that is (1) useful

in investment and credit decisions, (2) useful in assessing cash flow prospects, and (3) aboutcompany resources, claims to those resources, and changes in them

The emphasis on “assessing cash flow prospects” does not mean that the cash basis ispreferred over the accrual basis of accounting That is not the case Information based on

accrual accounting generally better indicates a company’s present and uing ability to generate favorable cash flows than does information limited to the

contin-financial effects of cash receipts and payments.3Recall from your first accounting course the objective of accrual-basis accounting: It ensures that a company records events that change its financial state-ments in the periods in which the events occur, rather than only in the periods inwhich it receives or pays cash Using the accrual basis to determine net incomemeans that a company recognizes revenues when it earns them rather than when it

recognized when earned,

and expenses are recognized

financial reporting differ

across nations Traditionally,

the primary objective of

accounting in many

continental European

nations and in Japan was

conformity with the law In

contrast, Canada, the U.K.,

the Netherlands, and many

other nations share the U.S.

view that the primary

objective is to provide

information for investors.

Parties Involved in Standard Setting 7

4Management’s fiduciary responsibility is to manage assets with care and trust

5

The terms principles and standards are used interchangeably in practice and throughout this

textbook

receives cash Similarly, it recognizes expenses when it incurs them rather than when it

pays them Under accrual accounting, a company generally recognizes revenues when it

makes sales The company can then relate the revenues to the economic environment of the

period in which they occurred Over the long run, trends in revenues and expenses are

gen-erally more meaningful than trends in cash receipts and disbursements

The Need to Develop Standards

The main controversy in setting accounting standards is, “Whose rules should we play by,

and what should they be?” The answer is not immediately clear Users of financial accounting

statements have both coinciding and conflicting needs for information of various types To

meet these needs, and to satisfy the fiduciary4 reporting responsibility of management,

companies prepare a single set of general-purpose financial statements Users expect these

statements to present fairly, clearly, and completely the company’s financial operations

The accounting profession has attempted to develop a set of standards that are

gen-erally accepted and universally practiced Otherwise, each enterprise would have to

develop its own standards Further, readers of financial statements would have to

familiarize themselves with every company’s peculiar accounting and reporting

prac-tices It would be almost impossible to prepare statements that could be compared

This common set of standards and procedures is called generally accepted accounting

principles (GAAP) The term “generally accepted” means either that an authoritative

accounting rule-making body has established a principle of reporting in a given area or that

over time a given practice has been accepted as appropriate because of its universal

appli-cation.5Although principles and practices continue to provoke both debate and criticism,

most members of the financial community recognize them as the standards that over time

have proven to be most useful We present a more extensive discussion of what constitutes

GAAP later in this chapter

PARTIES INVOLVED IN STANDARD SETTING

Four organizations are instrumental in the development of financial accounting standards

(GAAP) in the United States:

1 Securities and Exchange Commission (SEC)

2 American Institute of Certified Public Accountants (AICPA)

3 Financial Accounting Standards Board (FASB)

4 Government Accounting Standards Board (GASB)

Securities and Exchange Commission (SEC)

External financial reporting and auditing developed in tandem with the growth of the

in-dustrial economy and its capital markets However, when the stock market crashed in 1929

and the nation’s economy plunged into the Great Depression, there were calls for increased

government regulation of business generally, and especially financial institutions and the

stock market

As a result of these events, the federal government established the Securities and

Exchange Commission (SEC) to help develop and standardize financial information

presented to stockholders The SEC is a federal agency It administers the Securities

INTERNATIONAL INSIGHT

The International Organization of Securities Commissions (IOSCO), established in 1987, consists of more than 100 securities regulatory agen- cies or securities exchanges from all over the world Collectively, its members represent a substantial proportion of the world’s capital markets The SEC is

a member of IOSCO.

Explain the need for accounting standards.

Identify the major policy-setting bodies and their role in the standard-setting process.

Exchange Act of 1934 and several other acts Most companies that issue securities to thepublic or are listed on a stock exchange are required to file audited financial statementswith the SEC In addition, the SEC has broad powers to prescribe, in whatever detail it de-sires, the accounting practices and standards to be employed by companies that fall withinits jurisdiction The SEC currently exercises oversight over 12,000 companies that are listed

on the major exchanges (e.g., the New York Stock Exchange and the Nasdaq)

Public/Private Partnership

At the time the SEC was created, no group—public or private—issued accounting dards The SEC encouraged the creation of a private standard-setting body because itbelieved that the private sector had the appropriate resources and talent to achieve this daunt-ing task As a result, accounting standards have developed in the private sector either throughthe American Institute of Certified Public Accountants (AICPA) or the Financial Account-ing Standards Board (FASB)

stan-The SEC has affirmed its support for the FASB by indicating that financial statementsconforming to standards set by the FASB are presumed to have substantial authoritative

support In short, the SEC requires registrants to adhere to GAAP In addition, the SEC

indicated in its reports to Congress that “it continues to believe that the initiative for tablishing and improving accounting standards should remain in the private sector, subject

es-to Commission oversight.”

SEC Oversight

The SEC’s partnership with the private sector works well The SEC acts with remarkable

restraint in the area of developing accounting standards Generally, the SEC relies on the FASB to develop accounting standards.

The SEC’s involvement in the development of accounting standards varies In somecases, the SEC rejects a standard proposed by the private sector In other cases, the SECprods the private sector into taking quicker action on certain reporting problems, such asaccounting for investments in debt and equity securities and the reporting of derivative in-struments In still other situations, the SEC communicates problems to the FASB, responds

to FASB exposure drafts, and provides the FASB with counsel and advice upon request.The SEC’s mandate is to establish accounting principles The private sector, therefore,must listen carefully to the views of the SEC In some sense the private sector is the for-mulator and the implementor of the standards.6However, when the private sector fails toaddress accounting problems as quickly as the SEC would like, the partnership betweenthe SEC and the private sector can be strained This occurred in the recent deliberations onthe accounting for business combinations and intangible assets, and concerns over the ac-counting for off-balance sheet special-purpose entities, highlighted in the failure of Enron

Enforcement

As we indicated earlier, companies listed on a stock exchange must submit their financialstatements to the SEC If the SEC believes that an accounting or disclosure irregularity ex-ists regarding the form or content of the financial statements, it sends a deficiency letter tothe company Companies usually resolve these deficiency letters quickly However, if dis-agreement continues, the SEC may issue a “stop order,” which prevents the registrant fromissuing or trading securities on the exchanges The Department of Justice may also file

8 Chapter 1 䊏 Financial Accounting and Accounting Standards

6One writer described the relationship of the FASB and SEC and the development of financial porting standards using the analogy of a pearl The pearl (a financial reporting standard) “is formed

re-by the reaction of certain oysters (FASB) to an irritant (the SEC)—usually a grain of sand—that comes embedded inside the shell The oyster coats this grain with layers of nacre, and ultimately apearl is formed The pearl is a joint result of the irritant (SEC) and oyster (FASB); without both, it

be-cannot be created.” John C Burton, “Government Regulation of Accounting and Information,” Journal

of Accountancy (June 1982).

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